Question 97 from UPSC CSE 2021 - Economics

Question

Consider the following statements:
1. The effect of devaluation of a currency is that it necessarily improves the competitiveness of the domestic exports in the foreign markets.
2. The effect of devaluation of a currency is that it necessarily increases the foreign value of domestic currency.
3. The effect of devaluation of a currency is that it necessarily improves the trade balance.
Which of the above statements is/are correct?

Accepted Answer

Correct Option: A. 1 only

Strategy: Analyze the keywords: 'devaluation', 'necessarily', and the effects described for exports, currency value, and trade balance. Recognize that devaluation lowers the foreign value of the currency, not increases it, ruling out statement 2. Improving export competitiveness (statement 1) follows directly from lower currency value, making exports cheaper. However, 'necessarily improves trade balance' (statement 3) is too absolute; devaluation may not always result in a favorable trade balance due to various economic factors such as price elasticity of demand for imports and exports. Thus, only statement 1 is correct.

Key Info: Devaluation is the deliberate downward adjustment of a country's currency value relative to another currency, typically within a fixed or managed exchange rate regime. This measure is often employed to boost exports by making domestic goods cheaper for foreign buyers, thereby improving the international competitiveness of the country's products. However, devaluation also makes imports costlier, increasing the domestic price of imported goods and potentially leading to imported inflation.

- Devaluation lowers the foreign value of the domestic currency; after devaluation, more units of the domestic currency are needed to buy one unit of foreign currency.
- The effect of devaluation on the trade balance is not guaranteed to be positive. It depends on the price elasticity of both exports and imports. If the quantity of exports does not significantly increase or if imports are inelastic, the trade balance may not improve. For example, essential imports like crude oil can keep the trade deficit high even after devaluation.
- The impact of devaluation is governed by the Marshall-Lerner condition, which states that the trade balance will improve only if the combined price elasticity of exports and imports is greater than one.
- Historical examples include the 1966 and 1991 devaluations of the Indian rupee, both of which had complex and varied effects on trade balance depending on prevailing economic conditions.
- Devaluation is distinct from depreciation. Depreciation is a market-driven decrease in currency value under a floating exchange rate system.

Answer

Option B: 1 and 2

Answer

Option C: 3 only

Answer

Option D: 2 and 3