Question

Devaluation is of ten used by countries to improve their current accounts. Since the current account equals national saving less domestic investment, however (see Chapter 13), this improvement can occur only if investment falls, saving rises, or both. How might devaluation affect national saving and domestic investment?

Short answer

Devaluation may increase national saving by reducing consumption and imports while potentially increasing income from boosted exports. It can decrease domestic investment due to higher import costs for capital goods, creating an overall improvement in the current account if changes lead to a greater increase in saving than the decrease in investment.

Step-by-step solution

Understanding Devaluation

Devaluation refers to the reduction of a country's currency value against other currencies. It can potentially make a country's exports cheaper and imports more expensive, influencing trade balances.

Impact on National Saving

Because devaluation can make imports more expensive, consumers and firms within the country may reduce consumption and increase saving. Also, if exports increase due to improved competitiveness, it can lead to higher income and thus, potentially higher national saving.

Impact on Domestic Investment

Devaluation may discourage domestic investment because it can lead to increased cost of imported capital goods and raw materials, and create uncertainty in the economy. Conversely, it may encourage foreign investment if investors expect the currency to strengthen in the future.

Combining the Effects

To improve the current account, the effects of devaluation must lead to a net increase in national saving, a net decrease in domestic investment, or both. These changes can affect the balance of the current account through altered trade activity and capital flows.

Key concepts

Current Account Balance and Devaluation

When a country undergoes currency devaluation, it directly affects the current account balance—a measure of a nation's trade where the value of its exports of goods and services is compared to its imports. If a country's currency is devalued, the immediate effect is that its exports become less expensive to the rest of the world, which can stimulate demand for those exports.

Increased demand for exports can improve the trade balance, one of the critical components of the current account. Conversely, imports become more expensive, which tends to reduce the volume of imports. This change can potentially lead to a higher current account balance. However, this isn't a foolproof solution. If a country imports a significant amount of its raw materials and capital goods, the increased costs could offset gains from rising exports.

National Saving in the Context of Devaluation

National saving, which is the sum of private and public saving, can be influenced by currency devaluation. When the cost of imported goods rises due to a weaker currency, consumers may opt to save more rather than spend on expensive imports. This substitution effect towards savings can be part of a strategy to enhance financial security against economic uncertainty caused by devaluation.

Meanwhile, higher national income from a boost in export sales can also lead to increased saving, especially if households anticipate future economic fluctuations. It's important to understand that while devaluation can incentivize saving by increasing income from exports and decreasing consumption of imports, it may not always lead to an increase in overall national saving if the government's fiscal policy responds with increased spending, effectively offsetting gains in private saving.

Domestic Investment After Devaluation

Regarding domestic investment, devaluation can have contrasting effects. On one hand, the cost of imported capital goods could become prohibitive, slowing down investment in industries reliant on foreign machinery and technology. Higher prices on imports can deter firms from undertaking new investments, thus potentially reducing the domestic investment component.

On the other hand, with exports gaining a competitive edge, businesses might see an opportunity to expand production and invest domestically to meet international demand. Moreover, speculative foreign investors might delve into the market, anticipating a future appreciation of the currency. These dynamics suggest that devaluation can both hinder and facilitate domestic investment, and the net effect will depend on a myriad of factors including investor confidence, industry reliance on imports, and the elasticity of global demand for a country's exports.