Question

What does it mean to say that a currency is overvalued? undervalued?

Short answer

An overvalued currency means its current price is higher than its fair market value, which often results in expensive exports and cheaper imports, negatively impacting domestic industries. An undervalued currency, on the other hand, is priced lower than its fair market value, making exports cheaper and imports more expensive, which can positively affect the trade balance but lead to inflation and lower domestic buying power.

Step-by-step solution

Definition of Overvalued Currency

A currency is said to be overvalued when its current price is higher than its fair market value. This could happen due to various reasons such as government's monetary policy, economic indicators, interest rates, and market speculation.

Implication of Overvalued Currency

An overvalued currency could make a country's exports more expensive and imports cheaper which could negatively impact the domestic industries and balance of trade.

Definition of Undervalued Currency

A currency is said to be undervalued when its current price is lower than its fair market value. Like overvaluation, several factors could cause this like a country's monetary policies, economic conditions, market perception, etc.

Implication of Undervalued Currency

An undervalued currency could make a country's exports cheaper and imports more expensive. While this could improve the trade balance by promoting exports, it might also increase inflation and reduce the buying power of the domestic consumers.