Currencies: Overpriced and Underpriced

Types of Exchange Rate:

3 Factors Affecting Exchange Rates:

Undervaluing/ Overvaluing a Currency:

Advantages of Undervaluation:

  • The local economy is boosted because foreign currencies are more powerful leading to a large amount of the local currency being made from a small quantity of foreign currency. As a result, exports from the country increase as a result of this.
  • FDI becomes more attractive because the power of foreign currency means that firms can buy more land in the countries with undervalues currencies.
  • The local economy and economic growth is promoted because of the high levels of consumption of the economy.
  • Local firms are protected from foreign competition because the undervalued local currency mean that foreign products are overpriced.
  • The increased FDI creates new jobs in the local country promoting further economic growth

Disadvantages of Undervaluation:

  • The lack of foreign competition reduce competitiveness in the local country and therefore puts less pressure on firms to operate efficiently and optimally.
  • For a country with a limited labour supply, the increasing demand for jobs creating from foreign firms establishing in the country paired with reducing labour force means that wages for labour increases which leads to inflation. This has begun to occur in china after the one child policy had its full effect on the economy.

Advantages Of Overvaluation:

  • For a country which is dependant on its imports from emerging countries for goods and services, an overvalued local currency allows it to afford more foreign currency and therefore afford more of the outstanding good they wish to import.
  • An overvalued currency also creates increased political stability to the extent that some imports are handled/subsidised by the local government. The act of devaluing an overpriced currency would increase the cost of the imported good and therefore would cause the population to go into protest. Therefore, devaluing would be detrimental to the ruling regime
  • Having overvalued currencies will increase the level of imports which will settle inflationary pressure of the local currency. However, we need to consider that by doing so this will cause increased inflationary pressure on a foreign currency as their demand will increase leading to demand pull inflation.

Disadvantages of Overpricing:

  • There is less incentive for foreign firms to export from the country since it is cheaper for them to do so by exporting from a currency that is undervalued.
  • Local economy and labour demand will be dampened since foreign exports will seem artificially cheaper compared to manufacturing directly in the local country.
  • Reduced FDI from foreign countries because the conversion rates mean that there will be less purchasing power from a foreign currency in the overvalued currency.

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