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Home > Economics FAQs Blogs > What is the difference between external devaluation and internal devaluation?

What is the difference between external devaluation and internal devaluation?

Relevant Topics

This question pertains to topics in Macroeconomics, such as Exchange Rate, Internal Devaluation, External Devaluation

Definitions:

External Devaluation: This is a deliberate downward adjustment to the value of a country's currency relative to another currency, group of currencies, or standard. It is often orchestrated by the central bank and is typically used to correct a trade imbalance.

Internal Devaluation:
This is an economic policy that seeks to restore a country's international competitiveness without altering the value of its currency. It is often achieved through measures such as reducing wages, lowering prices, and increasing productivity.

Detailed Explanation:

External devaluation typically occurs when a country is operating under a fixed or pegged exchange rate system. The aim is to make the country's exports cheaper and imports more expensive, thereby encouraging domestic production and reducing the trade deficit. However, this could also lead to imported inflation as the cost of imported goods and services rise.

On the other hand, internal devaluation is often adopted by countries in a monetary union or those that do not want to devalue their currency for other reasons. It involves policies that lower domestic costs, including labour costs, to boost competitiveness. The downsides could include reduced domestic demand due to lower wages and a risk of deflation.

Recent: 

United Kingdom (1967): The UK carried out an external devaluation of the pound sterling by 14% against the US dollar. The move was aimed at boosting the UK's faltering economy by making its exports more competitive.

Latvia (2008-2010):
During the financial crisis, Latvia, being part of the European Exchange Rate Mechanism (ERM II), couldn't devalue its currency, so it pursued an aggressive internal devaluation policy. This involved severe wage cuts and austerity measures to restore its competitiveness.

Summary:

In summary, external devaluation and internal devaluation are two strategies used by governments to improve their international competitiveness. While external devaluation involves lowering the value of the country's currency, internal devaluation focuses on reducing domestic costs such as wages. Both have their advantages and potential drawbacks, and the choice between them often depends on a country's specific economic context and policy preferences.

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