The Reltaionship Between Devaluation and Inflation

A devaluation leads to a decline in the value of a currency making exports more competitive and imports more expensive. Inflation occurs when there is an increase in the general price level.

A devaluation could cause inflation for 3 reasons.

Firstly, there is likely to be an increase in AD. AD = C+I+G+X-M, Therefore if exports are cheaper will be more exports sold , imports will fall. If the economy is close to full capacity then higher AD will cause inflation.

Diagram: Demand Pull inflation

However, increased AD may not cause inflation it depends on various factors:

a) If the economy is in recession and there is spare capacity there will not be inflation

b) IF other components of AD are not increasing (e.g. consumer spending is low) then there is unlikely to be demand pull inflation. (X-M is not the biggest component of AD)

c) Also if exports are cheaper then the effect on AD depends upon the elasticity of demand. IF demand is inelastic there will only be a small increase in Quantity and there could be a fall in the value of exports (Marshall Lerner condition states devaluation only increases AD if PEDx + PEDm >1)

Secondly, if there is a devaluation then there