Undervalued Currency

Definition

An undervalued currency is a currency whose exchange rate is lower than its fundamental value, meaning it is underpriced relative to other currencies. This can occur due to various economic factors and government interventions in the foreign exchange market.

5 Must Know Facts For Your Next Test

1. An undervalued currency can make a country's exports more affordable and imports more expensive, potentially leading to a trade surplus.
2. Governments may intentionally undervalue their currency to boost exports and economic growth, a practice known as currency manipulation.
3. Undervalued currencies can lead to inflation, as imports become more expensive, and can also distort international trade and investment flows.
4. Determining whether a currency is undervalued or not is challenging and often involves comparing the exchange rate to the currency's purchasing power parity (PPP).
5. Addressing an undervalued currency can be a complex policy challenge, as it may require a combination of monetary, fiscal, and trade policy measures.

Review Questions

• Explain how an undervalued currency can impact a country's trade balance.
  • An undervalued currency can make a country's exports more affordable for foreign buyers, leading to an increase in demand for its exports. At the same time, imports become more expensive, making them less attractive to domestic consumers. This can result in a trade surplus, as the country's exports outpace its imports. The improved trade balance can help boost the country's economic growth, but it can also lead to tensions with trading partners and potential accusations of currency manipulation.
• Describe the role of purchasing power parity (PPP) in determining whether a currency is undervalued.
  • Purchasing power parity (PPP) is an economic theory that suggests the exchange rate between two currencies should equalize the prices of an identical basket of goods and services in those countries. If a currency's exchange rate is lower than its PPP, it may be considered undervalued. Comparing a currency's exchange rate to its PPP can provide insights into whether the currency is overvalued or undervalued, but it's important to note that PPP calculations can be complex and subject to various assumptions and limitations.
• Evaluate the potential consequences of a government's intentional undervaluation of its currency and the policy challenges involved in addressing it.
  • Intentional currency undervaluation by a government, known as currency manipulation, can have significant consequences. It can distort international trade and investment flows, leading to tensions with trading partners and potentially triggering retaliatory measures. An undervalued currency can also contribute to domestic inflation, as imports become more expensive. Addressing an undervalued currency can be a complex policy challenge, as it may require a combination of monetary, fiscal, and trade policy measures. Policymakers must carefully weigh the potential benefits of an undervalued currency, such as boosting exports, against the potential drawbacks, such as inflation and trade disputes. Striking the right balance and implementing effective policies to address an undervalued currency can be a delicate and challenging task.

Related terms

Exchange Rate:

The price of one currency in terms of another, which fluctuates based on the supply and demand for the currencies in the foreign exchange market.

Currency Manipulation: The act of a government or central bank intentionally influencing the exchange rate of its currency to gain an unfair competitive advantage in international trade.

Purchasing Power Parity (PPP): An economic theory that states that the exchange rate between two currencies should equalize the prices of an identical basket of goods and services in those countries.