Devaluation Question! Any help would be appreciated! Background: In the summer o
ID: 1193305 • Letter: D
Question
Devaluation Question! Any help would be appreciated!
Background: In the summer of 1997, Thailand experienced a speculative attack on its currency (the Baht), which was under a xed exchange rate regime. Unable to meet the demand for its foreign currency reserves, Thailand was forced to oat its currency. This precipitated an economic crisis not only in that country but also many other East Asian nations, as panic over the nancial stability of those countries led to runs on foreign exchange reserves there as well. The factors that made these counties vulnerable to speculative attack and currency runs, as well as the reasons that such attacks had such a negative impact on their economies, are numerous and well-documented. Corsetti et al. (1999) provide a useful summary.
Question: One reason that devaluation aected the economies was that their corporations held large amounts of debt that was denominated in foreign currency. Why would this be bad for the economy in the face of devaluation?
Explanation / Answer
Devaluation refers to the reduction in price of domestic currency in terms of foriegn currency.
This implies that now more units of domestic currency are needed to buy one unit of foriegn currency. In other words, foreign currency has become dearer.
When large amount of debt of corpoartions in an economy is denominated in foriegn currency and the economy devalues its currency then equivalent amount of debt in terms of domestic currency automatically increases because now 1 unit of foriegn currency commands more units of domestic currency with respect to period before devaluation.
This automatic increase in value of debt of corporations in terms of domestic currency due to devaluation when debt is denominated in foriegn currency can result in unsustainable level of debt and could lead to liquidation and bankruptcy of corpoartions making economic situation more fragile and therefore is considered bad for the economy in the face of devaluation.
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