Devalue, Revalue, Depreciate, Appreciate

It's no wonder that most people don't understand the world of exchange rates. It's as if economists speak a differenct language. Devalue and Revalue are terms that are applied to the changing price of a currency when the exchange rates are fixed. Devalue is a policy of reducing the value of the currency. Revalue is the opposite. We recently wrote a blog on the revaluation of the Chinese yuan. Depreciate and Appreciate are a decrease and increase, respectively, in the value of a currency when the currency is allowed to float. Clear?

Last week, the Japanese government intervened in currency markets to reduce the value of the yen. This is not a devaluation, as the yen floats. This is an example of an exchange rate policy designed to stimulate economic activity. As the yen falls, Japanese exports become cheaper. Exports rise as does aggregate demand ... at least in theory. A Bloomberg news story (Click here for article) reported last Friday that the intervention was "unsterilized".  (Still clear?)

As explained in the previous blog, when a central bank intervenes, their action involves a foreign currency. In this case, the Bank of Japan sold yen and purchased US dollars. Selling yen increases the supply of yen on foreign markets and makes the price of the yen fall. This is what leads to the increase in aggregate demand and output. There is a risk to this policy however. Those yen will enter into the Japanese money supply and if the rate of money growth exceeds the rate of economic growth, there is the risk of inflation. Sterilization means that the central bank undertakes measures to reduce the reserves in the banking system, perhaps by selling government securities. Unsterilized means that they leave the money in the system. This is what Japan has done.

Today, there is an article in the Globe and Mail suggesting that Canada should do the same as Japan and force a depreciation of the Canadian dollar. (Click here for article) We don't agree. Japan has a slightly different problem. For years, Japan has been trying to ward off deflation - a reduction in the price level. Since the mid 1980's Canada has maintained a strict objective of price stability. The current inflation target is 2% plus or minus 1%. Intervening without sterilization would cause the Bank of Canada to lose it's inflation fighting credibility.

A fluctuation exchange rate is not necessarily a bad thing. It does impose some risk on importers and exporters if their contracts are not written in Canadian dollars - most international contracts are written in US dollars by convention. There are, however, financial products that can be used to hedge against exchange rate risk; forwards, futures, options and swaps. Provided that the volatility in the price of the Canadian dollar is low, these risk hedging instruments are not very expensive. With the existance of these markets, the Bank of Canada's job is only to reduce volatility, not trend movements in the external value of the dollar.