Background
Understanding the concept of an over-valued currency is essential for comprehending international finance and exchange rate dynamics. The term describes a situation when a nation’s currency maintains an exchange rate exceeding the level that would balance its payments on the international stage.
Historical Context
Historically, instances of over-valued currencies have appeared during both fixed and floating exchange rate systems. For instance, the British Pound was widely regarded as over-valued following World War II, leading to its eventual devaluation in 1949 as part of the Bretton-Woods agreement adjustments.
Definitions and Concepts
An over-valued currency refers to a national currency whose exchange rate is too high to sustain a balanced international payment equilibrium:
- Without capital movements, it means the exchange rate prevents a balanced current account.
- With autonomous capital movements, it signifies the exchange rate which causes a current account deficit that cannot be sustainably financed by inward capital inflows.
Major Analytical Frameworks
Classical Economics
Under classical economics, currency valuation is typically related to the parity prices of gold and goods export-to-import ratios, facilitated through market forces and free trade.
Neoclassical Economics
Neoclassical theories focus on supply and demand for currency, interest rate differentials, and the purchasing power parity principle to explain the overvaluation and its impact on trade balances.
Keynesian Economics
Keynesian economists emphasize state intervention and short-term interest manipulation to correct over-valued currencies, highlighting resultant impacts on aggregate demand, employment, and external balances.
Marxian Economics
Marxian perspectives attribute over-valuation to broader capital accumulation crises and struggles in maintaining profit rates, underscoring systemic global capital imbalances contributing to misaligned currency valuations.
Institutional Economics
Focuses on policy frameworks, governance issues, and international agreements that govern exchange rates, exploring how institutional structures can contribute to or alleviate the consequences of over-valued currencies.
Behavioral Economics
Looks into psychological aspects influencing stakeholder decisions in currency markets, such as overconfidence in national economic policies, which can sustain unsustainable currency valuations.
Post-Keynesian Economics
This framework argues for long-term economic stability through realistic exchange rates achieved via active state intervention and pragmatic fiscal policies, opposing laissez-faire approaches.
Austrian Economics
Austrians advocate for market-determined exchange rates devoid of government intervention, with over-valuation viewed purely as a market distortion due to artificial factors like inflation.
Development Economics
In development perspectives, over-valued currencies hinder developing nations by adversely affecting their trade competitiveness and economic development agenda.
Monetarism
Emphasizes control of money supply to address over-valuation, suggesting that excessive currency valuation typically results from inappropriate monetary policies leading to inflationary pressures.
Comparative Analysis
Diverse theoretical frameworks offer various perspectives on identifying and responding to over-valuations:
- Classical and Neoclassical Economists: Advocate for market adjustments to correct currency over-valuation.
- Keynesian and Post-Keynesian: Emphasize active monetary and fiscal responses.
- Behavioral: Consider the non-rational behavior influencing currency value expectations.
- Institutional: Highlight structural and policy reforms required for valuation correction.
Case Studies
- British Pound Post-WWII: Adjusted over-valuation through devaluation within Bretton-Woods.
- Brazil’s Real in 1999: Significant devaluation to address over-valuation problems leading to financial crisis impacts.
Suggested Books for Further Studies
- “Exchange Rate Economics: Theories and Evidence” by Ronald MacDonald.
- “The International Economics” by Dominick Salvatore.
- “Currency Crises: Understanding the Role of Speculators in Financial Markets” by Timon Ross.
Related Terms with Definitions
- Exchange Rate: The price at which one currency can be exchanged for another.
- Balance of Payments: Statistical summary of a nation’s transactions with the rest of the world.
- Current Account: A portion of the balance of payments, encompassing trade balance, net primary income, and net cash transfers.
- Capital Movements: Cross-border transactions involving financial assets and liabilities.
