The costs of currency crises

Devaluations could have a large and prolonged negative impact on the economy. The immediate effect is a jump in the rate of inflation because the imported products become more expensive.

For example, a car imported from the U.S. to Indonesia before the devaluation in 1997 would cost, say, 10,000 dollars = 30 million rupiah as the exchange rate was 1 dollar = 3,000 rupiah. Then, in 1998, the exchange rate became 1 dollar = 10,000 rupiah. The U.S. car would then cost 100 million rupiah in Indonesia.

If the economy is relatively open, i.e. if many of the products consumed by its households are imported, then the devaluation would raise the general price level. Notice on the chart the sharp increase in the rate of inflation in Indonesia during the 1998 devaluation.

The inflation produced by the devaluation creates uncertainty and often leads to political unrest as people cannot afford food and other items. Because of that uncertainly, many businesses scale down their investments and their production and the economy slows down.

In addition, in a typical emerging market economy, many of the businesses have debt denominated in dollars. When the local currency depreciates, these debts become very expensive to service. The firms collect revenue from sales in local currency but they have to service debt in the much more expensive foreign currency. Some businesses don't make it and close down.

For these reasons, devaluations often produce not only high inflation but also a sharp recession. Notice on the chart that the Indonesian GDP declined in 1998. It took several years before it recovered to the 1997 level.
Eventually, the positive effect of the devaluation kicks in. The products made for export are now much cheaper on the international markets because the domestic currency is cheaper. That makes them more competitive. Exports increase and the economy recovers. So, even the worst of crises have an end.

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