When the US dollar is overvalued, a US tourist traveling to Mexico will find that many products seem cheaper there than in the US, after converting at the spot exchange rate. Thus an overvalued currency will buy more in other countries. An undervalued currency works in the opposite direction. When the US dollar is undervalued, the cost of a basket of goods in the US is lower than the cost in Mexico when evaluated at the current exchange rate.
To a US tourist, Mexican goods and services will seem more expensive on average. Thus, an undervalued currency will buy less in other countries. Finally, if the US dollar is overvalued with respect to the Mexican peso, it follows that the peso is undervalued with respect to the dollar. Since US tourists, in this case, would find Mexican goods comparatively cheap, Mexican tourists would find US goods to be comparatively expensive.
If the US dollar were undervalued, then the peso would be overvalued. Is over or undervaluation good or bad? That depends on who you are and what you are trying to achieve. For example, if the US dollar is overvalued with respect to the peso, then a US tourist traveling to Mexico will be very happy.
In fact, the more overvalued the dollar is, the better. However, for an exporter of US goods to Mexico, its price in peso terms will be higher the more overvalued is the dollar. Thus, an overvalued dollar will likely reduce sales and profits for these US firms. We can state unambiguously that overall depreciation by then has covered the overvalued part of the currency that was objected by the IMF two years ago because the inflation difference with world inflation during the two years was close to 6 per cent.
In June , the exchange rate depreciated by 9. Recalculation tells Since inflation difference during was 6 per cent, thus we can fairly say that the exchange rate was overvalued by 9. I call this depreciation in the exchange rate by 9. The readjustment was done by 1. REER index value shows that after readjustment exchange rate was still undervalued by 4. Though, inflation rate during July-Dec was high; month-over-month accumulated 7 per cent and year on year Considering month over month accumulated inflation differential would eventually lead us to conclude contrary to what REER index shows.
Finally, if the U. In this case, since the U. Is overvaluation or undervaluation good or bad? That depends on what a person is trying to achieve. For example, if the U.
In fact, the more overvalued the dollar is, the better. However, for an exporter of U. Thus an overvalued dollar will likely reduce sales and profits for these U. The second way over- and undervaluation is sometimes applied is in comparison to an exchange rate presumed necessary to induce trade balance, or balance on the current account. If one imagines that a trade deficit, for example, arises primarily because a country imports too much or exports too little rather than being driven by financial decisions tending to cause a financial account surplus , then one may also look for ways to either reduce imports or raise exports.
A change in the exchange rate offers one viable method to affect trade flows. Suppose the United States has a trade deficit which it indeed has had for more than thirty years prior to At the same time, a dollar depreciation would also cause U.
I Accept Show Purposes. Your Money. Personal Finance. Your Practice. Popular Courses. Economics Macroeconomics. Currencies are compared against the local price of a Big Mac in that nation's currency. Depending on the ratio, the currency could be considered over or undervalued. Compare Accounts.
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