In case you made a huge rookie mistake and signed up for 8:00 AM econ 101 freshman year too:
Generally speaking in 2014, a devaluation is when a government or central bank decides to decrease the relative value of its local currency in relation to the US dollar or some other reference currency (and historically, a reference commodity such as gold). Subsequently after deciding upon an objective value or range of values (a “band”) to allow the local currency to fall to, the central bank or currency board proceeds to either buy dollars or US treasury bonds on the open market to the point that the local currency falls enough in value with respect to the reference.
Depreciation is the supply and demand, or market-driven decrease, in the value of one currency relative to another. Since Argentina is special, in January 2014 the BCRA went from selling dollars in foreign exchange markets (to prop up the currency) to doing nothing at all, thereby allowing the peso to depreciate in value before once again intervening and engaging in its policy of selling dollars. I will label Argentina´s January 2014 actions a “managed depreciation” and this is known as a “managed floating” exchange rate regime.
Other currency regimes include the “peg,” which aims to maintain an exact relative value between a local currency and some reference currency, or a “free floating” exchange rate policy whereby the central bank takes a hands-off approach and allows its currency to fluctuate according to the market. If you find yourself in Zimbabwe and notice George Washington’s sheepish grin, that is because after a bout of hyperinflation in 2008 and a multitude of failed attempts to introduce new a fiat currency, the government decided to “dollarize” rather than issue another new currency or medium of exchange. That’s right: Zimbabwe could have opted to use cowry shells.
[FUN FACT] Cowry shells were one of the first known uses of “money” or some commodity used to barter and exchange.
If you are reading the news and you see that “peso subió” this means that the price of a peso rose relative to the dollar, or rather, the peso weakened in value (depreciated) and it now requires more pesos to purchase one dollar.
Expectations are crucial to understanding inflation. If the market (Argentines) expects future inflation, then at the present, people or the market will behave as if tomorrow their money or capital will be
worthless worth less with respect to what it can deliver in a free exchange of goods or services. This mindset increases the demand for dollars especially on the black market, thus further depreciating the perceived peso value relative to the dollar and putting pressure on the BCRA to do something to ward off the peso becoming overly overvalued (ha) so as to hurt consumption, investment, or make exports uncompetitive. The fear of overvaluation is especially poignant if the official rate does not increase concurrently with the blue rate. This something or policy action by the BCRA could mean capital controls, but since all kinds of controls are already deeply embedded in Argentina (think import restrictions), ‘something’ is more likely to result in some form of devaluation or managed depreciation.
Devaluation in turn fuels inflation. Inflation is generally calculated through a consumer price index (CPI), which takes the average growth in prices of a basket of goods. Since pesos are worth less after being devalued (obviously), the sellers of these goods in our proverbial basket will want to raise the goods’ prices in order to preserve their profits. This process fuels inflation further – inflation can be broadly defined as “a rise in prices over some period of time, all else (purchasing power) held constant“. There´s something about a multiplier effect in this scenario too (making inflation worse and harder to extricate), but I will spare you for the time being.
Please sir, more cowry shells.
The take away is that inflation is a vicious cycle that is very difficult to break out of without hurting output in the form of contractionary monetary policy. A depreciating peso makes policy more difficult, and although raising interest rates in an attempt to slow price rises would probably help stave off the peso’s decline, that would be the opposite of what the widening brecha (the difference between the official and black market exchange rates) suggests would be the ideal policy choice right now – another managed depreciation or devaluation.
Anyone have a spare stockpile of cowry shells?