International Finance Theory and Policy
by Steven M. Suranovic

Finance 30-6

Overvaluation and Undervaluation

It is quite common to hear people claim that a country's exchange rate is overvalued or undervalued. The first question one should ask when someone claims the exchange rate is overvalued is, overvalued with respect to what? There are two common reference exchange rates often considered. The person might mean the exchange rate is overvalued with respect to purchasing power parity (PPP), or it he may mean the exchange rate is overvalued relative to the rate presumed needed to balance the current account.

The mere use of these terms suggests immediately that there is some "proper" value for the exchange rate. However, one should refrain from accepting this implication. As was previously discussed, PPP is unlikely to hold, even over very long periods, for a variety of very good reasons. Also as discussed previously, there is no reason to think that current account balance represents some equilibrium or goal for an economy. Thus, overvaluation or undervaluation of an exchange rate, for either reason (PPP or CA balance) should be thought of simply as something that happens. Of more interest is what it means when it happens.

Over (Under) Valuation with respect to PPP

First let's consider over and undervaluation with respect to PPP. The PPP exchange rate is defined as that rate which equalizes the cost of a market basket of goods between two countries. The PPP exchange rate between the Mexican peso and the US dollar would be written as,


which represents the PPP value of the US dollar in terms of pesos.

If the US dollar is overvalued with respect to the Mexican peso then the spot exchange rate exceeds the PPP exchange rate,


This will also mean the exchange rate exceeds the ratio of market basket costs,


and therefore the following will hold.


The left-hand-side (LHS) of this expression represents the cost of a US market basket converted to pesos at the current spot exchange rate. The right-hand-side (RHS) is the cost of the basket in Mexico also evaluated in pesos. Since the LHS > RHS, goods and services cost more on average in the US than in Mexico at the current exchange rate. Thus, for the US dollar to be overvalued with respect to the peso means that goods and services are relatively more expensive in the US than in Mexico. Of course it also implies that goods and services are relatively cheaper in Mexico.

A simple guide to judge whether a currency is overvalued is to consider it from the perspective of a tourist. 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.

Over (Under) Valuation with respect to Current Account Balance

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 US has a trade deficit (which it indeed has had for more than 25 years prior to 2006). If the US dollar value were to fall - a dollar depreciation - then foreign goods would all become relatively more expensive to US residents, tending to reduce US imports. At the same time, a dollar depreciation would also cause US goods to become relatively cheaper to foreign residents tending to raise US exports.

Sometimes economists make numerical estimations as to how much the dollar value would have to fall in order to bring trade into balance. These estimations are enormously difficult to make for several reasons and should be interpreted and used with great caution, if at all. The primary reason is that many different factors on both the trade side and the financial side influence a country's trade imbalance besides just the exchange rate. The exchange rate that balances trade would depend on the values taken by all of the other factors that also influence the trade balance. Different values for all the other variables would mean a different exchange rate needed to balance trade. Thus, there isn't ONE exchange rate value that will balance trade. There are many exchange rate values that will balance trade depending on the other circumstances. Indeed, even the current exchange rate, whatever that is, can balance trade if other factors change appropriately.

Despite these cautions, many observers will still contend that a country's currency needs to depreciate by some percentage to eliminate a trade deficit, or needs to appreciate to eliminate a trade surplus. When it is believed a depreciation of the currency is needed to balance trade, they will say the currency is overvalued. When it is believed an appreciation of the currency is needed to balance trade, they will say the currency is undervalued.

In a fixed exchange rate system, a government can sometimes intervene to maintain an exchange rate that is very different from what would arise if allowed to float. In these cases, large trade surpluses can arise because the government maintains an artificially low value for its currency. Calls for a revaluation (appreciation) of the currency, to promote a reduction in a trade surplus, is somewhat more appropriate in these cases since the market does not determine the exchange rate. Similarly, large deficits could be reduced with a devaluation (depreciation) of the currency.

International Finance Theory and Policy - Chapter 30-6: Last Updated on 1/25/06