What happens when a currency gets devalued?

derivatives, derivatives toxic, problems with derivatives investingQ: What exactly does currency devaluation mean?

A: Put simply, you need more cash to buy the same goods. Let’s say Tuesday night you can buy a loaf of bread for $2, and then the currency gets devalued by the government at midnight. When you wake up in the morning, the loaf of bread hasn’t changed, but now it costs $4 or more for the loaf. You just lost half of your purchasing power overnight.

When a currency gets devalued, one of several events usually triggers the devaluation:

  • One event is when a new currency is taking the place of an old one, and people holding the old currency find their purchasing power falling rapidly.
  • Another form of devaluation is when additional fiat currency is printed, or the government changes how the money is valued.

An explicit devaluation happened in the United States when the conversion rate of dollars to gold went from $20.67 per ounce to $35 per ounce on January 31, 1934. Overnight anyone holding dollars lost almost half of their purchasing power. Said another way, one day your $20 bill got you an ounce of gold, and the next day your $20 bill got you 0.6 ounces of gold. That’s a devaluation of currency.

Today the currency in your bank account or in your wallet is being devalued by the hidden tax called inflation. They’re printing more currency into existence, devaluing the dollars already out there, including those in your bank account. Every time they do this, the newly created dollars are chasing the same fixed amount of goods in existence. This means the goods in existence will rise in price to reach an equilibrium between the supply and demand given the increased supply of dollars. The goods didn’t get any more valuable as they rose in price; instead, the dollar dropped in value and its purchasing power decreased.