For a currency to be devalued means that the issuing government has mandated that the price of the currency (in foreign dollars) is lower than it was before. For example: if the Russian government changes the exchange rate from 100 rubles = $1 to 150 rubles = $1, then the ruble has been devalued. Now, regardless of whether a country has a fixed or flexible exchange rate system, there exists a “true” (we say “equilibrium”) exchange rate. The equilibrium exchange rate is the exchange rate at which everyone who wants to sell the currency can find a buyer and everyone who wants to buy the currency can find a seller. By definition, a flexible exchange rate is the equilibrium exchange rate. This is not the case with a fixed exchange rate.

Consider the following analogy. The equilibrium price of a car is $10,000. If the government imposes no restrictions on car prices (i.e. car prices are flexible), then the free market price of a car will be $10,000. Further, there will be no surplus or shortage of cars — everyone who wants to buy a car (at $10,000) will find one to buy, and everyone who wants to sell a car (at $10,000) will find a customer. Now, suppose the government imposes a price floor on cars of $15,000. At the official price of $15,000, many people will want to sell cars, but few people will want to buy cars – there will be a surplus of cars. If the government wants to avoid ending up hip-deep in unsold cars, it will have to buy the extras itself. (Note: this is precisely what the government does in the case of farm subsidies.)

In the case of a fixed exchange rate, the Russian government declares that the official price of 100 rubles is $1. Suppose, however, that the equilibrium price of 100 rubles is $0.75. That is, people would be willing to trade 100 rubles for $1, but the government only allows trades of 100 rubles for $0.75. At the official price of 100 rubles to $0.75, many people will want to sell rubles (sellers receive $0.25 more than the equilibrium price), but few will want to buy rubles (buyers must pay $0.25 more than the equilibrium price). The result is that there will be a surplus of rubles: there are more people willing to sell than there are people willing to buy. As in the car example, if the government wants the market to continue, it must take up the slack. In this case, the Russian government must buy the surplus rubles (at the official price of 100 rubles to $1). How does the Russian government buy rubles? It pays for the rubles on the market with, for example, US dollars.

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