I recently read an article in the New York Times that talked about China devaluing its currency (which I believe is held to a peg against the US Dollar). My question is: specifically what tools does a central bank of a country employ to devalue its currency artificially and what effects does it have on its foreign trade?
Typically, a devaluation is achieved by selling the domestic currency in the foreign exchange market and buying other currencies. Suppose China sells one trillion Renminbi and buys 157 billion US dollars. From the point of view of the market, it is as if the supply of Renminbi just increased. As in any competitive market, an increase in supply will cause the price (i.e. the exchange rate) to fall: one Yuan will be worth less than before.
Devaluations are good for a country's balance of trade. Companies based in China ultimately care about how many Yuan they end up with. Suppose that the value of the Renminbi is 10 Yuan = \$1US. That means that a Chinese product priced at 10 Yuan would cost an American \$1 to buy. Now suppose that the value of the Renmimbi falls by half: 10 Yuan = \$0.50. Now the same product, still priced at 10 Yuan, will only cost an American 50 cents. It's as if everything China exports just got cheaper! This fall in the apparent price of Chinese exports will make people in other countries want to buy more Chinese products so that China will experience an increase in its exports. The argument also works in reverse: to a Chinese person, the devaluation makes it look as if American products got more expensive, so Chinese will demand fewer American (and British, and German, etc.) products and China will import less. Together, these two effects mean that China's balance of trade (i.e. the difference between exports and imports) will improve as a consequence of the devaluation.
I don't think that it is legal in all countries, but the central bank can also print more money and give it to the government, which in turn can use it to pay the state debt.
This will cause inflation, since there is more money representing the same goods and services. Inflation will cause the money to devalue.
Complementary to the answer of Ubiquitous with respect to the effect of a devaluation on foreign trade (and only of marginal importance), is the possibility that the positive effect of a devaluation on the current account occurs only after an initial worsening of the current account. This sequence of a worsening and subsequently improving current account in response to a devaluation is called the J-curve effect, introduced by, if I rembember well, Abba and Lerner. Its presence can be explained by disentangling two opposite effects that result from a devaluation: a volume-effect that positively affects the current account and a price-effect that negatively affects the current account.
The volume effect with a positive impact on the current account is exactly what is described by Ubiquitous. The negative impact of the price-effect on the current account follows from the fact that any given imported quantity becomes more expensive after the devaluation. This price-effect will dominate in the case that the price-elasticity of domestic demand for imports and the price-elasticity of foreign demand for domestic exports are low, because in that case the exported quantities will increase only modestly and imports will decrease only modestly. Or, put differently, in this case of low price-elasticities, de volume effect is small. This is typically the case in the short run. In the long run the volume-effect can be expected to dominate.
Devaluation is the reduction of the value of a currency, done by the country's Central Bank1 and it involves a change or adjustment of the value of the currency in respect to a standard2.
This standard could be gold or another currency, the US dollar for example. The main feature of the exchange standard is that the government guarantees a fixed exchange rate to the currency of another country that uses the standard, regardless of what type of notes or coins are used as a means of exchange.
The process of devaluation itself is related with the increase of the amount of money circulating by just printing more3 if your currency is fully convertible4 or by selling the reserve of the object your country uses as a standard and setting a new fixed rate with respect to a foreign reference currency.
The direct result of a devaluation is making the products of the economy cheaper, thereby more competitive. Additional use of the devaluation is protection of local economies from regional or global crisis, as the devaluation could be used as a buffer.
1. Or Currency Board supplanting the function of a Central Bank.
2. Units with which that currency can be exchanged.
3. This is done by issuing bonds or monetizing goods and services from the private sector in exchange for bonds.
4. Fully convertible currencies for example are : USD, GBP, EUR.