Depreciation of Currency

What is Depreciation of Currency?

Currency Depreciation refers to a decrease in the value of a currency as compared to other currencies in a floating exchange rate system. Market forces of demand and supply work towards the depreciation of the currency and determine a currency depreciation rate. The country’s trade exports and trade imports play an important role in determining the currency depreciation rate. The value of a currency is basically determined by its economic conditions along with exports and imports. It affects other economic decisions and the financial market.

Geeky Takeaways:

Currency depreciation refers to a decline in the value of a currency as compared to other currencies, only in a floating exchange rate system, not in a fixed exchange rate system.
Factors leading to currency depreciation include political instability, trade exports and imports, other macroeconomic variables, etc.
Currency depreciation generally occurs when there is a significant increase in imports of a country, affecting the domestic balance outflow. A situation of inflation arises in the home country donating higher interest rates.

Note: Currency depreciation and currency devaluation are two different concepts. Currency Depreciation is driven by market forces of demand and supply, and thus is not controlled by the government or Central Bank; whereas, Currency Devaluation is a deliberate practice to stabilise and achieve a favorable exchange rate.

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Reasons for Depreciation of Currency

Currency depreciation occurs due to various prevailing factors including changes in interest rates, political instability, and various other economic factors. Some of the most important market factors that lead to currency depreciation are:

Speculation of Currency in the Market
Central Bank Intervention
Reduced Interest Rates
Downfall in Country’s Exports

Example of Depreciation of Currency

There are two countries, out of which one country has currency A and the other country has currency B. One unit of A was equal to four units of B. However, due to certain industrial setbacks and other political events in the country having currency A, the exchange rate for its currency got affected. Therefore, for one unit of currency A, an individual gets 3.6 units of B. Can this shift be related to the depreciation of currency?

Initially 1 unit of A = 4 units of B or A/B = 4.

Later on, after the change in the value of the currency 1 unit of A = 3.6 units of B or A/B = 3.6

Only 3.6 B is paid now; however, 4 B was paid earlier for every unit of A. Therefore, currency A has depreciated, and currency B has strengthened.

Depreciation% = (4-3.6)/4 = 10%

Effects of Depreciation of Currency

Currency depreciation affects the economy of a country in general as well as individual variables like trade imports, trade exports, interest rates, etc. Some of the effects of currency depreciation involve:

1. As currency depreciation leads to higher interest rates, the debt instruments may become cheaper. But if the currency depreciation is happening due to some other factors, other than inflation, debt instruments may not get affected at all.

2. Due to currency depreciation, the interest rates may face a significant increase. In that case, the government will try to control the interest rates by imposing curbs on them, hence balancing the economy.

3. Currency depreciation will lead to more imports than exports, creating an imbalance in the balance of payment accounts. Thus, the country will need to correct the disequilibrium of the balance of payment account.

Critical Evaluation of Depreciation of Currency

Advantages of Currency Depreciation:

Currency depreciation can cause a rise in exports inviting a large foreign exchange in the country. A rise in exports will balance the trade deficit due to which currency depreciated in the first place.
Currency depreciation overall acts as a measure to correct the economy.

Disadvantages of Currency Depreciation:

Currency depreciation leads to an overall rise in the general prices of the products in the home economy, which in turn will lead to inflation. Currency depreciation arises due to more imports.
Investments in financial instruments become more expensive as the value of currency depreciates.
As currency depreciation affects the economy as a whole, it also affects employment, financial markets, foreign direct investments, balance of trade, etc.
All the currencies in the international market have some particular exchange rate. If there arises any depreciation of the currency, it will impact the overall performance of the currency in the international market.