Currency depreciation is the fall in the value of a currency relative to another currency in a floating exchange rate system. Floating exchange rate system refers to a foreign exchange system where the factors of demand and supply affect the value of the currency with minimal government intervention.
The value of a currency is always measured relative to another currency. Currency depreciation may happen because of various factors existing in the economy that move the value of domestic currency against the foreign currency. Economic decisions taken domestically also play an important role in affecting the value of a currency.
The opposite of currency depreciation is currency appreciation, where the value of a currency increases relative to another currency. Both currency appreciation and depreciation happen in a floating exchange rate environment.
Currency depreciation is different from devaluation where the value of the domestic currency is deliberately decreased by the government and central bank.
How does a currency depreciate?
Consider the following example: the exchange rate of GBP/AUD is 1.77, this means that 1 GBP is worth 1.77 AUD in the forex market. However, if the GBP/AUD exchange rate drops to 1.57 then GBP is said to have depreciated against the AUD. When the exchange rate drops to 1.57, the value of 1 GBP becomes equal to 1.57 AUD, which is lesser than the previous value of 1.77.
On the other hand, AUD is said to have appreciated against GBP, because one unit of AUD can be used to buy more GBP than what could be previously bought with it. Therefore, currency depreciates by 11.2%.
How does the supply of foreign exchange affect exchange rates?
Consider the following example showing the determination of exchange rate of Dollar in terms of Euro. The supply of Euro refers to the quantity of Euro available as foreign exchange, while the demand for Euro reflects its demand in the domestic country.
Considering the above diagram, the supply of Euro in the economy is increasing, while the demand for Euro remains the same. As more and more units of Euro are accumulated as foreign exchange, Euro depreciates while Dollar appreciates.
Therefore, the amount of foreign exchange available with a country affects the exchange rate of the domestic currency with respect to the foreign currency. As the units of foreign currency increase in a country, the value of domestic currency decreases.
What factors lead to currency depreciation?
A currency depreciation can occur because of domestic as well as international factors, these include:
More and more investors would demand foreign currency in exchange for the domestic currency of Country A. Thus, the demand for the domestic currency falls in the foreign market. This leads to a depreciation of the domestic currency in the international markets, while the value of foreign currency increases.
How does currency depreciation impact an economy?
Currency depreciation can lead to the following:
How can depreciation harm the economy?
Currency depreciation may lead to various disadvantages for an economy: