Currency Depreciation Definition

Currency Depreciation Definition

what is currency depreciation

When a country’s currency devalues, its imports become more expensive, whether raw materials, petroleum products, or food. In fact, foreign countries will be more willing to buy the country’s goods. A decline in a currency’s value can make foreign exchange traders lose or earn profits, depending on the degree of exchange rate fluctuation. Now that you understand the currency depreciation definition, it’s also good to know what causes depreciation of currency. Generally, there are many reasons for currency depreciation, like interest rates, inflation rates, political instability, and terms of trade. Currency devaluation can increase the risk of potential higher inflation which would erode consumers’ purchasing power.

what is currency depreciation

It’s possible that someday, those debts will come due and the lenders will want their money back. If lenders believe the debt level is unsustainable, theorists believe the dollar will weaken. However, since there’s a healthy demand for Treasuries, the U.S. typically issues new bonds to pay off any of the foreign-held bonds that are coming due.

Currency Depreciation

The question of whether currency depreciation is good or bad largely depends on perspective. If you are the chief executive officer of a company that exports its products, currency depreciation is good for you. When your nation’s currency is weak relative to the currency in your export market, demand for your products will rise because the price for them has fallen for consumers in your target market.

  1. Other factors that can affect a currency’s exchange rate are interest rates, political stability, and terms of trade.
  2. It has simply lost relative power compared to a different currency.
  3. A country with a high inflation rate may experience currency depreciation due to the increased production costs for exports.
  4. In the United States, there are fears that China’s growing interest in attaining reserve currency status for the yuan will reduce demand for U.S. dollars.

Accordingly, the various factors that can drive currency depreciation must be taken into consideration relative to all of the other factors. A country with a high inflation rate may experience currency depreciation due to the increased production costs for exports. As a result, the country’s exported products will be costly and less competitive in the global markets, resulting in a trade deficit. Well, when the central bank reduces the interest rates, the country’s currency will depreciate.

Falling Export Prices

A relative devaluation occurs when the foreign exchange value of one currency drops against the exchange value of other currencies. In either case, the economic roots of currency depreciation are dependent on the productive capacity of an economy and the size of its money supply. Currency depreciation is the decline of a currency’s value relative to another currency. It specifically refers to currencies in a floating exchange rate – a system in which a currency’s value is set by the forex market, based on supply and demand.

The opposite of currency depreciation is currency appreciation, where a currency becomes stronger. Forex traders can take advantage of both appreciation and depreciation, by taking a long or short position depending on their market predictions. Sudden bouts of currency depreciation, especially in emerging markets, inevitably increase the fear of “contagion,” whereby many of these currencies get afflicted by similar investor concerns.

Now, let’s turn our attention to the other implications of currency depreciation. Secondly, President Trump approved the doubling of steel and aluminum tariffs imposed on Turkey at a time when there were already fears about the country’s struggling economy. The lira plunged sharply after Trump released the news via a tweet. During the 2010 to 2011 USD depreciation, the greenback hit all-time lows against the Japanese yen (JPY), the Canadian dollar (CAD), and the Australian dollar (AUD).

As a result, this will reduce the foreign capital, causing the exchange rates to fall. One of the ways the United States finances its profligate ways is by issuing debt. China and Japan, two countries that export a significant amount of goods to the United States, help finance U.S. deficit spending by loaning it massive amounts of money. Treasury securities (essentially IOUs) and pays interest to the nations that hold those securities.

Understanding Currency Depreciation

Their employer (or customers) must either give them more units of currency or more valuable units of currency. Currencies are always traded in pairs, with the value of one being quoted against the other. The first listed currency – the base currency – is always worth one, while the second currency’s value – the quote currency – is given in relation to this.

Additionally, rapid or excessive devaluation can lead to financial market instability and impact investor confidence, stranding a country for capital demand in the long-term. By contrast, a currency represents the economy of a country, and a currency rate is quoted by pairing two countries together and calculating an exchange rate of one currency relative to the other. Consequently, the underlying economic factors of the representative countries have an effect on that rate. In a floating rate exchange system, the value of a currency constantly changes based on supply and demand in the forex market. The fluctuation in values allows traders and firms to increase or decrease their holdings and profit off them.

In the United States, the Federal Reserve (the country’s central bank, usually just called the Fed) implements monetary policies to either increase or decrease interest rates. Those borrowed dollars eventually get spent by consumers and businesses and stimulate the U.S. economy. Countries with weak economic fundamentals, such as chronic current account deficits and high rates of inflation, generally have depreciating currencies. Currency depreciation, if orderly and gradual, improves a nation’s export competitiveness and may improve its trade deficit over time. But an abrupt and sizable currency depreciation may scare foreign investors who fear the currency may fall further, leading them to pull portfolio investments out of the country. These actions will put further downward pressure on the currency.

Turkey’s currency, the lira, lost more than 20% of its value against the USD in August 2018. First, investors grew fearful that Turkish companies wouldn’t be able to pay back loans denominated in dollars and euros as the lira continued to fall in value. Between 2015 and 2016, the U.S. and China were repeatedly in a battle of words with regards to each other’s currency value.

This currency speculation plays an important function in international markets, but it is forward-looking and doesn’t cleanly equate to current purchasing power or national productivity. If the money supply in a country is fixed but productivity increases, then each unit of currency must store greater value. If the productivity of an economy is fixed but the supply of currency decreases, then each unit of remaining currency must store greater value. A weak dollar makes it more expensive to take that European vacation or buy that new imported car.

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