Currency depreciation or devaluation refers to a decline in a currency's exchange rate, as reported in a floating exchange rate system. The impact of that decline depends not only on the amount of the decline, but also on the impact of the decline of the currency as measured by a country's exchange rate relative to that of other countries.
A currency's exchange is influenced by multiple factors, including political instability and economical fundamentals.
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Effects of Currency Depreciation
An orderly depreciation of currency may increase the export activity of a country. The reason being is that a decline in the prices of products and services makes a country's exports more attractive to potential buyers.
If the depreciation of a currency occurs gradually and in an orderly manner, it can improve the competitive standing of a country's exports and improve the nation's trade deficit. If, however, a sizable currency depreciation occurs abruptly, foreign investors may relinquish their position. When this occurs, additional downward pressure is placed on the country's currency.
Consider this: Effects of Currency Devaluation on Investments
Causes of Currency Depreciation
The origins of currency depreciation are many. They include economic fundamentals, political instability, interest rate differentials and investor risk aversion. For instance, depreciation of a country's currency may occur if its economic fundamentals are weak. For example, a country may experience chronic current account deficits and high inflation, each of which can lead to or accelerate currency depreciation.
What's more, rising inflation increases production costs for exported products. This occurrence makes a country's exports less competitive in global markets. In turn, a trade deficit will increase and depreciate a country's currency. Also, when inflation is high, if the Federal Reserve uses interest rates to curb inflation, currency depreciation may occur. In this case, as interest rates decline, billions of dollars may be moved from investments that pay low interest rates to those with a higher yield.
Currency Depreciation and the 2007-2008 Financial Crisis
As the 2007-2008 global financial crisis grew more severe, the Federal Reserve initiated multiple rounds of quantitative easing which led to historically low bond yields. As a consequence, in December of 2008, the U.S. dollar index (USDX) fell by more than 7 percent. And, by 2011, the U.S. dollar index continued to topple. At that time, the dollar was at an all-time low against the Canadian dollar, the Japanese yen and the Australian dollar.
Consider this: How to Compare Currency Exchange Rates
International Effects of Currency Depreciation
If one country's currency depreciates rapidly and suddenly, the fear that the currency of other countries will follow suit begins to spread around the world. Investor concerns may ensure that the contagion spreads, namely, that many currencies will likewise depreciate. Such investor concerns led to the Asian crisis of 1997, which began with the collapse of the Thai baht. Once the baht dropped, other Southeast Asian countries experienced currency depreciation as well.
Likewise, in June of 2016, the British pound depreciated by more than 10 percent against the U.S. dollar once the United Kingdom voted to leave the European Union. Similarly, due to a concern that the U.S. Federal Reserve would lessen its bond purchases, the currencies of India and Indonesia experienced currency depreciation.