Currency depreciation is a decrease in the purchasing power of domestic currency against other currencies. Currency depreciation has considerable impacts on the economy, particularly international trade and international financial transactions.
If, for instance, the US dollar depreciates against Rupiah, it means US Dollar now buys Rupiah less than before. Americans will need more US dollars to get one rupiah. In contrast, Indonesians see their Rupiah to appreciates against the US dollar and can get one US dollar with fewer Rupiah.
For Americans, depreciation makes Indonesia’s goods and services more expensive. In contrast, for Indonesians, America’s products and services are cheaper as their rupiah exchange rate appreciates.
Depreciation and appreciation are common in a floating exchange rate regime. Many factors cause currency depreciation, including trade balance, interest rate parity, economic policies, and risk aversion among investors.
How does currency depreciation work?
Case 1: IDR14,000/USD changes to IDR15,000/USD -> Indonesians say, “Rupiah depreciates, while Americans say “US dollar appreciates.”
Now, Indonesians must exchange IDR15,000 for getting 1 US dollar, higher than before (IDR14,000). In this case, the Rupiah is less valuable than before, relative to the US dollar.
However, for Americans, the US dollar appreciates. With 1 US dollar, they can get IDR15,000, more than the previous of IDR14,000.
Case 2: IDR13,000/USD changes to IDR12,000/USD -> Indonesians say “Rupiah appreciates” = Americans say “US dollar depreciates.”
Now, Rupiah buys more US dollars than before. Therefore, Indonesians see their currency strengthening against the US dollar. They can get one US dollar with the only IDR12,000, lower than before (IDR13,000).
But, for Americans, the US dollar depreciates because they get less Rupiah. If exchanging their 1 US dollar, they only get IDR12,000, fewer than before of IDR13,000.
Which factors affect currency depreciation?
Several factors cause the exchange rate fluctuation, including:
- Trade balance
- Inflation rate
- Interest rate
Trade balance
A large trade deficit is associated with depreciation. A deficit occurs when the import value exceeds the export value.
International trade involves not only the exchange of goods but also currencies. We can explain the impacts of the trade on the exchange rate using the supply-demand concept.
When we export, foreigners demand domestic currency to pay us. Hence, demand for domestic currency increase so does with its prices (more valuable). As a result, the domestic currency will appreciate against trading partner’s currency.
Conversely, imports mean the demand for trading partner currency is increasing because we have to pay them in their currency. As a result, trading partner’s currency appreciates against the domestic currency. But, for domestic currency, it means a depreciation.
In conclusion, exports cause domestic currency to appreciate, while imports cause domestic currency to depreciate. Hence, a trade deficit should depreciate domestic currency since exports are higher than imports.
Furthermore, in the economics book, these conclusions are generalized to the current account. The reason, the trade balance usually covers a substantial portion of the current account. Thus, the impact will be relatively the same; namely, the current account deficit causes depreciation of the domestic currency, while the current account surplus causes appreciation.
Inflation rate
Inflation has an impact on currency exchange rates. High domestic inflation makes domestic goods less competitive in international markets. As the impacts, demand for domestics goods decreases, hence reduce exports and depreciate its domestic currency. The opposite effect occurs when domestic inflation is low.
Interest rate
Depreciation also works from capital flows. Expansive monetary policy through cutting interest rates policies can cause a depreciation of the domestic currency.
Lower domestic interest rates narrow the spread difference between domestic interest rates and international interest rates. The investment will outflow from domestic markets as investors searching for a higher return in the global market. Outflow makes domestic currency weaker (depreciation).
In contrast, the higher domestic interest rates will drive capital inflow as investors seek higher returns in the domestic market. Capital inflow makes the domestic currency stronger (appreciation).
Currency depreciation impacts
Depreciation makes imported goods more expensive. It can lead to imported inflation if foreign products are essential for the domestic economy.
In contrast, depreciation should boost exports. It is because foreigners would demand more on domestic goods as the prices become cheaper for them.
In summary, depreciation leads to fewer imports and more exports. Hence, the trade balance should be positive (surplus) and drive up domestic real GDP growth (economic growth).
Important note
However, the price effect due to exchange rate movements will not last long. Because the trade surplus will make the exchange rate appreciate. Economists often describe this phenomenon through the J curve.
Also, the impact of exchange rate depreciation may not be straightforward. It is because other factors affect exports and imports, including the elasticity of demand for traded goods and services, product competitiveness, global economic growth, and domestic economic growth. So when a currency depreciates, it doesn’t always mean that the country will report a trade surplus.