Appreciation and Depreciation

If you turn on the TV at any given time of the day, the likelihood that you will come across a news station that is talking about inflation, the dollar is appreciating or depreciating, rising interest rates, or foreign investments going up or down, is highly likely. But, what does it mean when the dollar is appreciating or depreciating? What causes a currency to gain or lose value and what effect does it even have on the economy? Here, we will take a look at all of these things and see some currency appreciation and depreciation examples along with the appreciation and depreciation formula.

Appreciation and Depreciation Definition

Appreciation and depreciation of a currency refer to the change in the value of one currency in comparison to another currency in the freely floating exchange rate regime. Appreciation occurs when the value of a currency increases in comparison to the value of another currency. Depreciation of a currency occurs when the value of a currency falls in comparison to the value of another currency. Forces of demand and supply for currency determine its value in the freely floating exchange markets.

What determines a currency's value?

To know if a currency appreciates or depreciates we need to know its value. If we look at it simply, a currency’s value is determined by the market's demand and supply for the currency just like any other good or service. Demand for a currency can be influenced by things like a country's interest rate, its inflation rate, how much money moves in and out of a country, or a country's money supply. The exchange rate can then help us determine the value of the currency in comparison to other currencies.

Exchange rate

The exchange rate compares the value of one currency to another and is often the go-to measure for currency value. The foreign exchange market is where these exchanges of various currencies occur. Various factors in the economy such as changes in supply, demand, and people's tastes and preferences can cause the value of a currency to appreciate or depreciate in comparison to another.

Examples of Currency Appreciation and Depreciation

An example of currency appreciation is when the increased value of the domestic currency, increases purchasing power in foreign markets. Let's say the USD is the domestic currency, and the United Kingdom (GBP) will be the foreign market. When a currency appreciates, the currency it is being compared to depreciates. So foreign, UK goods appear cheaper when the USD appreciates because the domestic currency, the USD, will be able to purchase more foreign currency, GBP, and therefore more foreign goods, assuming that foreign prices remained the same.

An example of currency depreciation is when the decreased value of the domestic currency decreases its purchasing power. Currency depreciation makes domestic currency appear cheaper when compared to foreign currencies. Currency depreciation is when the domestic currency decreases in value and the amount of foreign currency it can purchase falls.

Causes of Appreciation and Depreciation of Currency

An appreciation or depreciation in a currency can be caused by several factors:

• Interest rate
• Trade
• Speculation

Interest rate

Changes in a nation's interest rate can encourage investment by those looking to profit off of a nation's currency. If the government is offering higher interest rates on products such as treasury bills, corporate bonds, or certificates of deposits, then those investors that take a fixed income approach to investment, will want to purchase these products because of the higher investment yield that they offer. This increases the demand for the currency which appreciates its value.

Capital outflow and inflow can each cause currency depreciation and appreciation, respectively.

This can happen if domestic interest rates are low, and investors are looking to foreign markets that have higher interest rates to increase their returns. Money is flowing out of the domestic economy, and increasing the supply of the currency in the foreign exchange market. This causes a depreciation in the value of the currency.

When domestic interest rates are high relative to foreign ones, investors will want to purchase domestic currency which decreases its supply on the foreign exchange market, resulting in appreciation of the value of the currency.

Trade

The appreciation or depreciation of currency caused by the changes in the interest rate impacts international trade. The changes in the price of the currency affect the number of imports and exports. Aggregate demand in the economy partially depends on imports and exports. If the quantity of exports decreases because of an appreciation of the currency, then there is a loss in capital inflow and aggregate expenditure and therefore aggregate demand must fall. The rest of the aggregate demand is comprised of consumption, investment, and government spending.

Aggregate Demand Formula:

If a nation is running a trade surplus, meaning they export more than they import, there will be more domestic currency demanded as more domestic goods are bought by the foreign buyers. This will cause an appreciation of the currency.

On the other hand, a trade deficit, meaning imports being higher than exports, can cause a depreciation of the currency, because a country is having to buy foreign currency to purchase goods from other countries. This means domestic currency loses its value.

Speculation

Speculation happens when traders in the foreign exchange market buy and sell currencies based on if they think a currency will appreciate or depreciate. It is partially based on emotion and partially on opinions and experience. They form their opinions depending on factors like the political climate, government policies, inflation, and current trends in the market. These speculations can influence the market because as traders invest where they think they will make a profit, others will follow which means that as more and more people buy a currency the more it appreciates. Other currencies will depreciate relative to the currency that has appreciated.

Effect of Currency Appreciation and Depreciation

The effect of currency appreciation and depreciation is felt prominently in international trade. When a currency’s value changes, a country’s imports, and exports can be affected because trading may become either relatively cheaper or more expensive depending on the change in the value of the currency.

Effect of currency appreciation

When a currency appreciates, it will make foreign goods appear relatively cheaper and domestic goods more expensive. When a currency appreciates its purchasing power in the foreign markets increases because the same amount of currency can buy more foreign currency. This will encourage more goods to be imported which is good for the consumer since they will have a more diverse selection of goods due to lower import prices. On the other hand, the number of exports will decrease, which is not good for domestic producers, because domestic goods will appear more expensive in foreign markets. Therefore, when we see an appreciation in the currency, net exports decrease.

When exports decrease, domestic producers are generating less income, as capital outflows increase. This means we will see a decrease in the aggregate demand in the economy.

Fig 1. - Increase in demand for U.S. Dollars

Figure 1 shows an increase in the demand for U.S. Dollars. This change in demand can be due to a decrease in the interest rates in the European markets. This increase in demand is shown by the shift of the demand curve for U.S. dollars from D₁ to D₂. This causes the equilibrium quantity demanded of U.S. dollars to increase from Q₁ to Q₂. Since the supply of U.S. dollars has not changed, the equilibrium number of euros per dollar increases from XR₁ to XR₂. This indicates an appreciation of the exchange rate and therefore the price of U.S. dollars compared to euros increases.

An appreciated currency can help control inflation because imports become relatively cheaper and these relatively lower prices can help keep inflation low. Lower prices on imports force domestic producers to increase their productive efficiency to keep domestic prices low and competitive with the foreign goods.

Effect of currency depreciation

When a currency depreciates, it will make foreign goods appear relatively more expensive and domestic goods cheaper. The purchasing power of the domestic currency in foreign markets falls too. The benefit of depreciation is that domestic goods now appear cheaper in foreign markets which will encourage an increase in exports. This will promote a trade surplus and thus result in an increase in net exports. An increase in exports means domestic producers are generating more income which will increase capital inflows and encourage domestic producers to increase production to maximize profits. It also increases aggregate demand.

Fig 2. - Decrease in demand for U.S. Dollars

Figure 2 shows the effect of a decrease in demand for U.S. Dollars. This decrease in demand could stem from an unstable political climate, for example. The demand curve for U.S. dollars shifts from D₁ to D₂, which decreases the equilibrium quantity of dollars demanded from Q₁ to Q₂. The supply of dollars has remained unchanged, so the equilibrium number of euros per dollar falls from XR₁ to XR₂. This indicates a depreciation of the exchange rate and therefore the price of U.S. dollars compared to euros decreases.

Appreciation and Depreciation Formula

To find out if a currency appreciated or depreciated, and by how much, we need to know the old value of the currency and the new value of the currency. We then need to apply the following formula:

$\%\Delta invalue=\frac{newvalue-oldvalue}{oldvalue}$

Appreciation calculation

To calculate appreciation, we will use dollars to euros as an example.

Let the initial exchange rate be: $1.25/1€.

Imagine the dollar appreciates to $1.50/1€.

Now we must find out by how much in percentage terms the dollar appreciated.

We will plug our values into the formula for calculating the percentage change in value:

$\frac{\$1.50-\$1.25}{\$1.25}=\frac{\$0.25}{\$1.25}=0.2or20\%$

The dollar has appreciated by 20% relative to the euro.

Depreciation calculation

To calculate depreciation, we will use dollars to euros as an example.

Let the initial exchange rate be: $1.74/1€.

Imagine the dollar depreciates to $1.43/1€.

Now we must find out by how much in percentage terms the dollar depreciated.

$\frac{\$1.43-\$1.74}{\$1.74}=\frac{-\$0.31}{\$1.74}=-0.178or-17.8\%$

The dollar has depreciated by 17.8% relative to the euro. Note the negative percentage change that indicates depreciation.