How do currencies gain or lose their value? Currency Appreciation and Currency Depreciation explained.

Currency appreciation and depreciation:

We often hear about the terms currency appreciation and depreciation, but have you ever wonder why do the values of currencies fluctuate? Well...in this article, we are going understand currency appreciation and depreciation, the reasons behind these, and the factors controlling currency value.

Before we move forward, we must take a look at the definitions of currency appreciation and depreciation.

Currency Appreciation in simple terms, is the increase in the value of a country's currency with respect to other foreign currencies (usually the US Dollar).

On the other hand, Currency Depreciation occurs when the country's currency loses its value with respect to foreign currencies.

• The appreciation and depreciation of the currency is mostly the function of Floating Exchange Rate System. (We will discuss this further in the article.)

To understand this topic clearly, we must start with the basics of currency.

The Basics of Currency:

A currency note is nothing but a piece of paper. The only thing that makes it valuable is that it is designated as the official currency by the government and thus, it is used in trade for valuable goods. The currency makes the trade much more convenient than the old Barter System.

But the value of each currency is not equal and the reason is quite simple. Back in the days of Barter System, people traded goods they had for the goods they needed....but this trade was not random. The two items that were traded between two people had to have almost equal value. If someone needed some highly valuable item (such as diamond), then he had to pay an item of same value in return or a larger quantity of some less valuable item (such as iron) to make the values of the two traded items equal.

A similar logic applies to the currency system as well. The purpose of a currency is to be exchanged for the goods and services. It is quite obvious that the currency printed by the country's government is nothing but a tool used for the easy and convenient trade (of the goods and services produced by that country). So the amount of currency produced(printed) by the government represents the goods and services in that country, and this amount of currency has same value as these goods and services.

The value of the currency in circulation cannot be more than the value of goods and services in the country because something cannot be created out of nothing. This point will help us understand some of the factors that affect the value of the currency.

Factors affecting the currency value:

(1) Productivity:

Currency acts as a store of value and you can use this value in exchange for many things. As discussed above, the total currency in circulation has the same value as the goods and services produced in that country or in other words, the productivity of a country. So if the total currency in circulation remains the same but the productivity of a country increases, then each currency note or unit will also hold more value.

On the other hand, if the productivity of a country remains the same but the government print more currency (for many reasons like paying the salaries of government employees, or other government needs), then the value of each currency note will decrease and we will say that the currency is depreciated. This usually occurs when government runs out of money or the productivity of the country decreases.

Why doesn't the government print infinite currency?

If more currency is printed, the value of each currency bill will decrease accordingly (because of the point discussed above that the value of currency in circulation just cannot be more than the value of goods and services it represents). Thus the value of "total" currency in circulation would still be the same.   

(2) Currency Printing:

If a country increases its productivity, then the currency will gain value (if more money is not printed by the government). Increased productivity allows the government to print more currency accordingly without the loss of currency value. This money can then be used for economic development of the country and other purposes.

If the productivity of the country decreases or remains same and the government runs out of money, the government may consider printing more currency which will lead to currency devaluation. This newly printed money will not come out of nothing but it will actually be the lost value of the money already in circulation. In this scenario, the government gets money from the pocket of consumer in an indirect way.

(3) Demand in Foreign Exchange Market:

There might be a "relative" increase or decrease in currency foreign exchange value. The factor or rate at which one currency converts into another in called currency exchange rate.

Currency exchange rates are actually the value of currencies relative to each other in foreign exchange market. These foreign exchange rates are determined by the supply and demand of a currency. The more a currency is in demand, the more value it acquires and vice versa. Balance of Trade is a key factor in determining the demand for a certain currency.

Balance of Trade: Balance of trade is the difference between the value of a country's imports and exports (over a certain time period). The magnitude of imports and exports of a country has a direct impact on the value of that country's currency.

• If the value of a nation's imports increases, this will affect the balance of payment. To pay for these imports, the country will need the foreign currency. This increased demand of foreign currency will result in an increase in the value of that foreign currency. Thus it would cause "relative" depreciation of the country's own currency.
• On the other hand, if the exports of the country increase, then there will be an increase in the demand of the country's home currency leading to its relative appreciation (quite similar to the foreign currency in first scenario) because foreign countries will have to buy the currency of that country from where they're importing.
• If for some reason, the exports of the country are decreasing or the price of country's major exports is falling, it would mean that the overseas demand of that country's currency is decreasing. This will lead to currency devaluation.

This is how an increase (or decrease) in demand of a currency results in its appreciation (or depreciation) in foreign exchange market. Countries, however, may follow floating exchange rate system or managed exchange rate system.

In floating exchange rate system, the central bank isn't asked to influence the external value of exchange rate. Instead, the exchange rate is determined solely by market forces and the supply and demand factor.
In managed exchange rate system on the other hand, the central bank is allowed to intervene in foreign exchange markets and to influence the flow of currency in order to "manage" the exchange rate and the currency value. We will further discuss this role of central bank in our next point.

(4) Role of Central Banks:

In managed exchange rate system, central banks and the government play a very important role in controlling the value of the currency. They have the authority to influence the interest rates, to introduce monetary policies, and to print the currency. Central banks can also buy and sell the currencies in order to control the local currency value.

Central bank may go into the market to buy or sell its own currency for gold or other currencies. Central banks usually sell their own currency in exchange for gold and foreign currencies which leads to the depreciation of the currency. Central banks do this in order to become more competitive in the exports field (currency depreciation usually tends to boost exports).

Interest Rates: As we know, the value of a currency depends a lot on how much that currency is in circulation. The central bank sometimes fluctuate the interest rates to control the amount of currency in circulation.

Low interest rates increase borrowing and thus increase the amount of currency in circulation resulting in depreciation of the currency. On the other hand, high interest rates decrease borrowing and thus act to decrease the total currency in circulation. The lower a currency in circulation, the higher is the value of that currency. 

Also, high interest rates attract foreign investment (because investors like to buy the currencies with high interest rates in order to get a quick return on their investment) which also leads to currency appreciation. In this way, the central bank can control the total currency in circulation and the value of currency by fluctuating the interest rates.  

(5) Inflation:

The inflation in a country can affect the exports of that country and thus the currency value. Low inflation in a country means the goods and services in that country are quite cheap. These low prices will make the exports of that country more competitive in the international market (because of relatively lower price), boosting the exports. This boost in exports will lead to more demand of that country's currency resulting in currency appreciation. On the other hand, high inflation rate in a country will have a negative effect on the local currency.

(6) Speculation/Investors' Confidence:

The investors play a key role in deciding the value of a currency (as we've seen above that an increase in foreign investment increases the value of local currency and vice versa). Usually, the investors consider investing in a country (or not) based on the speculations. When a country's currency is excepted to perform good in the near future, demand of the currency increases because investors see profit in it. This increased demand causes the value of currency to rise. Political events in a country also affect the foreign investments because the investors prefer the countries that are stable politically. 

In this article, we looked at currency appreciation and depreciation, and understood the factors controlling the currency values. If you liked the article, make sure you share it with your friends. Thanks for visiting.