Depreciation vs Devaluation of currency

Drop in a currency’s value can be either due to market forces of supply and demand or monetary policy steps taken by central banks. When this fall is due to central banks, it is known as devaluation of the currency and when the fall is caused by international forces, it is called depreciation of the currency. Both the terms are economic steps that result in a fall in the purchasing power of a currency with respect to other currencies. The detailed explanation is as below:

Depreciation: It happens in countries that follow floating exchange rate system i.e. the exchange rate of a currency with respect to a foreign currency is determined by the forces of demand supply. There may be an intervention by the central bank of the country but at the end, it is the free open market operations that decide the exchange rate. Here, the rate changes on every minute. It tells the worth of the currency in the international monetary exchange market.

Devaluation: It happens in countries that follow fixed exchange rate system i.e. the exchange rate is determined by the central bank of the country. The government pledged to buy or sell its currency as and when required to keep the rate same. The rate only changes when the central bank decides do change it.

Effect on the economy

The effects of both the steps will be similar in the short run. As the currency loses its value, exports would become cheaper, imports would become more expensive and there would be an increase in domestic demand of goods and services. This also makes the country’s housing market more attractive to foreigners and we see increase in foreign buying. Due to all this, the current account deficit of a country starts shrinking.  The negative effect of this would be the companies that import their raw materials as the fallen currency value would lead to losses in the balance sheet and a drop in their share prices.

In the long run, when this happens in a floating exchange rate system, the value of the currency goes back up caused by increase in demand for the currency due to rise in exports but in the fixed exchange rate system, this cannot happen as it is only the government that can adjust the exchange rates.

For instance, China devalued Yuan in 2015 thrice, knocking off 3% value, which was the first in the last 20 years. The move was taken to increase the Chinese exports to support the GDP growth which went to its lowest since 2011 to 6.9%. In the past 2 weeks, Chinese Yuan has depreciated by 2.15% from the levels of 5.5039 to 6.6436 against USD, in between touching the high of 6.7225 amid trade tariffs imposed by US on $34 billion worth of Chinese imports. Yuan is expected to further depreciate as US plans to impose further tariffs on $500 dollar of Chinese goods.

Hence it is said that depreciation is self-correcting and natural while devaluation is considered artificial. Both have similar impact but the duration of their impact is different. Today, most countries follow managed exchange rate system wherein the currency prices are determined by market forces but central banks intervene to support the exchange rates.


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