Currency Appreciation and Depreciation
Currency Appreciation and Depreciation
In economics, the terms currency appreciation and currency depreciation describe the movements of the exchange rate induced by market fluctuations. If a country is fixing the exchange rate, official adjustments to the fixed exchange rate are called currency revaluation and devaluation. Currency appreciates when its value increases with respect to the value of another currency or a “basket” of other currencies. Currency depreciates when its value falls with respect to the value of another currency or a basket of other currencies.
These special terms have to be used because exchange rates can be expressed in different ways, so that using the words “rise” and “fall,” or “increase” and “decrease,” for changes in the exchange rate can be confusing. For example, if the exchange rate between the U.S. dollar and the euro is expressed in dollars per euro (e.g., 1.20 dollars per euro), an increase in the exchange rate (e.g., to 1.25 dollars per euro) means that the dollar depreciates with respect to the euro and the euro appreciates with respect to the dollar. In other words, the dollar becomes less valuable and the euro becomes more valuable. The same exchange rate can be expressed in euros per dollar (e.g., 0.83 euros per dollar). In this case, an increase in the exchange rate (e.g., to 0.9 euros per dollar) means that the dollar appreciates with respect to the euro and the euro depreciates with respect to the dollar.
In the short run, currency appreciations and depreciations are driven by changes in demand and supply for a currency in the foreign exchange market. The demand and supply of currency depend on a country’s imports and exports, international financial transactions, speculations on the foreign exchange market, and, under “dirty float,” government interventions in the foreign exchange market. In the long run, currency appreciations and depreciations are determined by the inflation rate and economic growth of the country.
Forecasting currency appreciations and depreciations turns out to be a big challenge for economic theorists. In a 1983 paper titled “Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample?” Richard Meese and Kenneth Rogoff demonstrated that a simple statistical model of the random walk—which states that the best forecast of the exchange rate tomorrow is the exchange rate today—does a better job at forecasting the exchange rate than any of the economic models available at that time. In addition, economic researchers have shown that the exchange rate tends to be “disconnected” from the fundamentals, or the factors that usually affect the exchange rate in economic models. These findings are known as the Meese-Rogoff puzzle and the “exchange rate disconnect” puzzle, respectively. In a 2005 paper, “Exchange Rates and Fundamentals,” Charles Engel and Kenneth West demonstrated that given the statistical properties of the fundamentals and the discount factor of the individuals (the weight they place on future consumption relative to today’s consumption), it should be expected that exchange rate behavior is similar to a random walk.
In a 2002 paper, “Order Flow and Exchange Rate Dynamics,” Charles Evans and Richard Lyons took another approach. They showed that using information on the demand and supply of foreign currency (the order flows by the banks participating in the foreign exchange market), it is possible to forecast currency appreciation and depreciation in the short run better than using the random walk.
Currency appreciation and depreciation affect all the international transactions of a country because they affect international relative prices. In international trade, currency appreciation makes a country’s exports more expensive for the residents of other countries if exporters in that country can increase the prices at which they sell their goods to foreign customers. If the exporters cannot increase their sale prices due to competition, their profits fall because the cost of production, which is denominated in their domestic currency, rises relative to their revenues, which are denominated in the foreign currency. If the profits decline a lot, some firms will stop exporting, so that the volume of exports from a country experiencing currency appreciation will decline. The reverse is also true: Currency depreciation will make a country’s exports more competitive, increase exporters’ profits, and increase the volume of country’s exports.
Similar mechanisms link currency appreciation and depreciation to a country’s imports. If a currency appreciates, the country’s residents will find imported goods inexpensive relative to goods produced domestically, and the volume of imports will increase. Likewise, if a currency depreciates, the country’s residents will find that imported goods are very expensive, and they will prefer to switch to buying goods produced domestically, thus lowering the volume of imports. Such changes in trade pattern occur in response to the long-run changes in the exchange rate, and they develop slowly over time because international trade contracts are written well in advance.
Currency appreciation and depreciation also affect international asset trade and the value of the holdings of foreign assets. If a domestic currency depreciates, the value of that country’s residents’ foreign currency asset holdings increases (because foreign currencies become relatively more valuable), while the value of foreigners’ holdings of that country’s assets declines. These changes can be described as capital losses and gains due to changes in the exchange rate. In the beginning of the 2000s, the U.S. dollar experienced substantial depreciation. While the United States continued to borrow abroad, its total debt to foreigners did not increase, because dollar depreciation meant capital gains for the U.S. residents and capital losses for the foreigners, which offset new borrowing by U.S. residents. This effect is known in economic literature as a valuation effect of exchange rate changes. Cédric Tille, in his 2003 paper “The Impact of Exchange Rate Movements on U.S. Foreign Debt,” calculated the exact contribution of the valuation effect to the international financial position of the United States.
When a country accumulates a large amount of foreign currency debt, a sharp depreciation of its currency can be very harmful. If firms’ revenues or assets are denominated in their own currency while their debts or liabilities are denominated in foreign currency, the currency depreciation will lower the value of firms’ assets relative to liabilities, sometimes so much that firms become bankrupt. Such an effect is known in the economic literature as the balance sheet effect. During the financial crises of the late 1990s, the negative balance sheet effects of currency depreciations outweighed their positive effects on exporters’ profits. This experience exposed the importance of matching the currency composition of assets and liabilities.
SEE ALSO Balance of Payments; Central Banks; Currency Depreciation; Currency Devaluation and Revaluation; Dirty Float; Exchange Rates; Greenspan, Alan; Hedging; Macroeconomics; Money; Mundell-Fleming Model; Purchasing Power Parity; Reserves, Foreign; Trade Surplus
Engel, Charles, and Kenneth D. West. 2005. Exchange Rates and Fundamentals. Journal of Political Economy 113: 485–517.
Evans, Martin D., and Richard K. Lyons. 2002. Order Flow and Exchange Rate Dynamics. Journal of Political Economy 110 (1): 170–180.
Meese, Richard, and Kenneth Rogoff. 1983. Empirical Exchange Rate Models of the Seventies: Do They Fit Out of Sample? Journal of International Economics 14: 3–24.
Tille, Cédric. 2003. The Impact of Exchange Rate Movements on U.S. Foreign Debt. Current Issues in Economics and Finance 9 (1): 1–7.