Currency depreciation refers to the decline in the value of the U.S. dollar relative to another currency. The currencies are described as being at parity if one U.S. dollar can be exchanged for one Canadian dollar. The U.S. dollar has lost value relative to its Canadian counterpart and has therefore depreciated against it if the exchange rate moves and one U.S. dollar can now be exchanged for 0.85 Canadian dollars.
A variety of economic factors can contribute to depreciation of the U.S. dollar. They include monetary policy, rising prices or inflation, demand for currency, economic growth, and export prices.
Key Takeaways
- Currency depreciation refers to the decline in the value of the U.S. dollar relative to another currency.
- Easy monetary policy by the Fed can weaken the dollar when investment capital flees the U.S. as investors search elsewhere for higher yield.
- Declining economic growth and corporate profits can cause investors to take their money elsewhere.
- The currency stays strong when a country’s currency is in demand.
Investopedia / Ellen Lindner
Monetary Policy
The Federal Reserve or “the Fed” is the central U.S. bank. It implements monetary policies to either increase or decrease interest rates. The Fed is said to be “easing” when it lowers interest rates or implements quantitative easing measures such as the purchase of bonds. Easing occurs when central banks reduce interest rates, encouraging investors to borrow money. These borrowed dollars are eventually spent by consumers and businesses and stimulate the U.S. economy.
The implementation of what’s known as “easy” monetary policy weakens the dollar, however. It can lead to depreciation. The U.S. dollar is a fiat currency not backed by any tangible commodity such as gold or silver so it can be created out of thin air. The law of supply and demand kicks in when more money is created, making existing money less valuable.
Investors often seek out the highest-yielding investments with the highest interest rates. U.S. Treasury bonds tend to follow suit when the Fed cuts rates and their yields fall. Investors transfer their money out of the U.S. and into other countries that offer higher interest rates. The result is a weakening of the dollar versus the currencies of the higher-yielding countries.
Inflation
Inflation is the pace of rising prices in an economy. There’s an inverse relationship between the U.S. inflation rate versus its trading partners and currency depreciation or appreciation.
Higher inflation depreciates currency because inflation means that the costs of goods and services are rising. These goods then cost more for other nations to purchase. Rising prices can decrease demand. Imported goods become more attractive to consumers in the higher inflation country to purchase.
Demand for Currency
The currency stays strong when a country’s currency is in demand. A currency remains in demand if the country exports products that other countries want to buy and demands payment in its own currency. The U.S. doesn’t export more than it imports but it has found another way to create an artificially high global demand for U.S. dollars.
The U.S. dollar is known as a reserve currency. Reserve currencies are used by nations across the world to purchase desired commodities such as oil and gold. An artificial demand for that currency is created when sellers of these commodities demand payment in the reserve currency, keeping it stronger than it might otherwise have been.
There are fears in the United States that China’s growing interest in attaining reserve currency status for the yuan will reduce demand for U.S. dollars. Similar concerns surround the idea that oil-producing nations will no longer demand payment in U.S. dollars. Any reduction in the artificial demand for U.S. dollars is likely to depreciate the dollar.
Slowing Growth
Weak economies tend to have weak currencies. Declining growth and corporate profits can cause investors to take their money elsewhere. Reduced investor interest in a particular country can weaken its currency. Currency speculators can bet against the currency as they see or anticipate the weakening, causing it to weaken further.
Falling Export Prices
Currency can depreciate when prices for a key export product fall. The Canadian dollar, known as the loonie, weakens when oil prices drop because oil is a major export product for Canada.
What About Trade Balances?
Some nations spend more than they earn. This is a bad idea because it produces debt. The United States imports more than it exports and it has done so for decades.
The United States finances this imbalance by issuing debt. China and Japan export a significant amount of goods to the United States and they help finance U.S. deficit spending by loaning it massive amounts of money. The United States issues U.S. Treasury securities in exchange for the loans and pays interest to the nations that hold these securities.
It’s possible that these debts will someday come due and the lenders will want their money back. Theorists believe the dollar will weaken if lenders believe the debt level is unsustainable. The U.S. typically issues new bonds to pay off any of the foreign-held bonds that are coming due, however, because there’s a healthy demand for Treasuries.
Important
Trade balances are also impacted by export prices, inflation, and other variables. The balance of trade changes as a result of other economic factors as well but it doesn’t cause those factors.
A Complex Equation
Several other factors that can contribute to dollar depreciation include political instability either in a particular nation or in its neighbors, investor behavior and risk aversion, and weakening macroeconomic fundamentals. These factors have complex relationships so it can be difficult to cite a single one that will drive currency depreciation by itself.
Central bank policy is considered to be a significant driver of currency depreciation. One would expect the value of the dollar to weaken significantly if the U.S. Federal Reserve implements low interest rates and unique quantitative easing programs. The strength of the dollar may rise, however, if other nations implement even more significant easing measures or investors expect U.S. easing measures to stop and foreign central banks’ efforts to increase.
The various factors that can drive currency depreciation must be taken into consideration relative to all the other factors. These challenges present formidable obstacles to investors who speculate in the currency markets. This was seen when the value of the Swiss franc suddenly soared and investments plummeted in 2015 as a result of that nation’s central bank making a surprise move to discontinue the currency exchange rate ceiling.
Depreciation: Good or Bad?
The question of whether currency depreciation is good or bad largely depends on perspective. Currency depreciation is good for you if you’re the chief executive officer of a company that exports its products. Demand for your products will rise when your nation’s currency is weak relative to the currency in your export market because the price for them has fallen for consumers in your target market.
Currency depreciation is bad news if your firm imports raw materials to produce your finished products. A weaker currency means that it will cost you more to obtain the raw materials and this will force you to either increase the prices of your finished products, potentially leading to reduced demand for them, or lower your profit margins.
A similar dynamic is in place for consumers. A weak dollar makes it more expensive to take that European vacation or buy that new imported car. It can also lead to unemployment if your employer’s business suffers because the rising cost of imported raw materials hurts business and forces layoffs. It can mean higher wages and better job security, however, if your employer’s business surges due to increasing demand from foreign buyers.
What Is Quantitative Easing?
Quantitative easing effectively means printing more money. A country’s central bank will then use that money to purchase government securities, reducing interest rates. The theory is that this will prompt financial institutions to increase lending and keep money flowing.
What Is Deficit Spending?
Deficit spending occurs when a government spends more than it receives in revenues during a fiscal period.
What Is the Strongest Currency in the World?
Forbes Advisor calculated the strongest currencies in October 2024 by determining how many dollars were necessary to buy one unit of another country’s currency. The Kuwaiti dinar was determined to be the strongest at that time. One dinar purchased $3.26 and $1 purchased 0.31 dinar.
The Bottom Line
A large number of factors influence currency value. Whether the U.S. dollar depreciates in relation to another currency depends on the monetary policies of both nations, trade balances, inflation rates, investor confidence, political stability, and reserve currency status. Economists, market watchers, politicians, and business leaders carefully monitor the ever-changing mix of economic factors to determine how the dollar reacts.
Read the original article on Investopedia.