In economics, depreciation and devaluation of currency are the two measures of changing the relative price of imports and exports of goods. Depreciation of currency implies the drop in the market value of the domestic currency with respect to foreign currency.
On the contrary, the Devaluation of currency can be understood as the government’s conscious downward adjustment of the market value of the domestic currency in relation to gold and reserve currency.
According to the theory of purchasing power parity, both depreciation and devaluation of the currency are regarded as one and the same thing because of the similar effect on foreign demand. However, there exists a fine line of difference between these two, which we are going to discuss in this article.
Content: Depreciation Vs Devaluation of Currency
|Basis for Comparison
|Depreciation of Currency
|Devaluation of Currency
|Depreciation of currency implies the dip in the value of currency in relation to other currencies, due to market forces.
|Devaluation of currency means the fall in international value of home currency in terms of other currencies due to government intervention.
|Exists under flexible exchange rate system.
|Exists under fixed exchange rate system.
|Occurs due to
|Market demand and supply factors
Definition of Depreciation of Currency
Depreciation of Currency can be understood as the decline in the monetary value of the currency in relation to other foreign reference currencies in a floating exchange rate regime. A floating or flexible exchange rate system is one wherein there is no standard currency value and so the value of a currency is determined by market demand and supply forces.
The prior causes of the depreciation of currency are market supply and demand forces, monetary and fiscal policies, risk aversion among investors, interest rate differentials, negative trade balance and political instability.
The countries that are not economically sound, i.e., the countries that have acute current account deficits and where the rate of inflation is relatively high, often face depreciation in their currency, leading to a loss of currency value in the international market. Meaning that the home currency becomes less valuable and so, more amount will be needed to buy the foreign currency.
Therefore, currency depreciation makes exports cheaper, as they can purchase more of a good with the same foreign currency and at the same time, imports become expensive, so the citizens would buy fewer imported goods.
When the currency depreciation is slow and manageable, it improves a country’s export competitiveness and trade deficit over the years. As against, when it is sudden and whopping, then the foreign investors may withdraw their money invested in the domestic market, in the fear that the currency may fall further, which leads to the downfall in the currency.
Definition of Devaluation of Currency
Devaluation of Currency is a mechanism used by countries with fixed or semi-fixed exchange rate systems, wherein the monetary authority, i.e. the central bank, deliberately lowers the value of the currency by deciding a new rate, with reference to another country’s currency or standard currency, to support the country’s trade balance by encouraging exports
Devaluation of currency is a result of monetary authority policies, which aim at preventing trade imbalance. It leads to a fall in the price of the domestic country’s exports, making them more competitive in the international market. At the same time, the price of imports will rise, and so the citizens of the home country will prefer domestic goods over imported ones, which also improves the domestic country’s businesses.
As exports become cheaper, they will attract foreign buyers, and thus the exporters will benefit from it, which will lead to the creation of jobs in that sector, which ultimately helps in economic growth. Further, the current account deficit will also be reduced with the increase in the country’s exports.
However, one of the major drawbacks of devaluation is that aggregate demand will be greater than the aggregate supply, as increased exports will increase in the overall demand, causing demand-pull inflation. Moreover, the domestic residents need to pay more, if they want to travel abroad, as it affects the purchasing power of the citizens abroad.
Key Differences Between Depreciation and Devaluation of Currency
The difference between depreciation and devaluation of the currency can be drawn clearly on the following grounds:
- Depreciation of Currency implies the reduction in the worth of the country’s currency in terms of other important currency benchmarks, occurring out of market forces. On the contrary, the Devaluation of Currency simply means a fall in the value of the currency, deliberately made by the country’s monetary authority, in relation to foreign currency or currency basket.
- Depreciation of currency occurs automatically due to market forces, interest rate differential, risk aversion among investors and so forth. Conversely, devaluation of the currency is a result of government intervention, i.e. it is a conscious effort by the government to combat the trade deficit.
- Depreciation of currency takes place under a flexible exchange rate system. On the other hand, devaluation of currency takes place under a pegged exchange rate system.
- Depreciation of currency mainly arises out of market demand and supply forces. In contrast, devaluation of currency occurs due to the action of the government or central bank.
As we have discussed in the beginning, the impact of both depreciation and devaluation of the currency would be the same, i.e. a fall in the value of the domestic currency would make our exports economical and imports will be expensive, resulting in the shrinking of trade deficit, so they can prove beneficial to the country, but they have drawbacks too, which cannot be neglected.