Depreciation and Devaluation of currency

Subject – Economy

Context – Rupee Weakens To 15-Month Low

Concept –

Devaluation of a currency

Devaluation of a currency is associated with countries having a fixed exchange rate regime.
Under the fixed rate regime, the central bank or the government decides the value of the currency with respect to other foreign currencies. The central bank or the government purchases or sells its currencies to maintain the exchange rate.
When the government or the central bank reduces the value of its currency, then it is known as the devaluation of the currency. Under this, the value of the domestic currency is deliberately reduced in terms of other foreign currencies.

Reasons of currency devaluation

Disadvantages of currency devaluation

Inflation: it can lead to increase in the inflation rate as essential imports such as oil etc will become more expensive. It can also lead to demand-pull inflation.
It reduces the purchasing power of the country’s citizens and foreign goods and foreign tours become expensive for them.
Large and quick devaluation of currency may reduce the faith of international investors in the domestic economy. Foreign investors would be less interested in holding the government debt as devaluation reduces the value of their holdings.
Devaluation of currency negatively impacts the corporates and individuals who hold debt in the foreign currency.

Reasons responsible for currency devaluation

Decline in exports: the decline in a country’s overall exports leads to a decline in export revenues. This reduces the demand for the country’s currency and leads to its depreciation.
Large increase in imports: a large increase in the demand for imported goods and services can lead to a trade deficit. Increase in the current account deficit can lead to a net outflow of the currency which can weaken the exchange rate leading to currency depreciation.
Monetary policy of Central Bank: if the central bank reduces its policy interest rates it can lead to the outflow of hot money such as foreign portfolio investment etc. This can lead to the depreciation of domestic currency.
Open market operations of the central bank: if the Central bank undertakes open market operations to buy foreign currency and gold etc it can lead to the depreciation of domestic currency. RBI undertakes open market operations in case of rapid appreciation or depreciation of the rupee and to reduce volatility in the foreign exchange market.

Depreciation of a currency

Depreciation of a currency is a phenomenon associated with countries with floating exchange rate regime.
In the floating exchange rate regimes, the value of a country’s currency is determined by the market forces of demand and supply. The exchange rate of the currency changes on daily basis as per the demand and supply of that currency with respect to foreign currencies.
A currency depreciates with respect to foreign currency when the supply of currency in the market increases while its demand falls.