Meaning of Appreciation and Depreciation

Meaning of Appreciation and Depreciation

The appreciation or devaluation denotes the deliberate rise or fall in the rate of one currency against another. The background for the so-called revaluation (appreciation) or devaluation is to be found in the foreign trade relations of the respective countries, or in the foreign exchange market itself.

  • Appreciation and devaluation can arise due to the supply and demand for a currency, but also due to targeted intervention by the respective central bank.
  • The devaluation of a currency can stimulate exports and lead to economic advantages in the short term.
  • The appreciation of a currency can have a long-term negative impact on an economy.

What are the exact causes of appreciation and devaluation?

On the one hand, for example, a devaluation can result from a country’s economic situation deteriorating drastically. Participants in the foreign exchange market lose confidence in the country and its currency. The value of the currency against other currencies falls, from the point of view of the country concerned there is a devaluation. Conversely, the currencies of the other countries will appreciate.

Another situation arises when a country’s central bank deliberately pushes the value of its own currency down against a foreign currency. The aim of this measure is to stimulate exports by making goods cheaper for foreign countries.

Before the introduction of the euro, Italy, for example, used the instrument of devaluation in phases of weak economic activity. Devaluation by the common currency is no longer possible within the euro zone, even if the purchasing power of the individual countries diverges widely.

The story of appreciation and devaluation

Originally the US dollar was linked to the gold price (gold parity). In 1944, the International Monetary Fund (IMF) created the system of fixed exchange rates depending on gold parity. The gold parity of the US dollar made it possible to determine how the individual currencies relate to the US dollar. Due to the dependence on the gold price, the relationship between the individual currencies was fixed.

Using the D-Mark as an example, however, it can be shown that this system could not last. In May 1949 the IMF fixed the value of one dollar at 3.33 DM. However, the value of the D-Mark fell, and by September the value of one US dollar was 4.20 D-Mark. The central bank had to intervene more and more frequently in the years that followed. In 1969, the fixed exchange rates had to be relaxed for the first time. In December 1971 the US abolished the gold parity of the US dollar. In March 1973, the member states of the European Economic Community (EEC) began collectively to unlock currencies against the US dollar.

In 1979 the European Monetary System was introduced with the ECU. This synthetic currency was based on the D-Mark. With the introduction of the euro, the USA was ultimately faced with an economic area with a single currency, which developed tremendously with the appreciation or devaluation of its currency against other currencies.

The consequences of revaluation and devaluation

The devaluation of a currency has positive effects for the respective country in the short term. The economy is stimulated. Conversely, imported goods are becoming more expensive. This, in turn, can mean that similar goods produced in the domestic economy are in greater demand.

The devaluation of crude oil becomes problematic. The US dollar is still the key currency on the oil market. The devaluation of a currency against the dollar leads to a corresponding increase in the price of a large part of the energy costs. A devaluation also leads to foreign travel becoming more expensive, a fact that is seldom taken up positively by the population.

In the long term, however, an appreciation can lead to a deterioration in the labor market. With falling exports due to the rise in the price of goods abroad, the consequence of the revaluation can mean a decline in production, which in turn leads to the exemption of workers.

The appreciation or devaluation of a currency also affects debt servicing. Regardless of whether they are private loans or loan turns the public sector, the debt service becomes cheaper when the loans were taken out in foreign currency and its currency was revalued. In this case, the borrower will need less money to repay the loan.

Appreciation and devaluation as a risk factor

The calculated appreciation or devaluation of a currency against other currencies can turn out to be a downward spiral. If one currency area also responds to a devaluation of another currency with a devaluation, this could lead to a downward spiral between these two currencies. Especially for an economic area like the European Union with a clear gap in economic output and average income, the effects of an appreciation or devaluation are drastically different.