Study notes

Exchange Rates - Reasons for a Currency Depreciation

A depreciation is a fall in the external value of one currency against another, for example the Australian dollar might depreciate against the US dollar so that one Australian dollar buys less of the US currency.

Here are some reasons why the exchange rate of a country might depreciate:

  1. There is a fall in the world price of a country's major export. This leads to a decline in export revenues and a fall in overseas demand for the exporting nation's currency
  2. There is a surge in the volume and value of imported goods and services coming into a country leading to a trade deficit. A deficit on the current account of the balance of payments leads to a net outflow of currency, causing exchange rate weakness
  3. A country's central bank reduce monetary policy interest rates, leading to a net outflow of hot money - this is short term financial capital that searches for the economy that offers the best risk-adjusted rate of return
  4. Depreciation might be caused by intervention from the Central Bank e.g. it goes into the foreign exchange market to sell their own currency and buy gold and foreign currencies. This would happen under a managed exchange rate system
  5. Demand for a currency might fall if currency traders / speculators expect the exchange rate to depreciate causing them to sell on the market

Countries running large / persistent current account deficits on their balance of payments tend to see weak currencies. Likewise, a currency can falling in value if the macroeconomic fundamentals worsen i.e. there is slower growth, falling profits for domestic and overseas investors and when the markets feel that the real exchange rate is over-valued and due for a correction.

Japanese Yen against the US dollar

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