Currency depreciation, in the context of the U.S. dollar, refers to the decline in value of the dollar relative to another currency. For example, if one U.S. dollar can be exchanged for one Canadian dollar, the currencies are described as being at parity. If the exchange rate moves and one U.S. dollar can now be exchanged for 0.85 Canadian dollar, the U.S. dollar has lost value relative to its Canadian counterpart and has therefore depreciated against it.
A variety of economic factors can contribute to depreciating the U.S. dollar. These include monetary policy, inflation, demand for currency, economic growth, and export prices.
In the United States, the Federal Reserve (the country’s central bank, usually just called the Fed) implements monetary policies to either strengthen or weaken the U.S. dollar. At the most basic level, implementation of what is known as “easy” monetary policy weakens the dollar, which can lead to depreciation. So, for example, if the Fed lowers interest rates or implements quantitative easing measures such as the purchase of bonds, it is said to be “easing.” Easing occurs when central banks reduce interest rates, encouraging investors to borrow money.
Since the U.S. dollar is a fiat currency, meaning that it is not backed by any tangible commodity (gold or silver), it can be created out of thin air. When more money is created, the law of supply and demand kicks in, making existing money less valuable.
There is an inverse relationship between U.S. inflation rate versus its' trading partners and currency depreciation or appreciation. Relatively speaking, higher inflation depreciates currency because inflation means that the cost of the goods and services are rising. Those goods then cost more for other nations to purchase. Rising prices decrease demand. Conversely, imported goods become more attractive to consumers in the higher inflation country to purchase.
Demand for Currency
When a country’s currency is in demand, the currency stays strong. One of the ways a currency remains in demand is if the country exports products that other countries want to buy and demands payment in its own currency. While the U.S. does not export more than it imports, it has found another way to create an artificially high global demand for U.S. dollars.
The U.S. dollar is what is known as a reserve currency. Reserve currencies are used by nations across the world to purchase desired commodities, such as oil and gold. When sellers of these commodities demand payment in reserve currency, an artificial demand for that currency is created, keeping it stronger than it might otherwise have been.
In the United States, there are fears that China’s growing interest in attaining reserve currency status for the yuan will reduce demand for the U.S. dollars. Similar concerns surround the idea that oil-producing nations will no longer demand payment in U.S. dollars. Reduction in the artificial demand for U.S. dollars is likely to depreciate the dollar.
Strong economies tend to have strong currencies. 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. As currency speculators see or anticipate the weakening, they can bet against the currency, causing it to weaken further.
Falling Export Prices
When prices for a key export product fall, currency can depreciate. For example, 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?
Nations are like people. Some of them spend more than they earn. This, as every good investor knows, is a bad idea because it produces debt. In the case of the United States, the country imports more than it exports, and has done so for decades.
One of the ways the United States finances its profligate ways is by issuing debt. China and Japan, two countries that export a significant amount of goods to the United States, help finance U.S. deficit spending by loaning it massive amounts of money. In exchange for the loans, the United States issues U.S. Treasury securities (essentially IOUs) and pays interest to the nations that hold those securities. Someday, those debts will come due and the lenders will want their money back. If lenders believe the debt level is unsustainable, theorists believe the dollar will weaken. Trade balances are also impacted by export prices, inflation, and other variables. The balance of trade changes as a result of other economic factors, it does not cause those factors.
A Complex Equation
A number of other factors that can contribute to dollar depreciation include political instability (either in a particular nation or sometimes in its neighbors), investor behavior (risk aversion), and weakening macroeconomic fundamentals. There is a complex relationship between all of these factors, so it can be difficult to cite a single factor that will drive currency depreciation in isolation. For example, central bank policy is considered to be a significant driver of currency depreciation. If the U.S. Federal Reserve implements low-interest rates and unique quantitative easing programs, one would expect the value of the dollar to weaken significantly. However, if other nations implement even more significant easing measures and/or investors expect U.S. easing measures to stop and foreign central banks efforts to increase, the strength of the dollar may actually rise.
Accordingly, the various factors that can drive currency deprecation must be taken into consideration relative to all of the other factors. These challenges present formidable obstacles to investors who speculate in the currency markets, as was seen when the value of the Swiss franc suddenly collapsed in 2015 as a result of that nation’s central bank making a surprise move to weaken the currency.
Depreciation: Good or Bad?
The question of whether currency depreciation is good or bad largely depends on perspective. If you are the chief executive officer of a company that exports its products, currency depreciation is good for you. When your nation’s currency is weak relative to the currency in your export market, demand for your products will rise because the price for them has fallen for consumers in your target market.
On the other hand, if your firm imports raw materials to produce your finished products, currency depreciation is bad news. A weaker currency means that it will cost you more to obtain the raw materials, which will force you to either increase the cost of your finished products (potentially leading to reduced demand for them) or lower your profit margins.
A similar dynamic 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. On the other hand, if your employer’s business surges due to increase demand from foreign buyers, it can mean higher wages and better job security.
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 in an effort to determine how the dollar reacts.