Currency appreciation is an increase in the value of one currency in relation to another currency. Currencies appreciate against each other for a variety of reasons, including government policy, interest rates, trade balances and business cycles.

Key Takeaways

  • Currency appreciation refers to the increase in value of one currency relative to another in the forex markets.
  • The value of a currency is not measured in absolute terms. It is always measured relative to the currency being measured against it.
  • Countries use currency appreciation was a strategic tool to boost their economic prospects.

Basics of Currency Appreciation

In a floating rate exchange system, the value of a currency constantly changes based on supply and demand in the forex market. The fluctuation in values allows traders and firms to increase or decrease their holdings and profit off them. 

Currency appreciation, however, is different from the increase in value for securities. Currencies are traded in pairs. Thus, a currency appreciates when the value of one goes up in comparison to the other. This is unlike a stock whose appreciation in price is based on the market’s assessment of its intrinsic value. Typically, a forex trader trades a currency pair in the hopes of currency appreciation of the base currency against the counter currency.

Appreciation is directly linked to demand. If the value appreciates (or goes up), demand for the currency also rises. In contrast, if a currency depreciates, it loses value against the currency against which it is being traded. 

Understanding Currency Appreciation

A standard currency quote lists two currencies as a rate. For example, USD/JPY = 104.08. The first of the two currencies (USD) is the base currency and represents a single unit, or the number 1 in the case of a fraction such as 1/104.08. The second is the quoted currency and is represented by the rate as the amount of that currency needed to equal one unit of the base currency. The way this quote reads is: One U.S. dollar buys 104.08 units of Japanese yen.

For the purposes of currency appreciation, the rate directly corresponds to the base currency. If the rate increases to 110, then one U.S. dollar now buys 110 units of Japanese yen and, therefore, appreciates. As a rule of thumb, the increase or decrease of a rate always corresponds to the appreciation/depreciation of the base currency, and the inverse corresponds to the quoted currency.

Appreciation of Currencies vs. Stocks

A stock is a security that represents ownership in a corporation for which its officers have a fiduciary duty to conduct operations that result in positive earnings for the shareholder. Thus, an investment in a stock should always be appreciating in value. 

By contrast, a currency represents the economy of a country, and a currency rate is quoted by pairing two countries together and calculating an exchange rate of one currency relative to the other. Consequently, the underlying economic factors of the representative countries have an effect on that rate. 

An economy experiencing growth results in a currency appreciating, and the exchange rate adjusts accordingly. The country with the weakening economy may experience currency depreciation, which also has an effect on the exchange rate.

Effects of Currency Appreciation

When a nation's currency appreciates, it can have a number of different effects on the economy. Here are just a couple:

  • Export costs rise:  If the U.S. dollar appreciates, foreigners will find American goods more expensive because they have to spend more for those goods in USD. That means that with the higher price, the number of U.S. goods being exported will likely drop. This eventually leads to a reduction in gross domestic product (GDP), which is definitely not a benefit.
  • Cheaper imports: If American goods become more expensive on the foreign market, foreign goods, or imports, will become cheaper in the U.S. The length to which $1 will stretch will go further, meaning you can buy more goods imported from abroad. That translates to a benefit of lower prices, leading to lower overall inflation.

Currency rates are, therefore, subject to the ebb and flow, or appreciation and depreciation, that correspond with the economic and business cycles of the underlying economies and are driven by market forces.

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Image by Sabrina Jiang © Investopedia 2020 

Real World Example of Currency Appreciation

China's ascension onto the world stage as a major economic power has corresponded with price swings in the exchange rate for the yuan, its currency. Beginning 1981, the currency rose steadily against the dollar until 1996, when it plateaued at a value of 1 dollar equaling 8.28 yuan until 2005. The dollar remained relatively strong during this period. It meant cheaper manufacturing costs and labor for American companies, who migrated to the country in droves. It also meant that American goods were competitive on the world stage as well as the United States due to their cheap labor and manufacturing costs. In 2005, however, China's yuan reversed course and appreciated 33% in value against the dollar until last year.