Currency Appreciation & Depreciation

Let’s continue our discussion on currency market and movements that we started in our previous article. We just understood what a currency market is and why currency appreciates and/or depreciates. In this article let’s try to understand why this upward/downward movement of currency is so important.

Suppose you want to import a costly laser machine from USA. The cost of machine is USD 1000. Currently the conversion rate given to you by your dealer is USD 1 = INR 65. So as of today, you will have to spend INR 65,000 to buy this machine. Due to some issues, you postpone your purchase and decide to buy it next month. Meanwhile due to reasons beyond your control, USD appreciates. We know that USD appreciation means INR depreciation. Thus, we will have to pay more in order to buy each unit of Dollar. Now after one month, you again ask for a quote from your dealer and he quotes USD 1 = INR 70. Thus, you will now have to pay more to import the same machine because of USD appreciation (INR depreciation).

Let’s take another example. Suppose you manufacture cycles. You want to export one cycle to US for INR 6000. The person importing this cycle in US will have to pay in INR and thus asks for a quote from his dealer to buy INR. His dealer quotes 1USD = 60 INR. So to buy INR 6000, he will have to spend USD 100 (6000/60). Just as in previous example, he also faces some issues and postpones his purchase by one month. After one month, you are again willing to sell the cycle at INR 6000, but suppose USD appreciated. Now it becomes USD 1 = INR 65. Thus, the US buyer will only have to pay USD 92.5, in order to buy the same product.

Above examples make it very clear that when foreign currency appreciates (domestic currency depreciates), local goods become cheaper in other countries, as foreigners will have to pay less to buy the same amount of INR. At the same time, it makes foreign goods costly as you will have to pay more to buy each unit of foreign currency. So when local currency depreciates, imports become costly and price of exported goods becomes cheap for foreign nationals. As price of imported goods increases, demand for imported article decreases and as price of goods exported becomes cheaper for foreigners, foreign demand for local goods increases. Hence we can now conclude that domestic currency depreciation leads to higher exports and lower imports. Opposite will happen when domestic currency appreciates.

India is a major oil importer as it doesn’t produce sufficient crude oil to meet its energy demands. Thus when rupee depreciates, it becomes more expensive for the Government to import oil. Higher oil prices increases the overall price level, as explained in our article on stagflation. Thus, it becomes important for many countries to ensure that their currency doesn’t excessively depreciate. But if a country doesn’t import many things, then it would want local currency to depreciate, so that local goods become cheaper in other countries and exports increases. Countries with excessive focus on exports use currency depreciation technique to boost their exports.