CHANGES IN EXCHANGE RATES
- Changes in exchange rates portray depreciation or appreciation of one currency. The terms, ` currency appreciation’ and ‘currency depreciation’ describe the movements of the exchange rate. Currency appreciates when its value increases with respect to the value of another currency or a basket of other currencies.
- On the contrary, currency depreciates when its value falls with respect to the value of another currency or a basket of other currencies.
Now suppose, the Rupee dollar exchange rate in the month of January is $1 = ` 65. And, we find that in the month of April it is $1 = ` 70. What does this indicate? In April, you will have to exchange a greater amount of Indian Rupees (`70) to get the same 1 US dollar. As such, the value of the Indian Rupee has gone down or Indian Rupee has depreciated in its value. Rupee depreciation here means that the rupee has become less valuable with respect to the U.S. dollar. Simultaneously, if you look at the value of dollar in terms of Rupees, you find that the value of the US dollar has increased in terms of the Indian Rupee. One dollar will now fetch ` 70 instead of ` 65 earlier. This is called appreciation of the US dollar. You might have observed that when one currency depreciates against another, the second currency must simultaneously appreciate against the first.
To put it more clearly:
- Home-currency depreciation (which is the same as foreign-currency appre- ciation) takes place when there is an increase in the home currency price of the foreign currency (or, alternatively, a decrease in the foreign currency price of the home currency). The home currency thus becomes relatively less valuable.
- Home-currency appreciation or foreign-currency depreciation takes place when there is a decrease in the home currency price of foreign currency (or alternatively, an increase in the foreign currency price of home currency). The home currency thus becomes relatively more valuable.
Figure 4.4.2
Home-Currency Depreciation under Floating Exchange Rates
The market reaches equilibrium at point E with equilibrium exchange rate e eq. An increase in domestic demand for the foreign currency, with supply of dollars remaining constant, is represented by a rightward shift of the demand curve to D1$. The equilibrium exchange rate rises to e1. It means that more units of domestic currency (here Indian Rupees) are required to buy a unit of foreign exchange (dollar) and that the domestic currency (the Rupee) has depreciated.
We shall now examine what happens when there is an increase in the supply of dollars in the Indian market. This is illustrated in figure 4.4.3.
Figure 4.4.3
Home-Currency Appreciation under Floating Exchange Rates
An increase in the supply of foreign exchange shifts the supply curve to the right to S1 $ and as a consequence, the exchange rate declines to e1. It means, that lesser units of domestic currency (here Indian Rupees) are required to buy a unit of foreign exchange (dollar), and that the domestic currency (the Rupee) has appreciated.
As we are aware, in an open economy, firms and households use exchange rates to translate foreign prices into domestic currency terms. Exchange rates also permit us to compare the prices of goods and services produced in different countries. Furthermore, import or export prices could be expressed in terms of the same currency in the trading contract. This is the reason why exchange rate movements can affect intentional trade flows.
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