What is depreciation?

Depreciation is called a decline in the purchasing power of money. This term is most often used to describe the decline in the real value of the domestic currency relative to the value of the foreign currency in a floating exchange rate system. Thus, we deal with the phenomenon of depreciation when the exchange rate of a currency depicted by the value of another currency falls.

 

Effects of depreciation

A decrease in the value of a country’s currency causes exports to increase, making its goods cheaper for foreigners. On the other hand, a depreciation makes imports from abroad more expensive in terms of the domestic currency and therefore imports fall. However, it can be noted that the effect of devaluation or depreciation on the balance of trade is ambiguous and quite uncertain, since a good deal depends on the price elasticity of a country’s exports and imports.

Currency depreciation usually raises the price level in a country, and thus increases the inflation rate. This happens for two reasons. As a result of depreciation, the prices of imported goods rise. In the case of imported consumer goods, their prices directly lead to an increase in the inflation rate.

Depreciation vs. importation?

In the case of imports of capital goods and raw materials, an increase in their import prices will not only directly raise the price level, but since they are used as inputs in the production of other goods, an increase in their import prices will also raise the production costs of these other goods, and thus cause cost inflation.

What are the relationships between depreciation and commodity exports?

Depreciation makes exports cheaper and thus more competitive in global markets. This causes an increase in exports of goods and reduces the supply and availability of goods in the domestic market, leading to an increase in the domestic price level. In addition, due to the higher prices of imported goods, a country’s citizens tend to substitute domestically produced goods for more expensive imports.