Currency Appreciation

What is Currency Appreciation?

Currency appreciation is the rise or enhancement in the value of a national currency over the importance of international currencies. This can be due to the demand for domestic currency in a global market, rise in inflation, and interest rates due to fiscal policy flexibility or government borrowings. The increase in the value of a currency usually leads to a lowering in the inflation rates.

Currency appreciation effects largely have an impact on local businesses as their products and services become costlier and their demand goes down. They reduce their prices and workforce to survive the dip in demand. However, the consumers significantly benefit from the appreciation as the prices locally drop due to a reduction in inflation.

1. Currency appreciation refers to the intentional enhancement in the value of a country's currency against dominant currencies in the world market.
2. A country appreciates or increases the value of its currency to have cheaper imports and reduce trade deficits.
3. Currency devaluation or depreciation is when the same government intentionally decreases the currency rate in the foreign market to make a country's or currency area's exports more competitive since they become more affordable to buy.

Currency Appreciation Explained

Currency appreciation is the rise in the domestic currency's value compared to a foreign currency. It enables imports to become cheaper and exports to become more expensive. The sentiments of the investors, lower inflation rates, political stability, nations' current accounts, recession, government trade, terms of trade, speculation, etc., are the probable causes of currency appreciation.

It leads to higher costs of exports, cheaper imports, lower inflation rates, etc. These impacts of current appreciation depend upon the ongoing situation of the economy and development in other nations.

In the below-mentioned diagram, when demand for the pound increases, then the value of the pound to dollar increases from 1 pound = 1.55 dollars

1.55 dollars to 1 pound = dollar 1.65.

Causes

Although concepts like foreign currency appreciation or even domestic appreciation is beyond the control of individuals or government organizations, it is important to understand the various causes to fully understand the concept. Let us discuss the few of the major causes through the points below.

1. Lower Inflation Rates- This means that a currency's value with lower inflation rates will rise compared to the value of the currencies with a higher inflation rate. This is generally because a lower inflation rate causes higher interest rates. This will attract more international investment in an economy, which, in turn, appreciates the demand for domestic currency.
2. Investors' Sentiment- Investors' sentiment influences the demand and supply of domestic currency in an international market. This is why investors' views are considered one of the important causes of the appreciation or depreciation of the domestic currency.
3. The other causes are government trade, recession, speculation, terms of trade, political stability, nation's current accounts, etc.

Effects

Let us understand the currency appreciation effects on the economy, consumers, and international trade through the discussion below.

#1 - Rise in Export Costs

If a country's currency appreciates, the number of goods exported from that country will drop. This will lower the GDP (gross domestic product), ultimately not favoring that.

#2 - Cheaper Imports

The imported goods will become cheaper in a foreign country if the domestic goods tend to become expensive on the international market. This means that a domestic currency can buy a higher value of a foreign currency, ultimately enabling the buyers to buy more international goods.

#3 - Results in Trade Deficit

It also results in trade deficits. This is high because strong currencies result in cheaper imports, and as a result, a nation opts to export less and import more.

#4 - Lower Inflation

With an appreciation in domestic currency, the imports will become cheaper, and the aggregate demand will also tend to fall. Therefore, all this together can lower the rate of inflation to a significant extent.

Examples

Let us understand the concept of foreign currency appreciation with the help of a couple of examples.

Example #1

XYZ Ltd. Manufactures PVC pipes and other sanitary products. Their main factory and warehouses are located in Minnesota. Their major clientele is from the European Union; they supply over 70% of their production to their clients in the EU.

However, due to the appreciation of the US dollar against the Euros, their sales have taken a hit. As a result, they took a call to reduce the costs of production and diversify into the local markets to remain competitive during turbulent times.

Example #2

An appreciation in the US dollar in comparison to Euro-

• During the end of the year 2010 €1 = $1.20
• In the middle of the year 2011 €1 = $1.45
• This means in this period, there was a rise in the value of the Euro in comparison to the US Dollar.

However, in the year 2014, the value of the Euro fell against the value of the US Dollar.

Advantages & Disadvantages

Let us understand the advantages and disadvantages of the domestic or foreign currency appreciation through the discussion below.

Advantages

• Currency appreciation can be advantageous as it helps in improving an individual's standard of living. With an appreciation in the domestic currency, customers can take advantage of cheaper imports and increase their purchases. Domestic goods might become expensive, which will ultimately cause the imported goods to become cheaper on the foreign market.
• In such a phenomenon, buyers can purchase more international goods as the domestic currency can be easily used to purchase a higher value of global currencies.

Disadvantages

• However, it can also be troublesome for an economy. If there is a rapid appreciation in the currency, it can become a major problem during economic disturbances. It can also be a reason for domestic countries to become less competitive in the international markets.
• It also leads to a rise in export costs. With the appreciation in an economy's currency, the number of exported goods from that country will fall. This will harm the GDP as the same shall fall significantly.
• It may also cause trade deficits as strong currencies often lead to cheaper imports, and as a result, a country might want to import more than it exports.

Currency Appreciation Vs Currency Depreciation

The key difference between currency appreciation and currency depreciation are-

• Currency appreciation can be defined as a rise in the national currency's value compared to international currencies. In contrast, currency depreciation can be defined as a fall in the national currency's value compared to international currencies.
• It results in cheaper imports, whereas currency depreciation results in cheaper exports.
• It results in the rise of imports whereas currency depreciation results in exports.
• In a currency appreciation, the cost of financing foreign debts with respect to national currency is reduced. In currency depreciation, the cost of funding foreign debts with respect to national currency is not decreased.
• It is more expensive, so it can be traded for a higher amount of international currency, whereas the same is not applicable in the case of currency depreciation.

Frequently Asked Questions (FAQs)

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