Currency depreciation is the decline in value of the dollar relative to another currency. There is a plethora of economic factors that affect the depreciation of the US dollar.
In the United States, the Federal Reserve, which is the country’s central bank, is the one which implements monetary policies to either strengthen or weaken the US dollar. In general, the implementation of the “easy” monetary policy weakens the greenback and this can result to deprecation.
For instance, if the Fed reduces interest rates or pushes for quantitative easing measures like buying of bonds, the central bank is considered to be easing. This happens when central banks try to lower interest rates to encourage investors to borrow more money.
Since the greenback is a fiat currency (not being backed by any tangible commodity), it can be created. When more money is created, the existing money becomes less valuable, following the law of supply and demand.
There is an inverse correlation between US inflation rate versus trading partners and currency deprecation.
Overall, higher inflation depreciates currency because inflation means that the cost of goods and services are increasing. Those goods then cost more for other nations to buy. Increasing prices lower demand. On the other hand, imported goods become more appealing to consumers in the higher inflation country to buy.
Demand for Currency
When a country’s currency is in demand, the currency remains relatively stronger. To make the currency stay in demand, the country may export products that other countries want to buy and demand payments in its own currency.
While the US doesn’t export more than it imports, it benefits from another way to create a high global demand for the US dollars—being the world’s reserve currency.
Reserve currencies are used by countries across the globe to buy desired commodities, like oil and gold. When the sellers of these commodities demand payment in reserve currency, an artificial demand for the currency is created, keeping it more robust than it might otherwise have been.
Unsurprisingly, strong economies usually have strong currencies. Weak economies in turn have weak currencies. It’s therefore not shocking to know that slowing growth and corporate profits can make investors try to find other ways to use their money.
Lower investor interest in a specific country can weaken its currency. Since currency speculators see or anticipate the weakening, they can bet against the currency, causing to weaken it further.
Falling Export Prices
When the prices for a key product slip down, currency can depreciate. For instance, the Canadian dollar or the loonie slumps down when the oil prices drop since oil is a huge export product for Canada.
Effect of Depreciation
Whether depreciation is good or bad depends largely on how you are viewing it. If, for example, you are the CEO of a company that has its products exported, currency depreciation may be good for you. When your nation’s currency is weaker relative to the currency in the export market, the demand for the product will increase as well since the price for them has fallen for the consumers in the target market.