Exchange Rates Explained: Appreciation, Depreciation and Devaluation
Why does one US dollar sometimes cost ₹82 and at another time ₹85? Exchange rates connect currencies and influence imports, exports, foreign travel, inflation, investment and international payments. Understanding the basic terminology makes this topic much easier.
Exchange rate = Price of one currency expressed in terms of another currency.
What Is an Exchange Rate?
An exchange rate tells us how much of one currency is required to obtain another currency.
For example, suppose:
This means ₹84 are required to obtain one US dollar at that exchange rate, ignoring transaction charges and different retail buying or selling rates.
Why Do Exchange Rates Change?
Currencies are influenced by demand and supply in foreign-exchange markets as well as broader economic and financial conditions.
Important influences can include:
Inflation
Interest rates and expectations
Imports and exports
Foreign investment flows
Economic growth
Commodity prices
Global financial conditions
Risk sentiment
Central-bank actions
An exchange rate normally cannot be explained by one factor alone. Several forces can operate at the same time.
What Is Currency Depreciation?
Depreciation refers to a decline in the value of a currency relative to another currency under a market-determined exchange-rate system.
Suppose the exchange rate changes from:
to
US$1 = ₹85
More rupees are now required to buy one dollar.
Therefore, the rupee has depreciated against the US dollar.
₹80 per dollar → ₹85 per dollar
Dollar becomes more expensive in rupees → Rupee weakened
What Is Currency Appreciation?
Appreciation means a currency increases in value relative to another currency under a market-determined exchange-rate system.
Suppose:
changes to
US$1 = ₹80
Fewer rupees are required to obtain one dollar.
The rupee has appreciated against the dollar.
₹80 → ₹85 per dollar = Rupee depreciation
₹85 → ₹80 per dollar = Rupee appreciation
Why Does This Sometimes Confuse Students?
Students often see the numerical exchange rate rising from 80 to 85 and assume that the rupee has risen.
But the quotation tells us how many rupees are required for one dollar. If more rupees are required, each rupee is worth less against the dollar.
A rise in the number of rupees per US dollar means rupee depreciation, not rupee appreciation.
Depreciation and Imports
When the rupee depreciates, imported goods priced in foreign currency can become more expensive in rupee terms, other things being equal.
Simplified Import Effect
A Simple Import Example
Suppose an imported item costs US$100.
At ₹80/$
US$100 × ₹80 = ₹8,000
At ₹85/$
US$100 × ₹85 = ₹8,500
The foreign price remained US$100, but the rupee cost increased by ₹500.
Actual import costs also depend on freight, duties, contracts, hedging and other factors.
Depreciation and Inflation
A weaker domestic currency can contribute to inflation when imported goods and production inputs become more expensive.
This is particularly relevant for an economy importing important commodities or intermediate goods.
Currency depreciation can contribute to imported inflation.
Depreciation and Exports
A weaker domestic currency can make domestically produced goods cheaper in foreign-currency terms in some circumstances.
This may improve price competitiveness for exporters.
However, export volumes do not automatically increase whenever the currency depreciates.
Exports also depend on foreign demand, production capacity, imported input costs, contracts, quality, competition and supply conditions.
Depreciation and Foreign Travel
A weaker rupee can make foreign travel more expensive for an Indian traveller when expenses are denominated in foreign currency.
If a hotel costs US$200:
₹80 per dollar
Approximate rupee value = ₹16,000
₹85 per dollar
Approximate rupee value = ₹17,000
What About Money Sent From Abroad?
If someone receives a fixed amount of foreign currency, a weaker rupee can translate that foreign currency into more rupees, other things being equal.
For example, US$1,000 converts to:
At ₹85/$ → ₹85,000
This does not necessarily mean the recipient is economically better off overall, because domestic prices and other factors may also change.
What Is Devaluation?
Devaluation is different from ordinary market depreciation.
Devaluation generally refers to an official downward adjustment in the value of a currency under a fixed exchange-rate or official parity framework.
Depreciation
Currency falls in value through market movements under a market-determined system.
Devaluation
Official authority reduces the currency’s value under a fixed or official parity arrangement.
Market-driven fall → Depreciation
Official downward adjustment → Devaluation
What Is Revaluation?
Revaluation is the opposite concept to devaluation under a fixed or official parity system.
It refers to an official upward adjustment in the currency’s value.
Market system → Appreciation / Depreciation
Official fixed/parity adjustment → Revaluation / Devaluation
Fixed Exchange Rate
Under a fixed exchange-rate system, authorities maintain the currency at or around an officially specified value or relationship according to the particular regime.
Maintaining the rate may require intervention and appropriate foreign exchange reserves.
Floating Exchange Rate
Under a floating exchange-rate system, currency values are primarily determined by market demand and supply.
Different countries use different versions of floating, managed or fixed arrangements.
What Exchange-Rate System Does India Have?
The Indian rupee operates under a market-determined exchange-rate framework.
RBI may intervene in the foreign-exchange market in accordance with its policy framework, including to address excessive volatility and maintain orderly market conditions.
Market determined does not mean “RBI never intervenes.”
What Is Forex?
Forex is a common abbreviation for foreign exchange.
The foreign-exchange market is where currencies are exchanged and foreign-currency transactions take place.
What Are Foreign Exchange Reserves?
Foreign exchange reserves are external reserve assets held by the monetary authority.
India’s reserves are managed by the Reserve Bank of India.
They include components such as foreign currency assets, gold, Special Drawing Rights and India’s reserve position in the IMF.
Why Can RBI Intervene in the Forex Market?
Foreign-exchange intervention can be used to address disorderly market conditions or excessive volatility and for other purposes within RBI’s foreign-exchange management framework.
Intervention does not necessarily imply maintaining one permanently fixed rupee-dollar rate.
What Is a Spot Exchange Rate?
A spot exchange rate is the rate applicable to a foreign-exchange transaction for settlement according to the standard spot convention of the relevant market.
What Is a Forward Exchange Rate?
A forward contract allows parties to agree today on an exchange rate for a currency transaction that will be settled on a specified future date.
Spot
Exchange transaction associated with near-term settlement.
Forward
Exchange rate agreed now for a specified future settlement.
Why Do Businesses Use Forward Contracts?
Businesses with future foreign-currency receipts or payments may face the risk that exchange rates move against them before settlement.
A forward contract can be used as one method of managing that exchange-rate risk.
What Is Currency Hedging?
Hedging means taking measures designed to reduce exposure to adverse currency movements.
Importers, exporters, borrowers and investors may use permitted financial instruments to manage foreign-exchange risk.
Hedging → Managing risk, not predicting the currency perfectly
What Is the Nominal Exchange Rate?
The nominal exchange rate is the observed rate at which one currency exchanges for another.
For example, ₹84 per US dollar is a nominal bilateral exchange rate.
What Is the Real Exchange Rate?
A real exchange-rate measure adjusts the nominal exchange rate for relative price levels between economies.
It is useful for analysing broader questions of relative prices and competitiveness.
Nominal exchange rate → Currency price
Real exchange rate → Also considers relative price levels
What Is REER?
REER stands for Real Effective Exchange Rate.
It is an inflation-adjusted measure of a currency against a weighted basket of trading-partner currencies.
What Is NEER?
NEER stands for Nominal Effective Exchange Rate.
It measures a currency against a weighted basket of other currencies without the price-level adjustment used in REER.
NEER → Nominal + Basket of currencies
REER → Real/inflation-adjusted + Basket of currencies
Exchange Rate and Interest Rates
Interest-rate differences can influence international capital flows and currency demand.
However, it is incorrect to assume that a higher interest rate will always strengthen a currency. Markets also consider inflation, economic prospects, risk and expectations about future policy.
Exchange Rate and Crude Oil
For a country importing substantial quantities of crude oil, changes in global oil prices and exchange rates can influence the domestic cost of energy imports.
If both the foreign-currency oil price and the foreign currency itself become more expensive in rupee terms, the pressure on the import bill can be greater.
Exchange Rate and Current Account
Exchange rates interact with exports, imports, services, investment income and other external transactions.
Therefore, exchange-rate movements can influence the current account, but the relationship is not mechanical or immediate.
Does a Stronger Currency Always Mean a Stronger Economy?
No.
Currency values can change because of interest-rate expectations, capital flows, global risk conditions, inflation differences, commodity prices and many other factors.
Do not use one day’s currency movement as a complete measure of an economy’s strength.
Does a Weak Currency Always Help Exporters?
No.
An exporter may also import raw materials, machinery, fuel or other inputs. Currency depreciation can increase these costs.
The net effect depends on the individual business.
Common Exam Traps
Incorrect. The rupee depreciated against the dollar.
Incorrect.
Incorrect.
Incorrect.
Incorrect.
Incorrect.
Test Yourself
1. What is an exchange rate?
2. If $1 changes from ₹80 to ₹85, what happened to the rupee?
3. If $1 changes from ₹85 to ₹80, what happened to the rupee?
4. What is devaluation?
5. What is revaluation?
6. Who manages India’s foreign exchange reserves?
7. What does forex mean?
8. What is currency hedging?
9. What does NEER stand for?
10. What does REER stand for?
60-Second Revision
₹80/$ → ₹85/$ → Rupee depreciation
₹85/$ → ₹80/$ → Rupee appreciation
Depreciation → Market-driven fall
Appreciation → Market-driven rise
Devaluation → Official downward adjustment
Revaluation → Official upward adjustment
Forex → Foreign exchange
Hedging → Managing currency risk
NEER → Nominal Effective Exchange Rate
REER → Real Effective Exchange Rate