Rupee Depreciation: Why do Currencies Depreciate?

The value of rupee has been hogging the news channels, papers and social media for quite sometime now and for no good reason. Rupee’s value hit a terrible low on 13 December 2011 against the Dollar, falling to an alarming Rs. 53.22 per dollar.

Rupee has not been performing well for quite some time now. This is cause for concern for policy makers, experts, investors, business people and even for ordinary people.

If the value of Rupee keeps on depreciating, it is recipe for an economic crisis. It points to some inconsistencies in our economic system. This could further erode investor confidence in the system and lead to its wide spread collapse.

Demand and Supply Explains Depreciation

In fact, the value of a currency depends just like that of any other commodity, i.e. on its demand and supply.

Depreciation is caused when the supply of the currency circulated in the economy is more than the demand for that currency. Likewise if the supply of the currency is less than its demand, the value of the currency increases or appreciates.

How Currencies Depreciate?

So now the question is what factors affects the demand and supply of the currency in an economy leading to depreciation?

Inflation: We all know that inflation means rise in prices. When prices increase more money is needed to buy a commodity. This lowers the purchasing power of the currency. It lowers the demand of the currency.

In addition, when more money is needed to buy goods and services, supply of money increases in the economy. Therefore the value of that currency depreciates.

Inflation can be caused when supply of goods and services is low, when there occurs any conflict, or even when government prints more money than the growth of the country’s GDP.

During hyper inflation when the prices of all goods and services sky rockets, the value of currency collapses and becomes worthless. Some well know examples of such situations are the hyper inflation in Germany during 1923, the Zimbabwe crisis of 2006 and the Hungry hyper inflation of 1946.

Negative Balance of Payment (BOP): International trade, Foreign Direct Investments, Foreign Institutional Investments all affects the BOP of a country, which is nothing more than a balance sheet of the nation.

When the country has a negative balance of payment it means that more currency is leaving the country with imports more than exports, capital flights out of the country and depletion of foreign reserves.

When the money outflow is more than what comes into the country, the BOP becomes negative and there is loss on the balance sheet. This builds up into an account deficit. More money is now needed to finance this deficit. This depreciates the value of that currency.

Low Interest Rate: When government lowers the interest rate, people are encouraged to take loans from banks and this money gets pumped into the economy. This increases the liquidity or supply of the money in the economy leading to inflation.

Thus when interest rate is lowered there is possibility for inflationary pressure to build up and results in depreciating the currency.

Intervention by Central Banks: The Central Bank of a country can influence the value of money directly. It can intervene in the markets to devalue the currency for specific reasons. This kind of intervention is done officially and is called Currency Devaluation.

The Reserve Bank of India engages with the market to regulate the value of rupee. If it wants to keep the value of rupee from sinking too low, RBI sells dollar reserves in to the market and buy back the excess Rupee. This will appreciate the Rupee value.

Releasing too much Rupee into the market and buying up dollars will depreciate the value of Rupee.

Surprisingly, when the Rupee depreciated recently RBI did not intervene in the market to hold back the falling Rupee. This led to further fall in its value as investors and traders lost confidence in the currency.

The cause of depreciation of a currency can be varied according to the economic, political or international reasons. Ultimately, what determines the value of the currency is the demand and supply of that currency.

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2 Responses to “Rupee Depreciation: Why do Currencies Depreciate?”

  1. Good one…Would you please let me know what’s the exact current reason for rupee depreciation..and how we get rid from this?

  2. This is caused by the adverse BOP. Economy needs balanced policy as regards to Imports/exports. Imorts of the luxury goods should be restricted and and the suppliers of the luxuries of the life should be asked to establish their assembly/manufacturing units in india so that it boosts the GDP and create employment opportunities. The investor friendly environment needs to be generated. Financing for consumerism be restricted or made very expensive.

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