Question

What does it mean to say that a currency appreciates or depreciates in value? Give an example of each and briefly mention what might cause such a change.

Short answer

In summary, currency appreciation refers to an increase in the value of a currency relative to another currency, while depreciation refers to a decrease in the value of a currency relative to another currency. These changes in currency values can result from various factors, such as interest rates, inflation rates, foreign investment, and economic/political stability. Examples of appreciation and depreciation include the US dollar appreciating compared to the euro and the Japanese yen depreciating compared to the US dollar, respectively.

Step-by-step solution

1. Definitions:

Appreciation refers to an increase in the value of a currency relative to another currency (or currencies). In other words, it takes less of the appreciating currency to buy the same amount of another currency. For example, if the currency in one country appreciates, it means that country's currency can now buy more foreign currency than before. Depreciation, on the other hand, refers to a decrease in the value of a currency relative to another currency. This means that it takes more of the depreciating currency to buy the same amount of another currency. In this case, the currency of one country becomes weaker compared to foreign currencies.

2. Example of currency appreciation:

An example of currency appreciation is when the US dollar (USD) increases in value compared to the European euro (EUR). Suppose that before the appreciation, 1 USD = 0.85 EUR. After the appreciation, 1 USD might now equal 0.90 EUR. This means that the USD has appreciated relative to the EUR because it now takes fewer US dollars to buy a certain amount of euros.

3. Example of currency depreciation:

An example of currency depreciation is when the Japanese yen (JPY) decreases in value compared to the US dollar (USD). Suppose that 1 USD was initially equal to 110 JPY. After the depreciation, 1 USD might now equal 120 JPY. This means that the JPY has depreciated relative to the USD because it now takes more yen to buy a certain amount of US dollars.

4. Causes of currency appreciation and depreciation:

There are multiple factors that can cause a currency to appreciate or depreciate in value. Some common reasons include changes in interest rates, inflation rates, foreign investment, and economic/political stability. For example, higher interest rates in a country can attract foreign investors, which increases the demand for that country's currency and might result in its appreciation. On the other hand, high inflation rates can cause a currency to depreciate, as the purchasing power of the currency decreases. Political instability or poor economic performance may also decrease foreign investors' confidence in the currency, leading to its depreciation.