What is Currency Appreciation and How Does it Work?

In currency appreciation, one currency becomes more valuable in comparison to another. Among the probable causes are investor sentiments, low inflation rates, political stability, nations’ current accounts, recession, government trade, terms of trade, speculation, etc. In turn, it increases the cost of exports, lowers the cost of imports, and lowers the inflation rate. A country’s economy and development are affected by the current appreciation depending on its current situation. Let’s take a detailed look at currency appreciation in this article.

Defining Currency Appreciation

Currency appreciation is when a national currency gains value over international currencies.

• A rise in inflation, demand for domestic currency in a global market, or interest rates due to fiscal policy flexibility or government borrowing can cause this. When a currency’s value rises, inflation rates usually drop.
• In general, currency appreciation hurts local businesses as their products and services become more expensive and their demand declines.
• To survive the dip in demand, they lower their prices and reduce their workforce.
• However, consumers benefit from the appreciation since inflation is reduced in the local area, which lowers prices.

Causes of Currency Appreciation

Lower Inflation Rates

A currency with a lower inflation rate will have a higher value than a currency with a higher inflation rate. The reason for this is that lower inflation leads to higher interest rates. An economy will attract more international investment, which will, in turn, boost domestic currency demand.

Investors’ Sentiment

A domestic currency’s demand and supply are influenced by investors’ sentiments on an international market. As a result, investors’ views are considered an important factor in determining the appreciation or depreciation of the domestic currency.

Other Causes

Other causes include government trade, recession, speculation, political stability, and the nation’s current account.

Effects of Currency Appreciation

Rise in Export Costs

The number of goods exported from a country will decrease if its currency appreciates. Ultimately, this lowers GDP (gross domestic product), which is unfavourable.

Cheaper Imports

Whenever domestic goods become more expensive on the international market, imported goods will become cheaper. Therefore, domestic currency can buy more foreign currency, allowing buyers to purchase more international goods.

Results in Trade Deficit

The reason for this is that strong currencies result in cheaper imports, resulting in a nation importing more and exporting less.

Lower Inflation

Imports become cheaper when the domestic currency appreciates, and aggregate demand decreases. All of these factors contribute to lower inflation rates.

Advantages of Currency Appreciation

• Enhanced Purchasing Power: Currency appreciation can elevate an individual’s standard of living by increasing purchasing power. As the domestic currency strengthens relative to foreign currencies, it allows consumers to acquire more goods and services from abroad at a comparatively lower cost.
• Cost-Effective Imports: Appreciation of the domestic currency leads to cheaper imports, benefiting consumers with access to a wider array of affordable foreign goods. This phenomenon occurs as the strengthened domestic currency reduces the cost of imported products in the local market.
• Global Purchasing Ability: When a domestic currency appreciates, it enables buyers to acquire more international goods as the stronger currency holds higher value against other global currencies. This expanded purchasing capacity allows individuals to diversify their purchases and potentially access a broader range of higher-value goods from international markets.

Disadvantages of Currency Appreciation

• Economic Disruption: Rapid currency appreciation during economic disturbances can pose significant challenges. Abrupt and substantial appreciation can disrupt economic stability, creating difficulties for industries reliant on stable exchange rates for their operations.
• Reduced International Competitiveness: Countries experiencing currency appreciation might face reduced competitiveness in international markets. As their currency strengthens, their goods become relatively more expensive abroad, potentially leading to a decline in export competitiveness against countries with weaker currencies.
• Increased Export Costs: Appreciation of a country’s currency elevates the costs of its exports, making them pricier in foreign markets. This can significantly impact the export-driven industries, potentially leading to a decline in export volumes and, consequently, a decrease in Gross Domestic Product (GDP).
• Trade Imbalances: A strong currency may result in trade deficits due to increased affordability of cheaper imports. This situation could lead to a scenario where the country imports more than it exports, potentially widening trade imbalances and impacting the overall economic health.

Currency Appreciation Vs Currency Depreciation

The table below outlines the distinct effects and outcomes associated with currency appreciation and currency depreciation.

Aspect	Currency Appreciation	Currency Depreciation
Definition	Rise in national currency value against international currencies	Decline in national currency value against international ones
Effect on Imports	Leads to cheaper imports	Can lead to cheaper exports
Impact on Exports	Tends to increase imports	Tends to boost exports
Foreign Debt Financing	Lowers the cost of financing foreign debts	Doesn’t affect the cost of financing foreign debts
Trading Strength	Allows exchange for a higher amount of international currency	Limits the exchange value for international currency

 

Factors that Lead to the Appreciation and Depreciation of the Indian Currency

Trade Surplus

A trade surplus occurs when a country sells more goods and services to other countries than it buys from them. The amount of foreign currency entering the country exceeds the amount needed to pay for imports. Alternatively, a trade surplus can be referred to as a rise in global demand for government-produced goods and services. As a result, the Rupee appreciates, foreign investments increase, and economic growth may be boosted. Moreover, stronger currencies can lead to lower import costs, which may help keep inflation in check.

Import and Export

Imports and exports of government-produced goods and services determine the currency’s demand. The Rupee appreciates if India exports more goods and services than it imports. The Rupee would depreciate if the country imported more goods and services than it exported.

Inflation

Currency prices rise as interest rates rise. Consequently, the value of the Rupee may fluctuate based on changes in liquidity ratios and cash reserve ratios.

Conclusion

Currency appreciation occurs when one currency gains value against another. Over time, it occurs when the exchange rate rises. As the currency appreciates, importers pay less in domestic currency for imported goods. The effect can be negative for exporters, as their goods will be more expensive for foreign buyers. However, when excessive appreciation threatens economic growth, central banks intervene.

Frequently Asked Questions (FAQs)