Answer:
Both depreciation and devaluation highlight the economic condition where there is a decrease in the value of a domestic currency in comparison to any other currency, leading to a decline in the currency’s purchasing power. However, the manner in which they occur are different. The differences between depreciation and devaluation are:
Depreciation happens in the floating exchange rate regime, in which the market forces determine the value of a country’s currency. On the other hand, devaluation is associated with the fixed/pegged exchange rate regime.
Depreciation is a decrease in the value of domestic currency due to the market forces of demand and supply. Whereas, in case of devaluation, the Central bank deliberately makes downward adjustment of the value of the domestic currency vis-a-vis any other
currency.Depreciation can occur on a daily basis, while devaluation is usually done occasionally by the Central bank.
Effects of depreciation and devaluation on the foreign trade of a country are:
Reducing trade deficit: Both depreciation and devaluation make imports expensive. Hence, residents often buy fewer imported goods. On the other hand, exported goods become less costly for international buyers, thereby, growing demand for exports. Thus, fewer imports and more exports will reduce the trade deficit and could also lead to surplus. However, the trade deficit may not reduce as much as expected or even increase if imports constitute essential commodities that are difficult to replace with domestic products.
Reduced foreign investment: Both depreciation and devaluation are viewed as a sign of economic weakness, therefore, the creditworthiness of the nation may be jeopardized. It may dampen investor confidence in the country’s economy and hurt the country’s ability to secure foreign investment. However, if the increased aggregate demand for domestic goods, owing to reduced imports and more external demand, leads to higher inflation and in turn higher interest rates, then it may also attract foreign investment.
Instability in the global markets: Trading partners may become concerned that it might negatively affect their export industries. Also, neighboring countries might devalue their own currencies to offset the effects of their trading partner’s devaluation. Such competitive devaluations tend to exacerbate economic difficulties by creating instability in the global financial markets.
In a free market economy, devaluation should be used sparingly. While the negative effects of depreciation can be countered by focusing on long term measures like improving export competitiveness, increasing efficiency of supply chains and pro-active government policies.
