Exchange Rates

6.2.4 Appreciation and Depreciation of an Exchange Rate

An exchange rate is the value of one currency expressed in terms of another. It determines how much of one currency you need to buy a certain amount of another. Exchange rates can fluctuate, leading to appreciation or depreciation.

Appreciation

Appreciation occurs when a currency becomes more valuable compared to another. This means that you need fewer units of the appreciating currency to buy one unit of the other currency.

Example: If the exchange rate between the British Pound (GBP) and the US Dollar (USD) is 1 GBP = 1.25 USD, and the GBP appreciates, the new exchange rate might be 1 GBP = 1.30 USD. The GBP has appreciated.

Causes of Appreciation:

• Increased demand for the country's goods and services.
• Increased foreign investment in the country.
• Higher interest rates in the country, attracting foreign capital.
• Political stability in the country.

Depreciation

Depreciation occurs when a currency becomes less valuable compared to another. This means that you need more units of the depreciating currency to buy one unit of the other currency.

Example: If the exchange rate between the Euro (EUR) and the Japanese Yen (JPY) is 1 EUR = 140 JPY, and the EUR depreciates, the new exchange rate might be 1 EUR = 130 JPY. The EUR has depreciated.

Causes of Depreciation:

• Decreased demand for the country's goods and services.
• Decreased foreign investment in the country.
• Lower interest rates in the country, leading to capital outflow.
• Political instability in the country.
• High government debt.

Calculating Appreciation and Depreciation

To calculate the percentage change in an exchange rate, we use the following formula:

Percentage Change = $$ \frac{\text{New Exchange Rate} - \text{Old Exchange Rate}}{\text{Old Exchange Rate}} \times 100 $$

Example:

The exchange rate of GBP to USD changed from 1.20 to 1.25.

Percentage Change = $$ \frac{1.25 - 1.20}{1.20} \times 100 $$

Percentage Change = $$ \frac{0.05}{1.20} \times 100 $$

Percentage Change = $$ 0.041666... \times 100 $$

Percentage Change = 4.17% (approximately)

If the percentage change is positive, the currency has appreciated. If the percentage change is negative, the currency has depreciated.

Table Summarizing Appreciation and Depreciation

Currency	Initial Exchange Rate	New Exchange Rate	Change	Type of Change
GBP to USD	1.20	1.25	0.05	Appreciation
EUR to JPY	1 EUR = 140 JPY	1 EUR = 130 JPY	-10	Depreciation