The Effects of Depreciation on Prices

Depreciation is the loss in value of a country’s currency against other foreign currencies. There are many factors that can cause a currency to depreciate, including economic policies that infuse too much money into the financial system or political instability that causes investors to refrain from doing business in a country. The effects from the devalued currency can put pressure on prices in the local markets, export and import prices, borrowing costs and even the value of the stock market.

When a currency depreciates, the effect may not be readily felt in the local market. The prices of local produce like milk or cheese, for example, will probably be marked in the same retail prices at the store. However, the effects of depreciation will be most apparent to locally manufactured goods that depend on intermediate products from abroad. For example, a U.S. automobile company that buys much of its car parts from abroad will experience more expensive imports. This is because it would take more dollars to get one unit of the foreign currency needed to buy car parts. The higher cost of imports will consequently increase the price of the final car product in the local market.

A depreciation of the domestic currency will also cause the domestic exports to be cheaper. For example, if the dollar depreciated against the Chinese yuan, U.S. exports will be cheaper to Chinese residents. Similarly, if the Chinese yuan depreciated against the dollar, Chinese exports would be cheaper to U.S residents. In the second case, U.S. can stand to lose because more money will be flowing to China as people chase the cheaper Chinese products. Alternatively, this means consumers will turn away from U.S. exports because they will be relatively expensive.

Depreciation in the local currency will also affect how much investors are willing to borrow. For example, many foreign investors who buy U.S. government bonds may decide to move their money to another country because the interest payments from U.S. bonds will be lower after the devaluation. Investors would rather buy bonds in other countries with a stronger currency that pays a higher interest. In effect, the price of U.S. bonds would fall. In order to keep investors in the U.S., the government may offer more dollar payments to counter the currency depreciation. It could force the U.S. government to raise the interest rate in order to match the value paid out by other countries.

Studies that have looked into the effect of depreciation on the stock market have reported a negative effect on stock prices. The prices of stocks traded in an economy would fall following a depreciation in the domestic currency. One reason is that the currency depreciation would yield a lower value of dividend payments for investors who hold local stocks in that economy. Furthermore, the depreciation can signal low growth opportunities for portfolio managers who hold stocks in the domestic economy. In turn, people will eventually shift their money to buy foreign stocks where they stand to gain a lot more for their investment.