The value of currency in any country rarely stays constant. Currency values usually continuously fluctuate. These fluctuations can be large or small depending on the current economic and political state of the country. Though the appreciation or depreciation of a currency occurs for a number of different reasons, some of the most common reasons are supply and demand, inflation and economic outlook.
Supply and Demand
Just as with goods and services, the principles of supply and demand apply to the appreciation and depreciation of currency values. If a country injects new currency into its economy, it increases the money supply. When there is more money circulating in an economy, there is less demand. This depreciates the value of the currency. When there is a high domestic or foreign demand for a country’s currency, the currency appreciates in value.
Inflation and Deflation
Inflation occurs when the general prices of goods and services in a country increase. Inflation causes the value of the dollar to depreciate, reducing purchasing power.
Deflation occurs when the general prices of goods and services go down. Deflation increases the purchasing power of money and causes its value to appreciate. Deflation generally occurs at times when an economy is experiencing slow or no economic growth. During times of deflation, businesses must continually decrease the prices of their goods and services to find buyers. This results in the business's earning less revenue, making it necessary to reduce output to cut production costs. A reduction in output then leads to job lay-offs and can eventually cause business and plant closures. This results in massive unemployment and a further weakening of the economy. Economists do not consider deflation a positive economic occurrence.
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If a country’s economy is in a slow growth or recessionary phase, the value of their currency depreciates. The value of a country’s currency also depreciates if its major economic indicators like retail sales and Gross Domestic Product, or GDP, are declining. A high and/or rising unemployment rate can also depreciate currency value because it indicates an economic slowdown. If a country’s economy is in a strong growth period, the value of their currency appreciates. Appreciation also occurs when major economic indicators like GDP and retail sales are on the rise.
A trade deficit occurs when the value of goods a country imports is more than the value of goods it exports. When the trade deficit of a country increases, the value of the domestic currency depreciates against the value of the currency of its trading partners. When the trade deficit of a country decreases, but the country remains in a deficit, the value of its domestic currency appreciates against the value of the currency of its trading partners.
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