Currency depreciation

Also called: Depreciation of domestic currency · Topic: Balance of Payments and Exchange Rates · NCERT: Class 12, Ch 6 "Open Economy Macroeconomics"

Meaning

Currency depreciation is a fall in the market value of the domestic currency against a foreign currency under a flexible (floating) exchange rate. It means more units of home currency are needed to buy one unit of foreign currency. For example, the rupee depreciates when the rate moves from ₹50 per $1 to ₹70 per $1.

It matters because it changes the price of every import and export. It also affects inflation, especially through oil. It is a key signal that the RBI watches when it decides whether to step into the forex market.

Formulas (E = rupees per dollar, a direct quote):

• Rise in the dollar's value = (E_new − E_old) / E_old × 100
• Fall in the rupee's value = (E_new − E_old) / E_new × 100 (this is the same as the fall in the rupee's dollar value, 1/E)

Explanation

How it happens: demand and supply of foreign exchange

• Exchange rate: the price of one currency in terms of another.
• Direct quote: the home-currency price of one unit of foreign currency, e.g. ₹50 per $1.
• Indirect quote: the same rate turned around. ₹50/$ = $0.02 per ₹1.

• Trap: under a direct quote, a higher number means a weaker rupee.

• Flexible exchange rate: the rate settles where the demand for dollars equals the supply of dollars. There is no central bank intervention.

• Demand for dollars comes from imports, gifts and transfers sent abroad, and buying foreign assets.
• Supply of dollars comes from exports, remittances (money sent home by Indians working abroad) and foreigners buying Indian assets (FDI, FPI).
• Worked example: a demand shift
• More Indians travel abroad, so they need more dollars.
• The demand curve for dollars shifts right.
• At the old rate there are not enough dollars for everyone who wants them (excess demand), so the dollar's price rises.

• The rate moves from ₹50 to ₹70 per $. The rupee has depreciated.

• Depreciation can also come from the supply side. If foreign investors sell Indian assets and take money out, fewer dollars are supplied, so the rupee falls.

What makes the rupee depreciate in the short run

Trade flows matter over the long run. In the short run, capital flows, expectations and interest rates move the rate.

• Interest rate differential (the gap between interest rates in two countries)
• Bonds pay 8% in country A and 10% in country B, a 2% gap.
• Investors sell A's currency and buy B's to earn more.
• A's currency depreciates and B's appreciates.

• So a cut in home interest rates tends to depreciate the home currency. This assumes free capital movement. Capital controls weaken the effect.

• Income growth

• Home income rises → imports rise → demand for dollars rises → the home currency depreciates.

• A country whose aggregate demand (total spending in the economy) grows faster than the world's usually sees its currency depreciate.

• Speculation and expectations

• Money is also an asset. People hold a currency for its expected gain.
• If many investors expect the rupee to fall, they sell rupees today.

• So the rupee falls today. The expectation fulfils itself.

• Uncovered interest rate parity (beyond NCERT): expected depreciation ≈ interest differential.

• If India pays 3% more than the US, the rupee is expected to fall about 3% a year against the dollar.

Effects of depreciation: the trade balance

• Imports become costlier
• The rate rises from ₹50 to ₹60 per $.
• A $100 import now costs ₹6,000 instead of ₹5,000.

• Indians buy fewer imports.

• Exports become cheaper for foreigners

• A ₹600 Indian good now costs a foreigner $10 instead of $12.

• Foreigners usually buy more Indian goods.

• But it does not always help

• Elasticity means how strongly buyers react to a price change.
• If foreign demand for Indian exports is inelastic (it barely reacts to price), each export earns fewer dollars and volume hardly rises. Total dollar earnings may fall.
• Marshall–Lerner condition: depreciation improves the trade balance only if the export and import demand elasticities add up to more than 1.
• J-curve: in the short run the trade balance often gets worse first and improves later. Old contracts are at old prices, and buyers take time to switch.

Worked example: the percentage trap

• The rate moves from ₹50 to ₹70 per $.
• The dollar gains (70 − 50)/50 = 40% in rupee terms.
• The rupee's dollar value falls from $0.0200 to $0.0143, a fall of about 28.6%.
• The two numbers are not equal. The base of the calculation matters.

In India

• Regime: India has a managed float. The market sets the rupee's rate, so day-to-day depreciation is market-driven. The RBI steps in when needed.
• How India reached a market rate:
• Under Bretton Woods (1944–early 1970s), the rupee was pegged (fixed) to the dollar. It could change only by official devaluation.
• In the 1991 BoP crisis, forex reserves ran very low and the rupee was devalued [NCERT, class 11].
• March 1992: the Liberalised Exchange Rate Management System (LERMS) began. It had a dual rate: one official rate and one market rate [8].

• 1 March 1993: LERMS gave way to a unified, market-determined exchange rate. From then on, the rupee could depreciate or appreciate through the market [8].

• RBI's role:

• The RBI says it intervenes only to curb excessive volatility (sharp swings in the rate). It does not defend a fixed level [4].
• To slow a sharp fall, it sells dollars. Its tools are spot sales and purchases, forwards and swaps, including "sell-buy" swaps (selling dollars now and agreeing to buy them back later) [4].

• Example of sharp swings: the taper tantrum after 22 May 2013. The rupee swung sharply on fears that the US Fed would slow its bond buying [5].

• IMF labels:

• India's de jure regime (what the law says) is floating. Its de facto regime (what the IMF sees in practice) is a crawl-like arrangement (2025 Article IV) [6].

• In the 2023 Article IV, IMF staff reclassified India's de facto regime for December 2022–October 2023. India disagreed. It said the stable rupee reflected a stronger external position [7].

• Market size: average daily global OTC turnover involving the rupee was $122 billion (April 2022). OTC means deals made directly between two parties, not on an exchange. Over 60% of it was offshore, mostly in NDFs [4].

• NDF (non-deliverable forward): an offshore contract on the rupee that is settled in dollars. No rupees change hands. Offshore NDF prices can put pressure on the onshore rupee.
• Indian banks with IFSC Banking Units (IBUs) have been allowed to trade in the rupee NDF market from 1 June 2020 [2][3]. This brings the trading closer to Indian regulators.

Don't confuse with

• Devaluation: an official cut in a fixed or pegged rate by the government or central bank, as under Bretton Woods or in 1991. Depreciation is a market-driven fall under a float.
• Currency appreciation: the opposite. Fewer rupees are needed per dollar (₹70 → ₹50). The direct-quote number falls when the rupee strengthens.
• Dollar's % gain vs rupee's % loss: going from ₹50 to ₹70, the dollar gains 40% but the rupee loses only about 28.6%. They are never equal.
• Direct vs indirect quote: in ₹ per $ (direct), a rise means depreciation. In $ per ₹ (indirect), a fall means depreciation.

Prelims Hooks

• ₹50 = $1 is a direct quote. A move to ₹70 = $1 is rupee depreciation, not appreciation.
• Depreciation happens through the market under a float. Devaluation is an official cut under a peg (Bretton Woods, 1991).
• LERMS (dual rate): March 1992 → unified market-determined rate: 1 March 1993 [8]. The market-driven rupee dates from 1993.
• A cut in home interest rates, or aggregate demand growing faster than the world's, tends to depreciate the home currency (assuming free capital movement).
• Marshall–Lerner: depreciation improves the trade balance only if export and import demand elasticities add up to more than 1. J-curve: the trade balance gets worse first, then improves.
• IMF de facto label for India: crawl-like arrangement. De jure: floating [6].

Mains Points

• Depreciation is not an automatic fix for the trade deficit:
• It helps only when elasticities are large enough (Marshall–Lerner). The J-curve can make the deficit worse in the short run.

• India imports a lot of oil, and demand for oil barely falls when its price rises (inelastic). So a weaker rupee raises the import bill and brings imported inflation. This weakens a "depreciate to export" strategy.

• Managed float as a middle path:

• A pure float can let shocks such as taper tantrums swing the rupee wildly. This raises costs for trade and investment and makes monetary policy harder [5].
• A peg invites a 1991-style crisis when reserves run out.

• RBI intervention against "excessive volatility" tries to balance the two [4]. But too much smoothing can look like a hidden peg, as in the IMF's 2023 reclassification [7].

• Interest rates and depreciation are linked (impossible trinity):

• A repo rate cut (the repo rate is the rate at which the RBI lends to banks for a short time) can push capital out, weaken the rupee and raise the price of oil imports.
• So when capital can move freely, the RBI cannot fully control both the interest rate and the exchange rate. It must choose which one to give priority to.

Related concepts

• Foreign exchange market
• Foreign exchange
• Foreign exchange rate
• Demand for foreign exchange
• Supply of foreign exchange
• Flexible exchange rate
• Currency appreciation
• Currency speculation
• Interest rate differential
• Interest rate parity

Read more

• The foreign exchange market and short-run exchange-rate determination