Currency devaluation can occur in absolute and relative senses. A relative devaluation occurs when the foreign exchange value of one currency drops against the exchange value of other currencies. In either case, the economic roots of currency depreciation are dependent on the productive capacity of an economy and the size of its money supply.

Understanding Currency Depreciation

Almost every major currency is controlled like a monopoly through legal tender laws. For this reason, governments and central banks control the factors that influence currency value. Even though these are not traditionally considered to be economic factors, they are nonetheless critical determinants.

Money also exists as a store of value. Employees trade the value of their working labor for a representative amount of money (in wages) and then trade that representative value for other goods and services in the market. As factors specific to labor, goods, manufacturing, or consumer preferences change, the value of each also changes. Thus, "exchange rates" between laborers and consumers may ebb and flow based on a variety of considerations.

Productivity

As an individual employee creates more value through increased productivity, they may see their salary increase proportionately. Their employer (or customers) must either give them more units of currency or more valuable units of currency.

If the money supply in a country is fixed but productivity increases, then each unit of currency must store greater value. If the productivity of an economy is fixed but the supply of currency decreases, then each unit of remaining currency must store greater value.

The opposite is also true. When productivity declines faster than the supply of money, the value of each unit of currency drops. The most common monetary phenomenon, inflation, is produced the other way around; the supply of money grows faster than productivity. There are more units of currency around to absorb productivity, so each one ends up representing less exchange value in the market.

Interest Rates

In addition to inflation, interest rates constitute a fundamental aspect of currency valuation and are a primary tool employed by central banks to regulate economic conditions.

The basis of interest rates is rooted in the attraction of foreign capital. Elevated interest rates tend to allure foreign investors in search of more lucrative returns on their investments, especially if those investments carry less risk but higher yields. Consequently, a nation raising its interest rates often witnesses heightened demand for its currency. On the other hand, a reduction in interest rates can set in motion a depreciation of the domestic currency. Lower interest rates diminish the attractiveness of a currency since that country's new bond offers have lower returns.

In the long term, interest rates also play an important role in shaping currency values. Long-term interest rates are influenced by a variety of factors, including inflation expectations, economic growth prospects, and global market conditions. When a country consistently maintains higher long-term interest rates, it can more easily attract long-term investment. Investors may have greater confidence in these higher, stable returns over an extended period.

Foreign Exchange Markets

The foreign exchange markets are particularly complex. This is partly because there are two types of forex traders. The first type of trader is looking to make a purchase in a foreign market, so they need to convert one currency to another. The vast majority of these transactions are performed by banks or other major financial institutions on behalf of their domestic customers.

The second type of trader is simply looking to trade currency with a lower expected future value for currencies with higher expected future values. This currency speculation plays an important function in international markets, but it is forward-looking and doesn't cleanly equate to current purchasing power or national productivity.

Political Stability

Political stability and economic performance also play an important part in generating and maintaining currency value. A politically stable environment means consistency, opportunity, and predictability. All of these traits enhance investor confidence. When a country is politically stable, investors have confidence that their investments will not be jeopardized by sudden changes in government policies, regulations, or political turmoil. This assurance encourages both domestic and foreign investors to engage in long-term investments, fostering economic growth. As a result, the currency of a politically stable country is more likely to be perceived as a safe and reliable store of value, contributing to its appreciation.

Conversely, political instability, corruption, or economic uncertainty can deter investors through increased political risk. If there is a perception that a country's political landscape is volatile or its economic prospects are uncertain, investors may not contribute their capital to that country (or no longer do future business with that currency). This disinterest may be fostered by changes to tax legislation, business credits, import/export agreements, or consumer access to specific goods.

Trade Agreements

Terms of trade represent the relative value of a country's exports to its imports. When a country experiences a decline in the prices of its exports compared to the prices of its imports, it faces a deterioration in its terms of trade and decrease in relative value of its currency.

The relationship between terms of trade and currency depreciation is caused by supply and demand in international trade. If a country's export prices fall relative to its import prices, it becomes less competitive in the global market. Foreign buyers may seek alternative sources for goods and services, resulting in a decrease in demand for the country's exports (which are denominated in the country's currency).

Governments often monitor and respond to changes to mitigate some of these effects. They may diversify the economy to reduce reliance on specific exports, implement trade policies to enhance competitiveness, or, as mentioned above, use monetary policy tools to stabilize the currency.

The Bottom Line

The wide range of possible factors that influence currency value in international markets includes the relative monetary policy between governments and central banks, differences in economic forecasts between one country and another, the differences in productivity between one set of workers and another, and the relative demand for the goods and services produced between different countries.