Question

Answer the following question.
Explain by giving examples, the distinction between depreciation and devaluation of the domestic currency.

Answer 1

While both devaluation and depreciation implies that the domestic currency (say Rupees) has become less expensive in terms of foreign currency (say US Dollar).

However, they differ on the ground that while on one hand, devaluation is practiced under a fixed exchange rate regime, on the other hand, depreciation is said to take place under a flexible exchange rate regime.

That is, devaluation is said to take place when the monetary authority deliberately reduces the value of a domestic currency against the foreign currency.

On the other hand, depreciation is said to take place when the value of the currency falls under a flexible exchange rate regime, i.e. due to market forces of demand and supply of foreign currency.

For example, if the country follows a fixed exchange rate system and the government or the monetary authority deliberately reduces the value of domestic currency against the foreign currency from Rs 50 per $ to Rs 60 per $, it will be said as the devaluation of the domestic currency.

Whereas, if the country follows a flexible exchange rate system and the domestic currency against the foreign currency decreases due to changes in demand and supply factors from Rs 50 per $ to Rs 60 per $, then we will say that the currency has depreciated.