Depreciation is a term used in accounting, economics and finance with reference to the fact that assets with finite lives lose value over time.  This is similar to devaluation of a Currency, except that a depreciation happens naturally in a floating exchange rate system, but a devaluation happens artifically at one time under a fixed exchange rate system. 


In accounting, depreciation is a term used to describe any method of attributing the historical or purchase cost of an asset across its useful life, roughly corresponding to normal wear and tear.1 It is of most use when dealing with assets of a short, fixed service life, and which lose value over that life.



Currency depreciation

is the loss of value of a country's Currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system. It is most often used for the unofficial increase of the exchange rate due to market forces, though sometimes it appears interchangeably with devaluation. Its opposite is called appreciation.  Example: a rise in the Euros price in terms of Dollars, for example from $1.10 per Euro to $1.40 per Euro is a n appreciation of the Euro, and a depreciation of the Dollar.  All things else equal,a depreciation of a countries currency makes its goods cheaper to foreigners



Why does a currency depreciate?

There are two underlying economic theories as to why a currency should depreciate against another currency:


  1. If the home country has higher inflation, then their currency should depreciate.  This economic law is called the "law of one price", or the Purchasing Power Parity Theorem (see PPP).
  2. If the home country has higher interest rates, then (contrary to normal thinking) the currency will likely depreciate.  I say "contrary to normal thinking" because most people think that if a country increases their interest rates, then the currency will see appreciation.  This is true in the short term, but over time, emperical evidence shows that the country with the highest interest rates normally also has the weaker currency.  For more discussion about this topic see our discussin about the "interest rate parity" theorem



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