Readers’s question: What is the difference between depreciation and inflation?
Depreciation refers to a fall in the value of an asset. A depreciation of the exchange rate means a currency becomes worth less than others. For example, the Pound sterling falls in value against the dollar/euro/Yen.
This graphs shows that the value of the Pound depreciated in 2007-08. By Jan 2009, the value of the Pound Sterling had fallen 30% against a basket of currencies compared to January 2007.
Definition of inflation
Inflation means a sustained increase in the average price level. Inflation reflects an increase in the cost of living.
This shows the global inflation rate. It shows that in 2008, inflation reached 9%, meaning that prices were rising by an average of 9%.
Inflation will cause a fall in the value of money. If there is inflation of 9%, it means at the end of a 12 month period a $100 bill will buy 9% fewer goods than previously. The more inflation we get the more money decreases in value.
Link between depreciation and inflation
A depreciation in the exchange rate can cause inflation. This is because a depreciation
- Increases the price of foreign imports
- Increases domestic demand (because exports are cheaper causing higher demand for exported goods)
- Exporters may have less incentive to cut costs because they can rely on depreciation to remain competitive.
Why Inflation can cause a depreciation in the exchange
Higher inflation in the UK will make UK goods comparatively more expensive than in other countries, therefore, there will be less demand for British goods and less demand for Pound Sterling.
Depreciation vs Devaluation
There is a slight difference between depreciation and devaluation. A depreciation of the exchange rate occurs in a floating exchange rate. A devaluation is a conscious decision to reduce the value of the exchange rate in a fixed exchange rate system. Both have the same effect of reducing the value of the exchange rate.