Definition of devaluation and depreciation
Readers Question: I read in a text-book that under a floating exchange rate a “devaluation” is not possible as a means of improving international competitiveness but a “depreciation” is. Could you please explain to me what a depreciation is as opposed to a devaluation.
In general, everyday use, devaluation and depreciation are often used interchangeably. In fact for A Level economics it is not absolutely essential to distinguish between the two, but there is a distinct difference and using them correctly is good practice.
Essentially devaluation is changing the value of a currency in a fixed exchange rate. A depreciation is reducing the value in a floating exchange rate.
Definition of Devaluation
A devaluation is when a country makes a conscious decision to lower its exchange rate in a fixed or semi fixed exchange rate. Therefore, technically a devaluation is only possible if a country is a member of some fixed exchange rate policy.
- For example in the late 1980s, the UK joined the Exchange Rate Mechanism ERM. Initially the value of the Pound was set between say 3DM and 3.2DM. However, if the government thought that was too high, they could make the decision to devalue and change the target exchange rate to 2.7DM and 2.9DM.
Definition of depreciation: When there is a fall in the value of a currency in a floating exchange rate. This is not due to a government’s decision, but due to supply and demand side factors. (Although if the government sold a lot of their currency they could help cause a depreciation.)
For example, the dollar has depreciated in value against the Euro during the last 12 months. This is due to market forces, there is no fixed exchange rate target for Euro to Dollar.
The problem is that in ever-day use, people talk about a devaluation in the dollar, when, technically speaking, they mean a depreciation in the dollar.