Is currency depreciation good or bad for the economy?

When a currency depreciates, the prices of domestically-produced goods decline relative to international prices. The exporting firms become more competitive and exports increase. If the growth of exports is significant, then production and employment also expand and the entire economy accelerates. For that reason, countries sometimes try to cause a depreciation of their currencies in order to stimulate the economy. Observe, for example, the growth of the UK economy after the 1992 depreciation of the British pound.

However, a depreciating currency does not necessarily cause an economic boom. In fact, the economy can go into a steep recession as in the case of Indonesia.
Whether or not depreciation causes an economic expansion depends on several factors. First, does the country import many raw materials and intermediate goods? If it does, when the currency depreciates, the cost of production increases and the country does not become more competitive. For example, if a clothing company imports all of its textiles, then its cost will increase when the currency depreciates. It would not become more competitive. It may be able to switch to using domestic textile but that is a long process and it may not even be possible if there are no domestic producers of textile.

Second, has the country borrowed extensively in foreign currencies? If it has, then the value of its international debt (expressed in domestic currency) increases as soon as the currency depreciates. If the currency value declines by 20 percent, the value of international debts immediately increases by 20 percent making it very difficult for governments, firms, and households to pay back their debts. Some firms and households (and possibly governments) may go bankrupt pushing the economy into a recession.

Third, would the depreciation cause high inflation? In countries that import many of their essential products such as food and fuels, currency depreciation can produce high inflation. The prices of these imported products increase but people cannot stop buying them. High inflation, in turn, creates an environment of financial instability and uncertainty and leads to lower economic activity. Inflation also creates political unrest as people cannot afford essential goods and often initiate public protests against the government.

All of the above helped push Indonesia into a steep recession.

See all articles

See all indicators