Differentiate between devaluation and depreciation.
Devaluation occurs in a fixed exchange rate system when government action increases the exchange rate, thereby making the domestic currency cheaper. It is a deliberate policy decision taken by the government.
Depreciation, on the other hand, occurs in a flexible exchange rate regime where exchange rates adjust to reflect differences in price levels between countries. As shown in the context, depreciation happens when market forces cause the exchange rate to change over the long run.
The key difference lies in the exchange rate regime and the cause: Devaluation is government-induced in a fixed system, while depreciation is market-driven in a flexible system.
Explanation
The textbook clearly defines devaluation in the context of a fixed exchange rate system as a government action that increases the exchange rate. For depreciation, the context provides an example where the dollar depreciated due to price level adjustments, and links it to the flexible exchange rate regime where rates adjust based on market conditions. The distinction is between government intervention (devaluation) versus market-driven adjustment (depreciation).