Relationship Between Inflation and Exchange Rate

Custom Student Mr. Teacher ENG 1001-04 3 January 2017

Relationship Between Inflation and Exchange Rate

The existence of linkages between the level of the exchange rate and the rate of inflation has been more commonly established in the theoretical literature. Using this definition, we can show the link between inflation and exchange rates. What is exchange rate and what is inflation? An exchange rate is the value of one currency expressed in terms of another currency. Exchange rates are expressed as a comparison of the currencies of two countries. There are many theories about the causes and definitions of inflation, but generally we can say that the inflation is a rise in the general level of prices of goods and services in an economy over a period of time. Exchange rates have a very important role in a country`s level of trade and it is critical to every free market economy worldwide. It can be high or low. Also we have three main divisions and they are: fixed, floating and managed exchange rate. Some of them influence the inflation directly.

If we take the fact that inflation is the consequence of other factors, and if we continue exploring different scenarios of this kind of relationship, we can see how significant exchange rate changes can be as factors affecting inflation. It is well known that if we have devaluation (when the value of a fixed exchange rate is lowered) of the fixed exchange rate it may result as an increase in inflation. Also there is a case when we have revaluation (when the value of the exchange rate is raised) of the fixed exchange rate where it may act as a decrease in inflation. Also in floating exchange rate if the policymakers keep the level of the rate depreciated (when the value of the exchange rate falls) or appreciated (when the value of the exchange rate rises) for a longer time may lead to a sustained increase or decrease in inflation.

Few questions in international economics have aroused more debate than the choice of exchange rate regime. Should a country fix the exchange rate or allow it to float? The answer could depend on a possible inflation that they might have. For example, if the country takes a high exchange rate, and they have high inflation, then it would decrease the inflation. So, if the value of the taken exchange rate is high, the price of goods which are imported will be low and doing this the price of imported raw materials and components would reduce the cost of production for firms. This would lead to lower prices of product which would be a great advantage for consumers.

Beside this it would make a pressure on domestic producers to be more competitive by keeping the prices low. On the other hand if the country takes a low exchange rate the imported components, such as raw materials, goods and services, would be more expensive. Firms use these components, especially raw materials, to produce their products and for them the cost of production would rise and that would lead to higher prices of certain products on the market. At that point the country would have inflation, which would rise as prices rise, in this way a disadvantage of low exchange rates. So, the high value of a currency may be very good to fight inflation, but it would create unemployment problems.

On the other hand low value of a currency may be good for solving possible unemployment problems, but it may create inflationary pressure. We can say that there is a strong link between fixed exchange rates and low inflation. If a country has fixed exchange rate, the inflation have a very harmful effect in the demand for exports and imports and because of this the government has to make measures to ensure that inflation is low, in order to keep its businesses competitive on foreign markets, which is an advantage of a fixed rate. The fixed exchange rate has its disadvantages, because if the exchange rate is in danger of a fall, the government has to raise the interest rates and increase demand. This will have a deflationary effect and an increase in unemployment.

We can say that the theoretical relationships are ambiguous and because of that the next evidences should evidence a strong relationship between inflation and the exchange rate regime. In the United Kingdom government uses monetary policy, since 1992, and that strategy can be characterized as one of floating exchange rates and inflation forecast targeting, with the measure of the inflation referring to consumer prices. A floating exchange rate gives the central bank the ability to use monetary policy to pursue an inflation target directly, in a way that orientation to a fixed exchange rate does not. Beyond that, however, the precise role and significance of the exchange rate in an inflation targeting regime, such as the U.K.’s, is a source of an argument, both in practical policy discussions and within the theoretical literature.

As a general rule, we can say that a country with a consistently lower inflation rate exhibits a rising currency value, while its power of purchasing increases relatively to other currencies. During the last second half of 20th century the countries with low inflation included Japan, Germany and Switzerland, while the United States and Canada achieved low inflation only later. The point is that those countries with higher inflation typically see depreciation in their currency in relations to the currencies of their trading partners.

This is also usually followed by higher interest rates. The exchange rate is one of the most important macroeconomic variables in the emerging and transition countries, because it affects inflation, exports, imports and mostly all economic activities. We can conclude that a higher currency makes a country’s exports more expensive, imports cheaper in foreign markets and decreasing the inflation , while a lower currency makes a country’s exports cheaper, its imports more expensive in foreign markets and increases inflation. A higher exchange rate can be expected to lower the country’s balance of trade and downward press the inflation, while a lower exchange rate would increase it.

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  • University/College: University of Arkansas System

  • Type of paper: Thesis/Dissertation Chapter

  • Date: 3 January 2017

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