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Inflation and Exchange Rates | Economics Help

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Inflation and Exchange RatesBy Tejvan Pettinger on May 17, 2012 in economics

Readers Question: Why is it that the value of the exchange rate falls when there is higher inflation?in the quantitativeeasing section (from Euro to Pound)

How Inflation Affects Exchange Rates

A relatively higher inflation rate in the UK compared to other countries will tend to reduce the value of pound because:This site uses cookies No problem More info



High inflation in the UK means that UK goods increase in price quicker than European goods. Therefore UKgoods become less competitive. Demand for UK exports will fall. Therefore there will be less demand for PoundSterling.Also, UK consumers will find it more attractive to buy European imports. Therefore they will supply pounds to beable to buy Euros and the Euro imports. This increase in the supply of pounds decreases value of Pound Sterling.

Therefore in the long run, changes in relative inflation rates should lead to a change in exchange rates.

Also markets anticipate future inflation. If they see a policy likely to cause inflation then they will tend to sell that currencycausing it to fall in anticipation of the inflation.

How the Exchange Rate Affects Inflation

If there is a depreciation in the exchange rate, this depreciation should cause inflation to increase.

A depreciation means the currency buys less foreign exchange, therefore, imports are more expensive and exports arecheaper. Therefore, we get:

Imported inflation. The price of imported goods will go up because they are more expensive to buy from abroadHigher domestic demand. Cheaper exports increases demand for UK exports. Therefore, there is an increase indomestic aggregate demand, and we may get demand pull inflation.Less incentive to cut costs. Manufacturers who export see an improvement in competitiveness without making anyeffort. Some argue this may reduce their incentive to cut costs, and therefore, we get higher inflation over the longterm.

Therefore, a depreciation causes both cost-push inflation and demand pull inflation.

Example of Depreciation Causing Inflation in UK

Subir_SahaHighlight

Subir_SahaHighlightInflation causes the value of the currency to go down. This implies that they can buy less with this currency in the forex markets.To avoid this phenomenon, if markets expect inflation in the future, they would sell the currency causing the value of the currency to go down further. (excess supply of currency).



During 2007 and 2008, we saw a significant fall in in the value of the Pound. This caused some inflation.

The UK did experience a spike in inflation towards the end of 2008.

Evaluation of impact on inflation.

The rise in UK inflation in 2008 was also due to higher oil prices.The effect on inflation was limited because in 2009 the UK was in recession, which reduced inflation.The impact also depends on elasticity of demand and whether firms will pass on the exchange rate costs onto



consumers. For example, firms may reduce profit margins rather than increase the price of impots.

inflation

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2 Responses to Inflation and Exchange Rates

1. Zee Mabuza June 4, 2009 at 3:56 pm #

Wow..Thanks that helped alot! Its like the acronym SPICED. Strong.Pound.Imports.Cheaper.Exports.Dearer.

Trackbacks/Pingbacks

1. Why you Need to Stay Alert of Changes in Exchange Rates | Broke Professionals - April 20, 2014

[] rate. National debt, changes in interest rate, recession, the strength of other currencies and inflation willimpact the exchange rate. This is knowledge that you will want to be aware of at all times, as this enables you to[]

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Tejvan R Pettinger



Tejvan studied PPE at LMH, Oxford University and works as an economics teacher and writer.

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