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Link Between Exchange Rates and Inflation

Link Between Exchange Rates and Inflation
Published:   12 Dec at 9 AM

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The link between exchange rates and
inflation can be quite complicated as its effect can be both positive
and negative. They are also similar in that both Inflation and exchange
rates determine if a nation is likely to be economically stable or not.

Inflation and its effects on exchange
rates can also be ascertained from the following facts. In the early
years of the foreign exchange market, it was proposed by a large portion
of leading economists to peg a particular currency or to “dollarise”
the currency of a particular nation. Emerging nations were typically
used to having a fixed type of exchange rate. They went to great lengths
to ensure that the exchange rate remained fixed or pegged because a
floating exchange rate was generally believed to cause problems when
trading. With the development of the strategy of “inflation targeting”
and exchange rates, which are more flexible, this belief has changed
somewhat. More and more countries are moving away from the fixed exchange
rates. This transition is in progress, when the majority of countries
are using inflation targeting as a way of conducting various monetary
policies. In several nations, the nominal exchange rate was frequently
used as a way of bringing down the level of inflation.

The exchange rates are essential
macroeconomic variables which is to say they variables of the biggest
economic movements. The exchange rate affects inflation, trade (both
in the form of imports and exports) and a range of additional economic
activities of a particular country. If the rate of inflation stays at
a low level for an extended period of time, the value of the country's
currency rises as a direct result of the increase in the purchasing
power of that currency, as discussed in the quotations section. The
perfect example of this would be the three countries Switzerland, Japan
and Germany whose inflation rates were particularly low during the twenties.
The countries, having higher rates of inflation observed depreciation
in their currency. Whereas in contrast, the countries with lower rates
of inflation did not endure this trend. In the event when a nation is
aware of a possible rise in inflation, it can take measures accordingly.
Exchange rates may also be affected by the type of inflation prevailing
in the economy. Inflation can come in the form of:

  • Cost push inflation -
    Cost-push inflation is a type of inflation that is brought on by significant
    increases in the cost of essential goods or services without any realistic
    alternative being available to them. Oil is a particularly good example
    and in the seventies, it was the oil crisis that brought about a significant
    increase in inflation in the Western world. Due to the impotance of
    petroleum to industrialised economies in particular, a hike in price
    is passed on through the sale of their goods and services and in turn
    a rise in the inflation rate.

- Demand pull inflation - The demand-pull
inflation becomes an issue when the agrregate demand in a particular
country's economy, increases or decreases faster than the aggregate
supply. This means inflaton rises as the real GDP (Gross Domestic Product)
increases and unemployment levels decrease. This frequently referred
to as “too much money chasing too few goods”. Realistically however,
it is more a case of “too much money SPENT chasing too few goods”
as it only the money that is spent tho on these goods and services that
contributes to the rise in inflation.

« Exchange Rates - What are they and how are they calculated?

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