Question

Does a higher inflation rate in an economy, other things being equal, affect the exchange rate of its currency? If so, how?

Short answer

A higher inflation rate in an economy, other things being equal, affects the exchange rate of its currency by causing depreciation. According to the Purchasing Power Parity (PPP) theory, exchange rates adjust to maintain equality in purchasing power between two countries. When a country has higher inflation than another, its goods and services become more expensive, leading to lower demand for its currency and causing depreciation against the foreign currency. This is reflected in the decline of the real exchange rate, which accounts for inflation differences between the two countries.

Step-by-step solution

Define inflation and exchange rate

Inflation is a sustained increase in the general level of prices for goods and services in an economy over some time, leading to a decrease in the purchasing power of money. The exchange rate is the value of one country's currency in terms of another country's currency. Both of these factors are important in determining the overall health of a nation's economy.

Explain the purchasing power parity theory

The Purchasing Power Parity (PPP) theory suggests that the exchange rate between two currencies should be equal to the ratio of the price levels in the two countries. In other words, a unit of one country's currency should have the same purchasing power in both countries. If there is a difference in inflation rates between the two countries, the exchange rate should adjust to maintain this equality in purchasing power.

Illustrate the impact of higher inflation on the exchange rate

Assuming other factors remain constant, if a country has a higher inflation rate than another country, its currency should depreciate relative to the other country's currency. This happens because higher inflation implies that the domestic country's goods and services become more expensive compared to foreign goods. As a result, demand for the domestic currency falls, while demand for the foreign currency increases. This leads to depreciation of the domestic currency against the foreign one.

Explain the concept of real exchange rate

The real exchange rate is the nominal exchange rate adjusted for differences in inflation between the two countries. It reflects the actual purchasing power of a currency when accounting for inflation. When a country has higher inflation than its trade partners, its real exchange rate will decline, reflecting its currency's depreciation.

Summarize the impact of higher inflation on exchange rates

In conclusion, a higher inflation rate in an economy, other things being equal, leads to the depreciation of its currency. The exchange rate needs to adjust to maintain purchasing power parity between the two currencies. A country experiencing higher inflation than its trade partners will see its real exchange rate decline, indicating the depreciation of its currency.