1) You say depreciation causes inflation for the three reasons you mention, but later, that in the long run, a higher rate of inflation will cause depreciation. So my first question is how are these two phenomena linked? Is ‘long run’ the key; i.e. it takes a prolonged high inflation to cause a devaluation, but devaluation causes inflation sooner? How long does it take for those three reasons to really kick in?
It depends, there is no straight answer. The two phenomena may occur simultaneously. Also it is complicated by the fact that many factors affect the exchange rate apart from just inflation. (e.g. short term interest rates)
2) My next question is that I’m aware that factors such as rising commodity prices can exert upward inflationary pressure, but are there any other factors that affect the devaluation of a currency – or is it purely down to inflation?
Many factors can affect exchange rates. These include:
- Interest Rates – lower interest rates cause less hot money flows and depreciation.
- Expectations – If investors expect a currency to devalue they will sell less. Confidence and market expectations are important in determining exchange rate
- Current account deficit. A large current account deficit may put downward pressure on exchange rates
3) Next, if devaluation does cause inflation, which in turn causes more devaluation, what tools does the government have to combat this vicious circle?
In the UK, the government target low inflation. They don’t have a specific target for the exchange rate. The main tool for controlling inflation is monetary policy and interest rates. If inflation is increasing above the target the MPC is likely to increase interest rates to reduce demand and inflationary growth
4) Finally, looking at a recent example, I saw on the news a few weeks ago that some manufacturing companies in the UK were enjoying a boost in demand. Would it be correct to say that inflation caused by rising energy prices, (which makes their exports less competitive) caused the pound to weaken, which balanced out the effect of inflation and then some, making their goods more competitive abroad?
The Pound has become weaker against the Euro. The Euro is our main trading partner. I think it is fair to say the benefits of lower exchange rate are greater than the increased costs of imported inflation.
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