Higher Inflation and Exchange Rates

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

A higher inflation rate in the UK will reduce value of Pound because:

High inflation in the UK means that UK goods increase in price quicker than European goods. Therefore UK goods become less competitive. Demand for UK exports will fall. Therefore there will be less demand for Pound Sterling.

Also UK consumers will find it more attractive to buy European imports. Therefore they will supply pounds to be able 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 currency causing it to fall in anticipation of the inflation.