Readers Question: Why is it that the value of the exchange rate falls when there is higher inflation?
How inflation affects the exchange rate
A higher inflation rate in the UK compared to other countries will tend to reduce the 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, and 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 the value of Pound Sterling.
Therefore, in the long run, changes in relative inflation rates should lead to a change in the exchange rates.
In the post-war period, the UK experience a higher inflation rate than Germany. This caused the Pound Sterling to depreciate against the German Mark. It was a reflection that German industry was becoming more competitive than UK industry.
Also, markets anticipate future inflation. If they see a policy likely to cause inflation (e.g. cutting interest rates) then they will tend to sell that currency causing it to fall in anticipation of the inflation.
How the exchange rate affects inflation
- If there is a depreciation in the exchange rate, it is likely to cause inflation to increase. – (Import prices more expensive)
- An appreciation in the exchange rate will tend to reduce inflation. (Import prices cheaper)
Why a depreciation causes inflation
A depreciation means the currency buys less foreign exchange, therefore, imports are more expensive and exports are cheaper. After a depreciation, we get:
- Imported inflation. The price of imported goods will go up because they are more expensive to buy from abroad
- Higher domestic demand. Cheaper exports increases demand for UK exports. THere is also a reduction in demand for imported goods, shifting consumption to domestic goods Therefore, there is an increase in domestic aggregate demand (AD), and we may get demand pull inflation.
- Less incentive to cut costs. Manufacturers who export see an improvement in competitiveness without making any effort. Some argue this may reduce their incentive to cut costs, and therefore, we get higher inflation over the long term.
Therefore, a depreciation causes both cost-push inflation and demand pull inflation.
Example of depreciation causing inflation in the UK
During 2007 and 2008, we saw a significant fall in in the value of the Pound. This caused some cost-push inflation in 2008/09.
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 the 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 imports.