READERS QUESTION Inflation makes exports less competitive because prices rise, but also, currency devaluation makes exports more competitive. Since devaluation of the currency and inflation are kind of coincidental (because as the currency becomes cheaper, it increases demand and also price), what exactly happens to the competitiveness of exports?
If a currency depreciates (falls in value). Then it tends to cause inflation for three reasons:
- Exports are cheaper. Therefore Net Exports tends to rise causing higher AD and demand pull inflation
- Imports are more expensive. (The £ Sterling price of imports is higher, because the currency is weaker) Therefore we get imported inflation
- Because UK exports become more competitive it is argued people have less incentive to cut costs.
The Effect of Inflation on Competitiveness
You are right, if UK inflation is higher than other countries, then UK goods will become comparatively less competitive. This will cause lower demand for UK exports (depending on elasticity of demand)
If a country has a higher rate of inflation then the currency will, in the long run, depreciate (fewer people buy the currency). This will help to restore the competitiveness of exports.
Therefore, there are 2 different effects occurring.
- Inflation is making exports less competitive
- The depreciation is restoring competitiveness.
The overall effect is uncertain; it depends how much the currency depreciates in response to inflation