Question

The Birr is the official currency of Ethiopia. The Wakandan dollar is the official currency of Wakanda. Both countries use flexible (floating) exchange rates

If in Ethiopia the CPI increases from 160 to 167 while in Wakanda the CPI increases from 120 to 126, what do we predict?

Answer: "we predict that the Birr will appreciate relative to the Wakandan dollar". Why?

Thanks

Answer 1

CPI is the weighted average of the prices of the basket of goods and services in an economy in a year. Inflation rate is the rate at which the average price in an economy has increased over the given period of time. The inflation rate is given by the following formula:

Inflation rate = Percentage change in CPI = (CPI2-CPI1)/CPI1 *100

Inflation rate in Ethiopia = (167-160) / 160 *100 = 4.37%

Inflation rate in Wakanda = (126-120)/120 *100 = 5%

This means the inflation rate is higher in Wakanda than Ethiopia.

Since the inflation rate is the increase in the average price level of the economy, it leads to a change in the value of the currency. A higher inflation rate exists when there is excess money supply in the economy which results in more money in the hands of people that increases the aggregate demand in the economy. More money in the hands of people decrease the value of money and leads to currency depreciation. Thus higher the inflation rate more depreciated the currency of the country.

The inflation rate is higher in Wakanda than in Ethiopia, thus, Birr which is the currency of Ethiopia will appreciate relative to the Wakanda dollar (or the Wakanda dollar depreciates relative to Birr).