Question

If inflation is high in Europe relative to the US, what effect will it have on the value of the US dollar as compared to the Euro? Why?

Answer 1

Higher inflation means prices in Europe rise faster than those in the US, which makes european goods more expensive both domestically and abroad. Higher prices mean that European goods will become less competitive relative to US goods. From perspective of US consumers, they will want less European goods than before and this will affect exchange rate: there will be less exchange of dollar for euro in order to buy these imported goods.

2) On the other hand, from the perspective of European consumers, with rise of domestic prices, they will find goods from US cheaper. They will want to exchange more yuans for dollars so they can buy more imported goods. This increase of supply of euro will lead to decrease of its value and exchange rate.

So, change in inflation should lead to a change in exchange rate between 2 currencies. If inflation in Europe is higher than that of the US, the exchange rate of euro against dollar should be depreciating-each US dollar will be now covered with more euros.