Question

If a country has persistently high inflation over the long-run, say 10% pa, explain how this will affect the value of the nominal exchange rate over the long-run. Assume that inflation elsewhere is 2% per annum.

Answer 1

As you might know, inflation is not the sole reason for poor exchange rate but one of the main reasons. A higher inflation generally meaans that the country's currency is weak. So, a 10% inflation p.a. poses a significant challenge to the currency of country mentioned. With optimum level of inflation at 1-3%, the country mentioned in the problem is undergoing a pretty tough economic phase.

Inflation is closely related to the interest rates, which influences the exchange rates which we are interested in at the moment. To elucidate this relation let's view the country's currency as a commodity itself. It's obvious that low interest rates in a country's economy would encourage more consumer spending, which basically means that the demand is exponentially increasing. As soon as there is a situation wherein the demand is much more than the supply, inflation ensues. In general, these lower interest rates does not entice Foreign investments, thereby a poor nominal exchange rate is perceived. But on the other hand a higher interest rates puts up higher demand on the country's currency thereby a healthy exchange rate is established.

This is the simple aspect in which the 10 % inflation increase the interest rates set by the central bankers, thereby giving rise to a stronger currency.

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