Question

Suppose a country with an inflation targeting regime announces a new anti-inflation program which reduces the inflation expectations in the medium and long term. What will happen to the value of domestic currency and the long end of the yield curve after this announcement?

Answer 1

Inflation is consistent rise in general prices of goods and services in an economy.

A prolong inflation reduces the value of money as more amount of it is required to buy goods and services than before. Inflation heats up the economy with higher amount of money supply.

In order to bring down inflation rate, the central bank increases the interest rates which reduces the money supply in the economy due to increase in borrowing cost of money.

The anti-inflation program to bring down inflation rate will lead to appreciation of domestic currency as due to higher interest rates, its demand would be higher leading to its appreciation.

As far as yield curve is concerned which shows yield at different interest rates to investment in bonds, and also anti-inflation programe would involve increase in interest rates, anticipating which yields will increase leading to a steeper yield curve than before.