Question

Suppose that a central bank chairman announces that inflation pressures have ebbed. Would such an announcement lead to an appreciation or depreciation of the domestic currency? Why?

Answer 1

Inflation is one of the key factors that affects the exchange rate of a currency and also its appreciation or depreciation. High inflation means the nominal rate will be higher and higher inflation also erodes the purchasing power of the currency so higher inflation would actually cause the domestic currency to lose its value vis-a vis other currency so it will depreciate and if the inflation reduces then the opposite will happen. So, when the Chairman says that the inflation pressure has ebbed, that means the inflation pressure has been low so the inflation is expected to reduce further that means the domestic currency will appreciate. These kind of announce are important because they actually form the basis of expectation of inflation by the business and they will plan their investment accordingly so lower inflation would cause the currency to appreciate.