Question

In: Finance

How can inflation affect exchange rates? I need a clear explanation with clear reasoning and examples.

Expert Solution

ANSWER DOWN BELOW. FEEL FREE TO ASK ANY DOUBTS. THUMBS UP PLEASE.

explanation:

For example let's say the USA has a lower interest rate than compared to India, It means due to low Inflation goods will be cheaper in the USA after a said period than compared to India.

therefore there is an inflow of money in the USA to buy goods in the USA (as cheaply available over there).

Thus the demand for USD increases. And hence $ appreciates and ₹ depreciates.

Inflation affects the exchange rate as per PPP.

Purchasing power parity:

It is the relationship between: inflation rate of two countries, spot exchange rate and expected spot exchange rate.

This is based on the law of one price. That is the prevention of the commodity Arbitrage.

E(S)/S = (1+Ia)/(1+Ib)

E(S)= Expected spot exchange rate.

S = spot exchange rate.

Ia = Inflation rate of price currency.

Ib= Inflation rate of base currency.

If the above equation does not hold good then there is a chance of Arbitrage between the forward exchange rate and spot exchange rate.

It describes:

The country which has a lower inflation rate, its currency will appreciate

And vice versa.

jeff jeffy answered 2 years ago

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