How Does Inflation Affect Exchange Rate?
The attractiveness of a particular currency at the forex market is determined by many things. The economic strength of a nation relative to another, however, is the most important factor. The strength of the economy itself is also affected by issues like inflation.
There are many factors in the economy that change inflation and thus affect the affairs in the forex market. The exchange rate of a particular currency is heavily influenced by how economic affairs within a country are managed. While there are many factors that affect the exchange rate of a currency, none is quite as instrumental as inflation. Inflation directly affects the price of goods and this has a direct impact on the value of the currency as well. So how exactly does inflation affect the exchange rate?
It changes the level of demand for the currency
Inflation causes goods from a particular country to become more or less attractive. The world is connected through trade. When the prices of commodities in a country increases, its goods become less desirable to those outside its borders. All countries exchange their currencies for others so that they can be able to trade effectively with their global partners.
If a country like the US experiences inflation, for instance, the goods that the US manufactures for overseas markets suddenly become less attractive as a result of the price increases. This, in turn, results in fewer people demanding the US dollar. With a lessened demand, the volume of trade of the dollar at the forex market goes down. The opposite scenario is also true. When the US dollar is receiving a high demand in the forex market as a result of competitive goods, its value also increases. Inflation is thus a critical factor that affects the exchange rates of particular currencies.
It changes the dynamics of a particular market
In addition to influencing the demand for goods, inflation is also directly responsible for influencing another important factor that affects the exchange rate - interest rates. Interest rates and inflation are directly correlated. Inflation comes as a result of an increased supply of currency in an economy. This supply, in turn, can be caused by the monetary policy which touches on interest rates. When there are low-interest rates, there is a tendency for consumers to spend and invest more. This results in a vibrant, thriving local economy. Such an economy attracts foreign investors and thus leads to an increased demand for local currency. When the demand is high, the price also goes high. On the other hand, high-interest rates have the opposite effect.
People tend to spend less and also invest less. The economy also does not attract foreign investment. The result of all this is a low demand for local currency. The exchange value of this currency thus also goes low to respond to the market forces. In general, though, there are many other complex factors that influence both inflation and interest rates. The stability of the economy and political factors can also play a role. Data reflected on forex indicators changes a lot depending on the situation of a particular economy.
Other issues that affect the exchange rate
It is important to note that inflation alone cannot provide sufficient information when looking at factors that influence the exchange rate. There is no single currency that loses or gains value only as a result of inflation. While inflation is a big part of the puzzle, other important factors should also be considered as they equally contribute to the changes in the exchange rate. Some of the most important of these factors are:
□ The rate of economic growth in the country
□ The level of debt
□ The balance of trade
In summary
A huge act of balancing is necessary for any economy to be strong. The value of a currency is one of those factors that indicate the health of an economy. Inflation has tremendous negative effects on the welfare of the economy. Inflation can be the catalyst that causes changes in interest rates and affects the demand for goods. This, in turn, affects the value of a currency and its demand in the forex markets. Inflation can thus be said to be at the core of determining the exchange rates. There are, nevertheless, other vital factors that must be put into the account for the whole narrative to play out.
■ How Does Inflation Affect Exchange Rate
TradingCenter Blog (2018)
