Key Takeaways
- High inflation generally weakens a currency by reducing its purchasing power, often leading to unfavorable exchange rates.
- Exchange rates are influenced by factors including inflation, interest rates, and political stability, impacting international trade dynamics.
- Central banks manage inflation and exchange rates by adjusting interest rates, balancing economic growth and currency stability.
- The degree of Exchange Rate Pass-Through (ERPT) determines how much currency value shifts affect consumer prices.
- Political and economic stability can attract foreign investment, thereby strengthening a country’s currency.
Inflation is the rise in prices over time, while an exchange rate is the value of one currency against another. Inflationary changes can influence a currency’s value. Central banks also manage inflation and support currency stability. Keep reading to learn how the relationship between inflation and currency value works, along with the broader implications on global trade.
Interest Rates: Their Influence on Inflation and Currency Exchange
Inflation is closely related to interest rates, which can influence exchange rates. Countries try to balance the two, but their relationship is complex and often difficult to manage. Low interest rates spur consumer spending and economic growth and generally positively influence currency value. If consumer spending increases to the point where demand exceeds supply, inflation may ensue, which is not necessarily a bad outcome within certain limits.
However, lower interest rates tend to detract from foreign investment. Higher interest rates tend to attract investors, increasing the demand for a country’s currency.
For this reason, a simplified way of thinking of the relationship is as opposite ends of a seesaw. When inflation rises in a country, its currency’s value often falls relative to other currencies. High inflation erodes purchasing power, making the currency less attractive to foreign investors and traders.
For example, from 2022 to 2023, as inflation surged in the United States, the U.S. Federal Reserve raised interest rates aggressively. This strengthened the U.S. dollar against many other currencies, as higher rates attracted foreign capital seeking better returns.
Below are the shifts in inflation and the real broad effective exchange rate, an index measuring the value of the U.S. dollar relative to a basket of foreign currencies adjusted for inflation (real terms). The data for both are presented monthly as a percentage change from the previous year. You can hover over the chart to see the data for specific months.
In general, when inflation is high, this weakens a currency because buying power is reduced. Goods are more expensive, and this tends to turn investors away from doing business. When the inverse happens, and inflation is low, more money flows into the country, and the currency becomes more valuable as its buying power increases, improving its exchange rate.
Practical Scenarios of Inflation and Currency Exchange
Given the U.S.’s broader ability to protect itself from exchange rate shifts, let’s look at two more countries. Below, you can see Argentina has been keeping its shifts in exchange rates relatively flat, despite devastating inflation.
The Argentine central bank (Banco Central de la República Argentina) has been actively intervening in the foreign exchange market to stabilize the peso. Even with high inflation, interventions like selling foreign reserves or implementing capital controls can prevent large swings in the exchange rate—but often at a cost to the country’s currency reserves.
A good example of a currency that has largely been left to float freely, with minimal government intervention, is the Australian dollar (AUD). This means market forces of supply and demand determine its value without direct intervention from the Reserve Bank of Australia (RBA).
Australia is a major exporter of commodities such as iron ore, coal, and natural gas, so the AUD is highly sensitive to shifts in commodity prices, inflation, and global demand. When inflation rises or falls, the exchange rate tends to adjust accordingly.
Like other central banks, the RBA uses interest rate policies to manage inflation. Since the AUD floats freely, the exchange rate adjusts naturally in response to these shifts. For instance, when inflation is high and the RBA raises rates, the AUD may appreciate as higher interest rates attract foreign investment. Conversely, when rates are cut, the AUD tends to depreciate.
Exchange Rate Pass-Through (ERPT) Explained
ERPT is the degree to which changes in an exchange rate affect the prices of goods, both for imports and exports. When the value of a currency fluctuates, it can lead to either an increase or decrease in the cost of foreign goods for domestic consumers or businesses. The extent of this pass-through depends on market competition, supply chain costs, and the pricing strategies of the companies involved.
There are two main types of ERPT: partial and full. With partial pass-through, changes in the exchange rate only somewhat impact consumer prices. This happens when businesses absorb some of the exchange rate shifts to remain competitive. By contrast, full pass-through occurs when exchange rate changes are fully reflected in consumer prices, often making goods more expensive or cheaper depending on currency movements.
The level of ERPT often determines how directly exchange rate changes affect inflation. In economies with a high ERPT, local currency depreciation can lead to more rapid increases in consumer prices as businesses quickly pass on the higher costs of imports to consumers. This can result in a faster rise in inflation, particularly in sectors heavily reliant on foreign goods, such as energy and consumer electronics.
Fast Fact
Exploring Research on ERPT and Inflation Dynamics
Studies have generally indicated that emerging market economies have had a notable decrease in exchange rate pass-through since the 2007–2008 global financial crisis. This decline is closely linked to lower inflation rates in these countries. In contrast, advanced economies have maintained relatively low and stable exchange rate pass-through over time.
These findings suggest a virtuous cycle between lower inflation and reduced exchange rate pass-through. As countries, particularly in emerging markets, have succeeded in bringing down inflation rates, they’ve also become less vulnerable to inflation spikes caused by currency fluctuations.
Fast Fact
This lower vulnerability of emerging markets to inflation spikes elsewhere has important policy implications: Central banks in these economies may now have more flexibility to allow their currencies to float without fear of sparking runaway inflation. However, it also means that using exchange rate adjustments to influence inflation has become less effective.
For global trade and investment, these changes present a mixed picture. On one hand, more stable inflation rates in emerging markets could lead to increased economic stability and potentially attract more foreign investment. Meanwhile, the reduced sensitivity of domestic prices to exchange rate movements might make it harder for these economies to gain competitive advantages by depreciating their currencies.
Studies have also shown that Americans, as expected, are far more insulated from such pass-through effects than others:
- Currency denomination effects: When a large fraction of a country’s trade is denominated in foreign currencies, its inflation rate is far more affected by exchange rate fluctuations. However, this is not the situation in the U.S.
- U.S. dollar dominance: The U.S. invoices over 90% of its imports in U.S. dollars. This gives the U.S. a significant advantage in stabilizing inflationary threats from imports.
- Partial pass-through for the U.S.: When the dollar depreciates by 10%, import prices measured in dollars rise by between 3% and 4% for consumers. This incomplete pass-through helps insulate the U.S. economy from exchange rate shocks.
- U.S. monetary policy dominates: The above also means that when other central banks shift their interest rates to influence monetary policy, the U.S. inflation rate is relatively immune.
- Asymmetric effects: When the U.S. tightens monetary policy, it has far stronger effects on inflation in other countries than vice versa.
Other Influences on Inflation and Currency Rates
If a country is perceived as politically or economically unstable, or if there is any significant possibility of a sudden devaluation or other change in the value of the country’s currency, investors tend to shy away from the currency and are reluctant to hold it for significant periods or in large amounts.
A recent example of this can be seen in Turkey, where political instability and unorthodox economic policies led to high inflation and a significant devaluation of the Turkish lira against major currencies in 2021 and 2022. Let’s look more closely at these factors:
The Role of Political Stability
Political stability is crucial in the relationship between inflation and exchange rates. Stable political environments tend to attract foreign investment, strengthening the local currency and potentially reducing inflationary pressures. Conversely, political instability can lead to currency depreciation and higher inflation as investors seek safer havens. For example, during political turmoil, a country often has rapid currency depreciation, which can quickly translate into higher domestic prices for imported goods.
Depreciation vs. Devaluation
Both terms mean a currency’s value falls, but depreciation is a gradual drop in a floating exchange rate system, caused by market forces, interest rates, or economic performance. Devaluation is a deliberate downward change in the value of a currency by a country’s government or central bank.
Influence of Economic Growth
The pace of economic growth significantly influences both inflation and exchange rates. Strong, sustainable development can lead to currency appreciation since it attracts investment and increases demand for the local currency. However, if growth is too rapid, it may lead to inflationary pressures. Conversely, slow growth or a recession can weaken a currency, potentially leading to deflation.
How Trade Balances Affect Inflation and Currencies
A country’s trade balance, which is the difference between exports and imports, affects its exchange rate and can also influence inflation. A trade surplus (more exports than imports) tends to strengthen the local currency, which can help keep inflation in check by making imports cheaper. Meanwhile, a persistent trade deficit can lead to currency depreciation, potentially increasing inflation through higher import prices.
However, the impact of trade balances on inflation also depends on the country’s reliance on imports and the proportion of trade conducted in its own currency vs. foreign currencies. In the end, as was the case in the early 2020s, the fact that exchange rates are relative could mean that only small changes in exchange rates might tell you little about inflation. That is because when all currencies rise, their rates will remain stable compared with one another. However, this will be little comfort to consumers buying their staples at local stores.
Do Interest Rates Affect a Nation’s Exchange Rate with Other Currencies?
In theory, yes. Interest rate differences between countries will tend to affect the exchange rates of their currencies relative to one another. This is because of what is known as purchasing power parity and interest rate parity. Parity means that the prices of goods should be the same everywhere (the law of one price) once interest rates and currency exchange rates are factored in. If interest rates rise in Country A and decline in Country B, an arbitrage opportunity might arise, allowing people to lend in Country A money and borrow in Country B money. Here, the currency of Country A should appreciate vs. Country B.
Does Relative Inflation Impact Interest Rates and Exchange Rates?
Yes. Since inflation can be thought of as a decline in the value of money, when inflation increases, the money in that economy will tend to depreciate relative to other currencies. Meanwhile, the central bank in the country experiencing inflation may raise interest rates to mitigate the effect of rising prices, which could also counteract and strengthen the currency.
Do High or Low Inflation Rates Affect Currency Exchange Rates?
Typically, high inflation has been more of a concern in international currency markets than low inflation, weakening the currency and its exchange rate.
Does Inflation Depreciate Currency?
In general, inflation tends to devalue a currency since inflation can be equated with a decrease in a currency’s buying power. As a result, countries experiencing high inflation tend to also see their currencies weaken relative to other currencies.
The Bottom Line
The value of a currency and its exchange rate depend on the demand for that currency. Many factors affect the demand for a currency, including the political stability of the nation, the balance of trade, inflation, and interest rates.
Generally, high inflation weakens a currency and weakens its exchange rate. When inflation is low, the opposite is true. However, the interplay of these factors is complex and depends on global economic conditions and investor sentiment. An important point is the exchange rate pass-through (ERPT), which determines how much consumer prices will go up or down when the relative values of currencies shift.
It’s important to understand how external factors like global market conditions and investor sentiment contribute to fluctuations in exchange rates. The specific challenges and policy implications vary for different countries and advanced and emerging market economies.
