Inflation and exchange rates, both determine, if a nation is likely to be economically stable or not.For several years, exchange rates have caused much debate and different opinions were expressed with regard to exchange rates.
Inflation and its effects on exchange rates can also be ascertained from the following facts. In earlier days, it was suggested by a majority of the economists to peg a particular currency or to dollarize currency of a country. Nations (emerging countries) were used to having a fixed type of exchange rate. Every effort was made to keep the exchange rate fixed because a floating exchange rate was feared to cause inconvenience in trading. With the advent of the concept of “inflation targeting” and exchange rates, which are flexible, the scenario has changed. More and more countries are moving away from the fixed exchange rates. This transition is taking place, when most of the nations are adopting inflation targeting as a means of conducting various monetary policies. In many countries, the nominal exchange rate was used as a means to bring down inflation.
Inflation and exchange rates- value of currency:The exchange rates are essential macroeconomic variables. It affects inflation, trade (imports and exports) and various other economic activities of a nation. If the rate of inflation remains low for a considerable period of time, the value of currency rises. This occurs due to increase in the purchasing power. Switzerland, Japan and Germany were three countries, the inflation rates of, which were low during the late twentieth century. Other countries to follow suit were Canada and United States of America. The countries, having higher rates of inflation observed depreciation in their currency. On the other hand, countries with low rates of inflation did not observe this trend at least for the time being. In the event when a nation is aware of a possible rise in inflation, it can take measures accordingly. Exchange rates may also be affected by the type of inflation prevailing in the economy. Inflation may be:
- Cost push inflation
- Demand pull inflation
We discover a close association between inflation and exchange rates, which affect almost all sectors of the economy.