How Prolonged Inflation Can Affect Foreign Exchange Rate?

How Prolonged Inflation Can Affect Foreign Exchange Rate?

30 Jul 2019 04:41 PM

Inflation is not just one factor which causes volatility in foreign exchange rate, yet it is considered to be one of the major influencing factors. This is mainly because, inflation hits hard on the value of a currency through its negative effect.
A particular currency of any country becomes weaker compared to the other currencies as its purchasing demand lowers down.

Just as high rate of inflation negatively impacts the currency exchange rate, similarly, prolonged low rate of inflation also does not guarantee a favourable exchange rate. When the inflation and GDP growth of any country is low, the Central bank tends to cut the rates of the currency. This is mainly done with intent to boost the spending and corporate investments.

Inflation- Meaning

Common explanation of the term inflation refers to a persistent rise in prices over time. It indicates a free market principle of supply and demand. When the demand for a product is greater than the supply (in a free and open market) in such situations, the prices of that product tends to increase. Inversely, when supply is greater than demand in such a situation we find prices go down. Simply put, with too much of product supply in the market each unit loses value.

Technically speaking, inflation is not so much about an increase in prices, but the decrease in the buying power of the dollar. Investors who deal with international goods or services are hugely affected by forex rates. The higher inflation rates can cause exchange rate depreciation, potentially leading to higher import prices.

It even leads to higher inflation and more depreciation in the foreign exchange rate. This is relatively a rare situation and should not be often observed, provided that periods with high inflation are usually met with an increase in domestic interest rates.

Inflation, Interest Rates & FX

The direction of interest rates is to a large extent influenced by the rate of inflation. Inversely, interest rates influence the direction of inflation and if inflation is at the higher side, the interest rate is ideally raised by the nation’s Federal Reserve to slow economic growth. Again, when inflation is low, economic growth is generally low and such decrease in rates is enacted to lower the cost of borrowings and to spur economic growth.

Similarly, when interest rates are increased to tame inflation, foreign capital gets attracted to higher rates as compared with other countries. Investments are at bulk when the rate of interest is at higher levels. This helps to boost the foreign exchange rate. But when inflation is high, the rise of the currency automatically tends to become limited. As currency rates go lower, currencies suffer in such an environment.

What are the factors that lead to Inflation?

Government & Public Debt- If the government spends more than they take in, they must either borrow or print money out of thin air to cover their operating expenses. When a country borrows its debt increases to raise the money which is required for debt repayments, the government may use one of the several methods including rising taxes or printing more money.

An increase in taxes to businesses will result in higher prices of goods and services for customers because businesses must pass on the increased burden of the corporate tax. The government borrows money it “monetizes” it which is one way the government “prints money.” It is the increase in the money supply which is the primary cause of price inflation.

Monetary & Fiscal Policy- By lowering the interest rates and instituting quantitative easing (QE), the Central bank of the country can create an expansionary monetary environment to increase the money supply in the economy and create a liquidity surplus. When there is surplus liquidity, money flows freely. When money flows freely most participants in the economy have greater purchasing power and the aggregate demand increases and such creates upward pressure on the prices. Individuals may also use the extra discretionary income to buy more nonessential items while businesses may make more investments, hire new employees or improve employee compensation.

The monetary policy in a planned economy such as India cannot be framed independently, without taking into consideration the fiscal policy. Achieving growth with price stability is the primary objectives of monetary policies.

Increasing Consumer Confidence & Demand- When the economy is doing better, people have more money to spend, unemployment levels are lower and wages tend to increase. The flow of increased liquidity in the economy implies more demand for consumer goods. Going by what the law of supply and demand reflects- an increased demand pushes prices of goods and services up. In economic terminology, this is referred to as the demand-pull effect and it results in more inflation.

Increase in Input Costs- The manufacturers also initially see the increase in input costs (raw materials, labor, and utilities) but eventually, this cost is passed on to the consumers by increasing the price of finished goods.

Currency Devaluation- The currency devaluation is the loss of value of a currency. As the quantity of currency increased, its value becomes diluted so each dollar buys fewer goods in the local market. However, if other currencies retain their value this creates an imbalance between the two countries and exports become less expensive to buyers using the stronger currency, so they buy more. The lower value of each dollar combined with increased demand for goods from abroad tend to increase the prices locally and this result to price inflation. There is a reduction of imports caused by currency devaluation as Importers face huge issues to buy foreign goods denominated in the stronger currency with that of a weaker currency.

With currency volatility increasing due to reformed monetary policies, government decisions on trade or imposition of import duties, importers as well as exporters need to stay more vigilant about the market moves. For specialized support related to corporate forex management, do get in touch with Myforexeye. We cover a wide range of forex services to help businesses manage forex transactions in gainful ways. 

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