The link between exchange rate and inflation

Introduction

Exchange Rate

Exchange Rate is a rate at which one currency can be exchanged into another currency. In other words it is value one currency in terms of other.

For example:

US $ 1 = Rs.45.18

This rate is the conversion rate of every US $ 1 to Rs. 45.18

The exchange rate is used when simply converting one currency to another (such as for the purposes of travel to another country), or for engaging in speculation or trading in the foreign exchange market. It is also called rate of exchange or foreign exchange rate or currency exchange rate.

Factors Determining Exchange Rates

(a) Fundamental Reasons:

- Balance of Payment – surplus leads to stronger currency.

- Economic Growth Rates –High/Low growth rate.

- Fiscal / Monetary Policy- deficit financing leads to depreciation of currency.

- Interest Rates –currency with higher interest will appreciate in the short term.

- Political Issues –Political stability leads to stable rates

(b) Technical Reasons

- Government Control can lead to unrealistic value.

- Free flow of Capital from lower interest rate to higher interest rates.

(c) Speculation – higher the speculation higher the volatility in rates

Inflation

The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling.

The overall general upward price movement of goods and services in an economy (often caused by a increase in the supply of money), is usually measured by the Consumer Price Index and the Producer Price Index. Over time, as the cost of goods and services increase, the value of a rupee is going to fall because a person won't be able to purchase as much with that rupee as he/she previously could.

Measures Of Inflation

The three most widely used measures of inflation in the India are:

• The Consumer Price Index (CPI) which measures inflation at the retail level,

• The Producers Price Index (PPI) which measures inflation at the wholesale level and therefore may also predict future retail prices. However, wholesalers may not always pass the full increase along to retailers during a sluggish economy or when they think the increase is temporary,

• And the Gross Domestic Product Deflator, the broadest indicator, which measures prices for all finished goods produced domestically, including those for governmental purchase, capital investments, and net exports.

Factors of Inflation

Inflation is defined as the rate (%) at which the general price level of goods and services is rising, causing purchasing power to fall. This is different from a rise and fall in the price of a particular good or service. Individual prices rise and fall all the time in a market economy, reflecting consumer choices or preferences and changing costs. So if the cost of one item, say a particular model car, increases because demand for it is high, this is not considered inflation. Inflation occurs when most prices are rising by some degree across the whole economy. This is caused by four possible factors, each of which is related to basic economic principles of changes in supply and demand:

• Increase in the money supply.

• Decrease in the demand for money.

• Decrease in the aggregate supply of goods and services.

• Increase in the aggregate demand for goods and services.

Types of Inflation

1. Cost-Push Inflation

Aggregate supply is the total volume of goods and services produced by an economy at a given price level. When there is a decrease in the aggregate supply of goods and services stemming from an increase in the cost of production, we have cost-push inflation. Cost-push inflation basically means that prices have been “pushed up” by increases in costs of any of the four factors of production (labor, capital, land or entrepreneurship) when companies are already running at full production capacity. With higher production costs and productivity maximized, companies cannot maintain profit margins by producing the same amounts of goods and services. As a result, the increased costs are passed on to consumers, causing a rise in the general price level (inflation).

2. Demand-Pull Inflation

Demand-pull inflation occurs when there is an increase in aggregate demand, categorized by the four sections of the macroeconomy: households, businesses, governments and foreign buyers. When these four sectors concurrently want to purchase more output than the economy can produce, they compete to purchase limited amounts of goods and services. Buyers in essence “bid prices up”, again, causing inflation. This excessive demand, also referred to as “too much money chasing too few goods”, usually occurs in an expanding economy.

The link between exchange rate and inflation rate

Inflation and its effects on exchange rates can be ascertained from the following facts. In the early years of the foreign exchange market, it was proposed by a large portion of leading economists to peg a particular currency or to “dollarize” the particular currency of a particular nation. Emerging nations were typically used to having a fixed type of exchange rate. They went to great lengths to ensure that the exchange rate remained fixed or pegged because a floating exchange rate was generally believed to cause problems when trading. With the development of the strategy of “inflation targeting” and exchange rates, which are more flexible, this belief has changed somewhat. More and more countries are moving away from the fixed exchange rates. This transition is in progress, when the majority of countries are using inflation targeting as a way of conducting various monetary policies. In several nations, the nominal exchange rate was frequently used as a way of bringing down the level of inflation.

The exchange rates are essential macroeconomic variables with the biggest economic movements. The exchange rate affects inflation, trade (both in the form of imports and exports) and a range of additional economic activities of particular country. If the rate of inflation stays at a low level for an extended period of time, the value of the country’s currency rises as a direct result of the increase in the purchasing power of that currency. The countries having higher rates of inflation observed depreciation in their currency. Whereas in contrast, the countries with lower rates of inflation did not endure this trend. 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.

Conclusion

The exchange rate of the currency in which a portfolio holds the bulk of its investments determines that portfolio's real return. A declining exchange rate obviously decreases the purchasing power of income and capital gains derived from any returns. Moreover, the exchange rate influences other income factors such as interest rates, inflation and even capital gains from domestic securities.