Inflation is one of the biggest economic factors that influence the currency exchange rate, but there are several other factors that influence it as well. Inflation is thought to affect the currency exchange rate by depreciating the value of a country’s currency, while the value of currencies of countries that are in a period of deflation often increases. Deflation is not always a sign of economic strength, and inflation is not always a sign of a weakening economy, so it is not the only factor that affects the currency exchange rate. The currency exchange rate is also affected by purchasing power parity (PPP) which is the difference in prices from one country to another.
How PPP affects the currency exchange rate
PPP is the difference in prices for the same commodity, and the theory of PPP suggests that prices for one good will relatively be the same from one country to another. For instance, there is the Big Mac Index, which is a bit of a humorous anecdote, and is based on the PPP theory that the price for one Big Mac in one country should be around the same in a different country. A greater quantity of currency may be required to purchase a Big Mac for a country that has a high inflation rate, and likewise a country with a stronger currency and a lower inflation rate will normally require less of its currency to purchase one. This generally holds true for other goods, but other factors affect the price of a good such as the country of its production, transportation costs, and other logistics.
Inflation increases the amount of currency in circulation and negatively impacts the currency exchange rate
Another effect that inflation has on the economy is that it increases the amount of currency in circulation. Although some would argue that this in theory is a good thing, since more currency is available in the economy, the net result is often that the value of the currency becomes diminished because a higher quantity of currency is often created without the work necessary to create value. This occurs when the central bank of a country “prints” currency to put more of it into circulation; the result is that the inflation rate often increases while the value of the currency diminishes because the prices for goods and services almost always go up after inflation increases.
Price inflation and the currency exchange rate
Price inflation is tied to monetary inflation, and when inflation rates rise, prices will also often rise to compensate. Prices for goods and services essentially “absorb” the extra currency in circulation like a sponge. As a result, a country’s currency will often decline in value, both for its value when buying goods and services in the country itself, and for its value in buying other country’s currencies (the currency exchange rate). Inflation may also be a sign of economic distress, for example the stock market and mortgage security crisis of 2008 was followed by QE (quantitative easing) and the Federal Reserve bailout package, both of which involved printing more currency into circulation to prevent a massive economic crisis.