Exchange rates and inflation

Exchange rates themselves can effect inflation a lot. A common way leading to increased inflation are when prices on imported goods go up.

The reason is usually a severe devaluation or weakening of the exchange rate, as in the case of Britain in the beginning October 2008 to mid-March 2009, where Sterling lost over 23 % against the US Dollar.

Exchange rate effect on inflation depends on imports of a country. For UK, it’s playing a major role as the British economy is far too small to be self-sufficient and thus counts as an open economy where imports account for over 25 % of the total GDP.

If we then take the U.S. as an example, the imported inflation plays a very small role in the country’s overall inflation. The reason for this is that the U.S. economy is huge in comparison and can be self-sufficient to a very large degree. Imports in the U.S. accounts for only 10% of the total GDP.

This means that changes in exchange rates affect inflation and growth in a country with a open economy much more (like UK and Sweden) than in countries with greater self-sufficiency (such as U.S.).

But perhaps the most unexpected blow may come from domestic sources. Although products manufactured in their own country becomes more expensive, as companies find it more profitable to sell the products for export. They then get the better paid, measured in domestic currency. It drives prices up and thus eliminates inflation increases even more.

Such situations usually fall into a vicious spiral that is difficult to escape. It often takes a few months before the increased prices can be seen, since most firms (both exporting and importing companies), tend to hedge their cash flows to and from abroad.

<< Previous (Inflation) Next >> Valuation of currencies

Article written by Athanasios Karagiannis and Markus Jalmerot.
Anything we forgot about exchange rates and inflation? Send us an email to info at online forex dot net.