It turns out that other things being constant, domestic inflation will cause the value of a nation’s currency to depreciate in the foreign exchange market! Holy hell, it will. Deflation has the opposite effect: it results in appreciation of the currency. Don’t ask me why exactly, but what follows here is a reasonably sound explanation of the phenomenon. With macroeconomics exams approaching, it is only timely my mind has wandered into this murky area!

For the inspired, only when the exchange rates are free to fluctuate is when we can expect currency to appreciate or depreciate. If you are thinking about countries that ‘peg’ exchange rate to a fixed value, then there are other policy steps that need to be taken to avoid a financial crisis resulting from falling foreign currency reserves available to the country. Enough said, lets move back to the basics.

For the initiated, suppose prices in the US rise by 50% while our trading partners are experiencing stable prices. The domestic inflation will cause US consumers to increase their demand for imported goods (think cheap!) and consequently, foreign currency will flow into the US. Tit-for-tat, foreign consumers will stop buying US goods, now that these are overpriced! This will cause a reduction in the supply of foreign currency to the exchange market. If consumers don’t buy US goods with their currency, then it does not enter the ‘exchange’ marketplace. C’mon! With falling supply of foreign currency, and rising demand for it, what do you think is going to happen?

There is going to be a need for the US to ‘buy’ the foreign currency to prevent excessive depletion of its international reserves (as economists like to call them), thus flooding the marketplace with US currency. As more and more US currency is needed to buy a shrinking supply of foreign currency, the US dollar will start to depreciate ‘in exchange for’ the foreign currency. It will take more and more of the $ to buy the Euro, etc.

Hopefully this brief post made sense for those trying to make sense of how exchange rates are impacted by domestic inflationary fluctuations.