One of my students asked a pertinent question as part of revision a couple of days ago. Will deflation cause an appreciation of the local currency because real interest rates will be high and "hot money flows", or a depreciation because of animal spirits and the resulting capital flight? Or will there be a depreciation because the common response to deflation is to lower nominal interest rates, reducing real interest rates, while there are still low animal spirits?

My answer was that much depends on the scope that a central bank has to cut nominal interest rates if a country experiences a period of negative consumer price inflation. For example, the policy rate in the UK has remained at 0.5% since March 2009 and the European Central Bank has cut nominal rates to the floor and introduced a huge (albeit delayed) programme of quantitative easing.

If the price deflation is being caused mainly by a chronic lack of aggregate demand - this - combined with falling profitability of businesses pressed to cut their prices - will usually bring about a depreciation of the exchange rate as foreign investors look elsewhere for higher returns.

But deflation might also be caused by falling import prices which for a net importing country could cause their exchange rate to rise

I suppose the answer depends on the circumstances facing each country!

Incidentally - another student also pointed me to this interesting and topical article from the BBC news site on the growing use of negative interest rates in a number of countries.


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