Revision: The Exchange Rate and Inflation

The exchange rate affects the rate of inflation in a number of direct and indirect ways:

1.Changes in the prices of imported goods and services – this has a direct effect on the consumer price index. For example, an appreciation of the exchange rate usually reduces the sterling price of imported consumer goods and durables, raw materials and capital goods.

2.Commodity prices and the CAP: Many commodities are priced in dollars – so a change in the sterling-dollar exchange rate has a direct impact on the UK price of commodities such as oil and foodstuffs. A stronger dollar makes it more expensive for Britain to import these items.

3.Changes in the growth of UK exports: A higher exchange rate makes it harder to sell overseas because of a rise in relative UK prices. If exports slowdown (price elasticity of demand is important in determining the scale of any change in demand), then exporters may choose to cut their prices, reduce output and cut-back employment levels.

Bank of England research suggests that a10% depreciation in the exchange rate can add up to 3% to the level of consumer prices three years after the initial change in the exchange rate. But it is important to realise that the impact on inflation of a change in the exchange rate depends on the cause of the fluctuation and on what else is going on in the economy. For example – will the depreciation in the sterling exchange rate index during 2008 create some inflation problems for the UK economy in 2009?