Practice Exam Questions
Currency Appreciation and impact on Inflation - Chain of Reasoning
- AS, A-Level, IB
- AQA, Edexcel, OCR, IB, Eduqas, WJEC
Last updated 24 Nov 2022
In this short revision video we walk through an example of a chain of reasoning on the link between a currency appreciation and the rate of inflation in an economy. We add a little evaluation into the mix as well!
Analyse how an appreciation in a nation’s currency can affect their inflation rate.
Chain of Analytical Reasoning
- A currency appreciates inside a floating exchange rate system when the external value rise against other currencies.
- One way this can impact on inflation is through a reduction in import prices.
- Since most commodities are priced in US dollars, if for example, the Euro appreciates against the $, then prices of imported energy and raw materials & components into countries such as Spain will fall.
- As a result, there will be an outward shift of short run aggregate supply (SRAS). Consequently, there is downward pressure on the general price level.
- Thus, the annual rate of inflation may fall - this is known as disinflation.
- In addition, a stronger currency makes exports less price competitive in overseas markets.
- If export volumes contract, there will be a fall in AD, perhaps leading to a negative output gap and a fall in demand-pull inflationary pressures.
Supporting Analysis Diagram
Brief Evaluation Perspective
- The impact on inflation depends on the extent to which a country is highly dependent on imported raw materials & energy supplies
- The effect on inflation depends on PED for their exports – i.e. will there be a fall in X demand if overseas export prices rise?
- The exchange rate is not the only factor influencing the rate of inflation. External factors such as world commodity prices are important.
- It is possible that an appreciation in the exchange rate may make the Central Bank more willing to cut interest rates. Which in turn could increase demand-pull inflationary pressures.