Currency Appreciation and impact on Inflation - Chain of Reasoning

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!

Question

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

1. The impact on inflation depends on the extent to which a country is highly dependent on imported raw materials & energy supplies
2. 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?
3. The exchange rate is not the only factor influencing the rate of inflation. External factors such as world commodity prices are important.
4. 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.