Inflation And Currency

Previously we have learned that the higher a country's inflation, the lower the value of its currency. But why is that so? What is the relation between inflation and currency? Let's discuss: 

In the long run, the most important factor influencing exchange rates is inflation. The relation between exchange rate and inflation, while other factors remain constant is known as the Purchasing power parity (PPP). Inflation leads to a loss of purchasing power. Thus, as per PPP, if inflation in India (say 10%) is higher than that of the US (say 4%), USD should appreciate against INR in the long run to the extent of the inflation differential. The rationale behind PPP is the law of one price which must hold good to prevent commodity arbitrage.

For example, we'll take 2 fictional countries A & B. Suppose that on January 1st, 2020, the price for every good in each country is identical. Thus, a pen that costs $20 in country A costs 20rupees in country B. If PPP holds, then 1 Dollar will be worth 1 rupee, otherwise, we can make a risk-free profit by buying pens in one market and selling in the other. So here PPP requires a 1 for 1 exchange rate.

Now suppose country A has an inflation rate of 50% and country B has 0% inflation. If inflation in country A impacts every good equally, the price of a pen in country A will be $30 on January 1st, 2021. Since there is 0 inflation in B, the price of pens will be ₹20 on January 1st, 2021. If PPP holds, we will not be able to make money from buying a pen from B at ₹20 and selling them to A at $30. 

If $30 = ₹20, then ₹1 =$1.5. 

Thus, the Rupee-to-Dollar exchange rate is 1.5, meaning that it costs 1.5 dollars to purchase 1 rupee on the foreign exchange market.

But for PPP to hold good:

• There should be no barriers to trade or arbitrage.
• There should be no transaction costs.
• The good has to be homogeneous.

However, these conditions generally do not meet. So, the actual exchange rates in real life differ from PPP. These differences are known as real appreciation/depreciation of a currency. Since PPP has its effect, in the long run, an economy that has a higher inflation rate than that of the other, the currency of that economy should trade at a discount in the forward market against that of another currency.