How does exchange rate developments influences inflation?

Question

factors influences inflation

Answer 1

Excellent question. It depends partially upon the amount of trade that takes place.

If a nation is a net importer, then some inflation comes from the inevitable depreciation of the exchange rate. As this importer "buys" more foreign currency to buy more foreign goods, its domestic currency exchanges for less on the international market, and so it takes more domestic currency to "buy" the same amount of foreign currency, which means that prices effectively rise (even if the price of the imported good doesn't change in the country that produces it).

This phenomenon is exacerbated by an expansionary monetary policy, and in the severe case by seigniorage (the printing of money rapidly in order to devalue sovereign debts).

Likewise, if a nation is a net exporter, it may itself experience inflation if the demand for its exported goods rises sufficiently and if those exported goods are used domestically. We saw this over the past year in Iran, one of the world's largest oil producers. As the price of crude rose, the value of Iran's exports rose, but since Iranian's used refined crude in the form of gasoline, their costs also rose. But that's inflation due to market pressures, not to exchange rates.

I should also note that inflation may be "exported" via the exchange rate when national currencies are tied to one another. Consider that in the late 1990s, Argentina "pegged" its peso to the dollar. This means that the peso was backed up by US currency, such that an Argentine could exchange one peso for one dollar at the Argentine central bank (at least in theory). If the dollar were to experience inflation via an expansionary monetary policy, Argentina would feel the exact same effects, and in order to ensure that the peso traded internationally on a one-to-one basis with a depreciating dollar, Argentina would have to devalue its own currency as well, which would lead to inflation via imported goods.