The rate of inflation in a country can have a major impact on the value of the country's currency and the rates of foreign exchange it has with the currencies of other nations. While exchange rates can be subject to myriad factors in intraday trading – from market sentiment, breaking economic news, and cross-border trade and investment flows – inflation and interest rate policy are often important indicators for exchange rate trends and they can help traders gain an idea of what is likely to be a profitable trade for foreign exchange positions taken over longer periods.
While exchange rates can be subject to myriad factors in intraday trading – from market sentiment, breaking economic news, and cross-border trade and investment flows – inflationand interest rate policy are often important indicators for exchange rate trends – they can help traders gain an idea of what is likely to be a profitable trade for foreign exchange positions taken over longer periods.
Inflation is defined as a rise in the general level of prices – in other words, an increase in the price of everything. Thus, it is not all that much of a surprise that inflation will affect foreign exchange rates. Exchange rates are after all simply the price of one currency when expressed in another. The price of a currency is included in those prices of everything, so in a sense it is simply one more price that changes as inflation rises.
Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than another's will see an appreciation in the value of its currency. The prices of goods and services increase at a slower rate where the inflation is low. A country with a consistently lower inflation rate exhibits a rising currency value while a country with higher inflation typically sees depreciation in its currency and is usually accompanied by higher interest rates.
Inflation is generally a bad thing for an economy, as it discourages investment, especially in fixed income instruments (bonds and currencies). It hurts consumers, who see their paychecks become worth less, and their costs increase. During inflationary periods, investors do not want to buy debt instruments issued by a country, because they are denominated in the currency that is being devalued due to the inflation. Some economists view some inflation necessary to help an economy overcome a recession or a large debt burden. This is generally referred to as “inflating your way out of debt.” This has long-term negative consequences on a country as it causes currency depreciation.