Relationship Between Inflation and Dollar Strength

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Relationship Between Inflation and Depreciation: It’s Complicated

It’s understandable to think inflation (price increases within a country – indicating the dollar has weakened in purchasing power for domestic goods purchases) would lead to depreciation – weakening of the dollar against other currencies.

The logic of this common misunderstanding is not too complex; if the dollar has weakened for a foreign import, say a $20,000 car, why shouldn’t we expect the foreign company to charge more dollars for the same good, thus indicating depreciation has occurred for the American currency?

The reality is quite different and in many ways the opposite of this simplified story. Let’s say both the imported and domestic cars start at $20,000. Then there is inflation in the U.S. and the price of domestic cars, once US automakers include inflation, increases to $23,000. The imported car is still $20,000. This tends to cause U.S. buyers to switch to the 20,000 dollar import over the 23,000 equivalent domestic car, increasing the foreign firms’ market share in the U.S. It can be worth it for the foreign central bank to buy foreign reserves to maintain this favorable exchange rate.

Citing research by economists Richard Clarita of Columbia University and Daniel Waldman of Barclays Capital, Nobel Laureate (Nobel Prize Winner in Economics) and international finance expert Princeton’s Paul Krugman reports that the Clarida-Waldman study confirms that inflation leads to appreciation, and the effect is stronger for core inflation (excluding food and energy) than for headline inflation (overall CPI). [1]

Much of the reason for this and other changes in a currency’s value (appreciation or depreciation) is due to interest rates. When global investors expect inflation, they expect the Central Bank of that country will raise real interest rates (interest rates adjusted for inflation) enough to decrease the excess inflation. Higher real interest rates make global...
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