Discuss whether a rise in a country's exchange rate will always reduce its inflation rate.
The inflation rate is the percentage change in average general price level. It is measured through either RPI (Retail Price Index) or CPI (Consumer Price Index. The exchange rate is the price of one currency against another currency and a rise in such would cause appreciation.
Inflation is caused when a component of AD increases. Exchange rate in itself shares a weak negative relationship with the balance of payments so it is assumed that if the exchange rate was to rise then the balance of payments surplus/deficit would decrease or increase respectively. This is because the exchange rate is crucial in the determination of pecuniary factors of domestic goods to the international market.
If the exchange rate was to increase this would mean that goods from the home economy would lose their international competitiveness in terms of pecuniary factors. So the price of the domestic goods and services would look more expensive in comparison to other economy's goods and services. Therefore it is likely that exports would decrease significantly as a result of the economy losing its international competitiveness and therefore the balance of payments will either move into a bigger deficit or lose its surplus. As the balance of payments is a component of AD this would result in AD shifting left (AD1-->AD2) resulting in movement along AS as the price level would drop from P1 to P2 showing a reduction in inflation rate.
However this is assuming that Marshall Lerner Condition satisfies in other words the PED is greater than one and therefore elastic. As for some economies the goods/services the home economy exports could be extremely inelastic, for example hi-tech machinery. Therefore despite this increase in exchange rate the level of exports would remain constant and so would result in having no effect on the inflation rate as the price level would remain constant as the BOP would not change.
If the exchange rate was to increase however this would mean that imports would also be cheaper to import. This could mean to domestic producers who require raw materials that their cost of production would decrease significantly and enable them to reinvest in their capital stock, this would therefore shift AS right due to increase in productivity and prevent overheating from taking place. As AS shifts right this would mean there is movement along AD as price level would decrease from P1 to P2 and therefore shows that there would be a decrease in the inflation rate.
However with capital investment this would mean that the goods produced would also be of a higher quality as well as shifting AS right (AS1-->AS2). This would mean that the goods would become more internationally competitive in terms of non-pecuniary factors as the good will be of a much better quality. This could mean providing the goods with a edge that could exceed rival economies despite an increase in price, and thus would mean that exports would rise significantly regardless of the rise in exchange rate. As the BOP is a component of AD it would shift AD right (AD1-->AD2) showing no change in price level regardless of the change in exchange rate.
An increase in exchange rate would also mean that the goods and services would becomes less internationally competitive in terms of price. To prevent loss of revenue the firm must become more price competitive and as a result firms are more likely to become innovative in outlook, as they have an incentive to do such. This would mean investment in R&D and would result in AS shifting right as it would result in cost of production decreasing significantly through innovation. This would therefore result in price level decreasing and shows an increase in exchange rate can reduce the inflation rate.
However for R&D to take place this would mean that the firm would have a high level of funds to do such. For an infant sunrise firm this may not be able to occur and therefore AS will not shift right and instead the price level could remain constant. AD may not shift left either due to the decrease in exports as other components of AD could rise. Essentially it is dependent on ceteris paribus and as other components of AD can rise it would cause price level to remain constant and therefore inflation rate would remain constant or could even rise if injections are greater than leakages.
While the relationship between exchange and inflation rate may be a weak negative relationship, it is always dependent on what component of AD the economy is dependent on. In the case of a country who is predominately reliant on exports, such as China a decrease in exchange rate may decrease AD as it uses export led growth. This would therefore shift AD right as its their main component of growth and as a result it would reduce the inflation rate significantly. However in the case of the UK whose main component of growth is consumption which totals around 60-65% then the exchange rate would have a negligible e account on the inflation rate as it predominately is reliant on consumption rather than the BOP. Essentially therefore a reduction in the exchange rate will not always decrease the inflation rate, it is dependent on other component of AD.
Inflation is caused when a component of AD increases. Exchange rate in itself shares a weak negative relationship with the balance of payments so it is assumed that if the exchange rate was to rise then the balance of payments surplus/deficit would decrease or increase respectively. This is because the exchange rate is crucial in the determination of pecuniary factors of domestic goods to the international market.
If the exchange rate was to increase this would mean that goods from the home economy would lose their international competitiveness in terms of pecuniary factors. So the price of the domestic goods and services would look more expensive in comparison to other economy's goods and services. Therefore it is likely that exports would decrease significantly as a result of the economy losing its international competitiveness and therefore the balance of payments will either move into a bigger deficit or lose its surplus. As the balance of payments is a component of AD this would result in AD shifting left (AD1-->AD2) resulting in movement along AS as the price level would drop from P1 to P2 showing a reduction in inflation rate. However this is assuming that Marshall Lerner Condition satisfies in other words the PED is greater than one and therefore elastic. As for some economies the goods/services the home economy exports could be extremely inelastic, for example hi-tech machinery. Therefore despite this increase in exchange rate the level of exports would remain constant and so would result in having no effect on the inflation rate as the price level would remain constant as the BOP would not change.
An increase in exchange rate would also mean that the goods and services would becomes less internationally competitive in terms of price. To prevent loss of revenue the firm must become more price competitive and as a result firms are more likely to become innovative in outlook, as they have an incentive to do such. This would mean investment in R&D and would result in AS shifting right as it would result in cost of production decreasing significantly through innovation. This would therefore result in price level decreasing and shows an increase in exchange rate can reduce the inflation rate.
However for R&D to take place this would mean that the firm would have a high level of funds to do such. For an infant sunrise firm this may not be able to occur and therefore AS will not shift right and instead the price level could remain constant. AD may not shift left either due to the decrease in exports as other components of AD could rise. Essentially it is dependent on ceteris paribus and as other components of AD can rise it would cause price level to remain constant and therefore inflation rate would remain constant or could even rise if injections are greater than leakages.
While the relationship between exchange and inflation rate may be a weak negative relationship, it is always dependent on what component of AD the economy is dependent on. In the case of a country who is predominately reliant on exports, such as China a decrease in exchange rate may decrease AD as it uses export led growth. This would therefore shift AD right as its their main component of growth and as a result it would reduce the inflation rate significantly. However in the case of the UK whose main component of growth is consumption which totals around 60-65% then the exchange rate would have a negligible e account on the inflation rate as it predominately is reliant on consumption rather than the BOP. Essentially therefore a reduction in the exchange rate will not always decrease the inflation rate, it is dependent on other component of AD.
Comments
Post a Comment