Inflation and exchange rates, how do price changes affect the exchange rate of the national currency?

The inflation rate is one of the key factors of the economy; its change affects a lot of other economic indicators, including the country’s currency exchange rate.

Let's try to figure out how inflation and exchange rates are related, and by how much the value of the national currency depends on changes in consumer prices.

It is generally accepted that there is a stable connection between changes in the inflation rate and the exchange rate of the national currency.

That is, as prices for goods and services rise, the value of the national currency falls in relation to other world currencies. And with the stabilization of domestic prices and the slowdown of inflation, the exchange rate will stabilize.

Inflation growth and exchange rates

There are many reasons that explain why the national currency depreciates when prices rise:

• Money loses purchasing power - fewer goods and services can be bought per unit of national currency.
• Falling investor interest – traditionally, only currencies of countries with low inflation rates are in high demand among investors.
• Increased demand for foreign currency - during periods when everything becomes more expensive, the demand for foreign currencies increases sharply.

An excellent example of the impact of inflation are the following facts:

• Zimbabwe - in 2008, the inflation rate in the country was 231 million percent; at the beginning of 2008, one US dollar was worth 30,000 Zimbabwean dollars; at the end of 2008, 1 US dollar was already worth 100 trillion Zimbabwean dollars.

• Ukraine – in 2022, the official inflation rate in Ukraine rose to 26.6%, during the same period the exchange rate of the Ukrainian hryvnia fell against the US dollar by 33%.

It should be noted that this pattern is not always observed, since foreign currency may also have its own level of inflation. Take for example the US dollar and the Swiss franc.

In 2022, according to https://www.forbes.ua/ , inflation in Switzerland was 2.8%, but the exchange rate of the franc against the dollar remained virtually unchanged. The secret lies in the fact that the increase in consumer prices in the United States in 2022 was even greater, as much as 8%.

Deflation and the national currency exchange rate

If high inflation reduces the exchange rate, then it is natural to believe that deflation will cause a strengthening of the national currency.   

Most often, this happens; after the news appears about a decrease in inflation rates, the national currency exchange rate stabilizes.

An example of the impact of deflation on the exchange rate is the same Swiss franc ; in 2009, the general price level in the country decreased by 0.7%, that is, deflation occurred. This caused the Swiss franc to strengthen against the US dollar by 10%.

As a result, we can conclude that two indicators such as inflation and exchange rates are quite closely related, and there is an inverse correlation .

That is, an increase in consumer prices leads to a depreciation of the national currency and, conversely, a decrease in inflation causes a strengthening of the national currency.

This pattern can also be used in a news trading strategy the economic calendar is suitable as a source of signals .