Inflation, Interest Rate and Exchange Rate

Inflation is an autonomous occurrence that is impacted by money supply in an economy. Central Banks use the interest rate [monetary policy, discretionary] to control money supply and, consequently, the inflation rate.

i) Interest rate vs Inflation
When interest rates are set high by the Central Bank, it becomes more expensive to borrow money and savings become attractive. A high interest rate influences spending patterns and shifts consumers and businesses from borrowing to saving mode. This influences money supply. [i.e. People are more willing to put money in banks to earn higher return than spending. This impacts on the circulation of money]

When people are less willing to spend, money supply in circulation is reduced, consequently there will be less spending on goods and services, and this reduces the demand and if the supply is not elastic, the price will drop and the inflation is checked.

If the Central government raises the income tax [fiscal policy], the disposal income is reduced. This impacts on the circulation of money. Thus, for similar reasoning, the inflation is checked.

Of course, by controlling the government budgets [deficit or surplus, fiscal policy], the money supply can be control to stimulate the economy or check the inflation.

A rise in interest rates boosts the return on savings in building societies and banks. Low interest rates encourage investments in shares. Thus, the rate of interest can impact the holding of particular assets.

A rise in the interest rate in a particular country fuels the inflow of funds. Investors with funds in other countries now see investment in this country as a more profitable option than before.
When interest rates are low, banks are able to lend more, resulting in an increased supply of money. Alteration in the rate of interest can be used to control inflation by controlling the supply of money.

ii) Exchange rate vs Inflation
The exchange rate affects the rate of inflation in a number of direct and indirect ways:
• Changes in the prices of imported goods and services – this has a direct effect on the consumer price index. For example, an appreciation of the exchange rate usually reduces the price of imported consumer goods and durables, raw materials and capital goods [against the weaker currency of the exporting country]. The effect of a changing currency on the prices of imported products will vary by type of import and also the price elasticity of demand which is influenced by the extent of competition within individual markets. The inflation is under check because of cheaper imports.

• Changes in the growth of exports – movements in the exchange rate affect the competitiveness of a country’s export industries in global markets. A higher exchange rate makes it harder to sell overseas because of a rise in relative export prices. If exports slowdown (price elasticity of demand is important in determining the scale of any change in demand), then exporters may choose to cut their prices, reduce output and cut-back employment levels. A fall in export demand will reduce real national income relative to potential output – and thus might lead to a negative output gap. This puts downward pressure on inflation. The inflation is again under check. But, another set of problem i.e unemployment of people will surface.

• The exchange rate and wage bargaining – some economists believe that the exchange rate influences the power of employees to bargain for increases in real wages. When the exchange rate is high, there is pressure on businesses to control their costs of production in order to remain competitive – this may lead to downward pressure on wage inflation.

Note: The final effects on inflation depend also on the response of economic policies to exchange rate movements. For example if a rising value of a currency causes inflation to drop below target, the Central Bank might opt to reduce short term interest rates in order to stabilise demand and prevent the risk of price deflation.