Appreciation of a currency- Isn't it inflationary too?|
When a currency depreciates, it loses its buying power, thereby leading to an increase in prices of goods in the market, thus causing an increase in inflation. But when a currency appreciates, though the currency has got more buying power, the effective money supply which is still chasing the same set of goods has gone up, thus shouldn't appreciation of a currency lead to an inflationary environment too?
|5/19/2008 3:57:12 PM
Re : Appreciation of a currency- Isn't it inflationary too?|
Thanks for your question. To answer it, one has to keep in mind the reason for the appreciation of the currency.
1. Often it is tighter monetary policy that leads to an appreciation, such as if a central bank raises interest rates. Uncovered interest parity conditions would ensure that the exchange rate appreciates immediately in response. The higher interest rates make deposits more attractive than money in search of goods. Thus, the tighter monetary policy will tend to reduce aggregate demand in the economy and hence reduce inflationary pressures relative to the case when interest rates were not raised and the currency did not appreciate.
2. If appreciation is due to large capital inflows, say into a country's stock market, then appreciation can occur as foreign investors demand the country's currency. However, the appreciation by itself will reduce demand for the currency (as returns for foreign investors will decline, all else being equal as it will take more foreign currency to buy the same amount of domestic shares in this example). Of course, the capital inflows do tend to get converted to domestic currency so that would increase domestic money supply that could be inflationary. In this case, the central bank often has to intervene by selling bonds domestically to reduce money supply, in an operation called the sterilization of inflows. However, the appropriate comparison in this case is to the case when the exchange rate would not be allowed to appreciate, in which case there would be even higher inflationary pressures. So in this case also, inflationary pressures are lower when the currency is allowed to appreciate.
So in both examples above, appreciation of the currency produces lower inflation than if the currency did not appreciate, whether it be due to tighter monetray policy or due to capital inflows.
|5/20/2008 12:05:18 PM