Effect of Inflation on Currency Pairs

Inflation is a very good indicator of current account balance in a country. The rising and falling prices (inflation) within a country can provide information about medium term direction in foreign exchange and the current account balance can be used to determine the long term movements.

Higher and Lower Inflation

It is general economic theory that high inflation in a country will result in its poor economy whereas, low inflation or deflation can result in economic progress. It can also be said as the other way around. The idea behind this theory is that when inflation is high in a country, the costs of consumer goods is very high. High costs attract less foreign customers and the country’s trade balance is disturbed. Lower demand of the currency will ultimately lead to a fall in currency value.

Purchasing Power Parity (PPP)

Purchasing Power Parity model or PPP is another method of explaining the effect of inflation on currency pairs. According to this model, one unit of currency of a country should have the same power of purchasing some goods from another country (excluding the transportation costs and the taxes). If there is inflation and the balance is disturbed then the PPP model distorts for the two countries. The currency exchange rate between the countries can be adjusted to bring the equilibrium.

Let us take an example to explain this. If a Subway meal costs $5 in the United States but the same meal costs around $7 in Australia then the Purchasing Power Parity model is clearly out of sync. Even though the products are same and their production cost is also equal, then how come it costs more in one country but less in other?  This is because of inflation. Inflation in Australia caused the prices in the country to rise so a Subway meal costs a lot more in Australia as compared to in America. It is an indication that high inflation in Australia caused its currency value to decrease against US Dollars.

Medium Term Outlook

Inflation does not have a significant effect on short term trades because inflation acts in a diffused pattern and its disturbance lasts for a longer time period.  But for long term benefits, it is essential to consider the effects of inflation. You can make use of inflationary data such as CPI. CPI causes markets to move quickly when released.

Generally, inflation affects the currency exchange rates in a medium term direction. Countries with high inflation will observe depreciation in their currencies over the medium term, whereas countries with low inflation are likely to observe appreciation in their currencies over the medium term. Countries with high inflation can also benefit from carry trade transactions.

Conclusion

Currency exchange rate is affected by inflation which directly affects your trades. A declining exchange rate decreases your purchasing power. It also influences other income factors such as interest rates. Even the most experienced traders can lose trades if they lack sufficient knowledge of inflation.

If you have a better grasp of knowledge about inflation, you will be able to deal efficiently in forex market trades. You will know what to expect when you are dealing with currency exchange rates.