How Does Inflation Affect Inflation

How the Exchange Rate Affects Inflation

If there is a depreciation in the exchange rate, this depreciation should cause inflation to increase.

A depreciation means the currency buys less foreign exchange, therefore, imports are more expensive and exports are cheaper. Therefore, we get:

• Imported inflation. The price of imported goods will go up because they are more expensive to buy from abroad

• Higher domestic demand. Cheaper exports increases demand for UK exports. Therefore, there is an increase in domestic aggregate demand, and we may get demand pull inflation.

• Less incentive to cut costs. Manufacturers who export see an improvement in competitiveness without making any effort. Some argue this may reduce their incentive to cut costs,

Monetary Inflation:

Monetary inflation is a form of demand-pull inflation. In this case, excess demand is created by an excessive growth of the money supply. A group of economists, appropriately called monetarists, believe that the only cause of inflation is the money supply increasing faster than output. They argue that if the money supply increases, people will spend more and this will lead to an increase in prices.

In explaining their view, monetarists examine the relationship between the money supply and the velocity of circulation on one hand and the price level and output on the other. By definition, both sides must be equal as both represent total expenditure.

For example, if the money supply is $100bn and, on average, each dollar changes hands four times, a total of $400bn will be spent. If an output of $200bn products is produced, the average price would be $2 (200bn x $2 = $400bn). If the money supply increases by 50% to $150bn and output and the velocity of circulation remain unchanged, the average price would rise to $3 ($150bn x 4/200bn).

There are many reasons why costs might rise:

1. Component costs: e.g. an increase in the prices of raw materials and components. This might be because of a rise in global commodity prices such as oil, gas copper and agricultural products used in food processing – a good recent example is the surge in the world price of wheat.

2. Rising labour costs - caused by wage increases that exceed improvements in productivity. Wage and salary costs often rise when unemployment is low (creating labour shortages) and when people expect inflation so they bid for higher pay in order to protect their real incomes.

3. Higher indirect taxes imposed by the government – for example a rise in the duty on alcohol, cigarettes and petrol/diesel or a rise in the standard rate of Value Added Tax. Depending on the price elasticity of demand and supply, suppliers may pass on the burden of the tax onto consumers.

4. A fall in the exchange rate – this can cause cost push inflation because it normally leads to an increase in the prices of imported