Sunday, November 13, 2011

How does inflation cause a country's currency to be overvalued with regard to the exchange rate?

If two countries experience different rates of inflation
and the exchange rate does not adjust, then the exchange rate between the two will
overvalue the currency of the nation that has the higher
inflation.


Let us imagine that Country A has high inflation
and Country B does not.  As A's currency inflates, it should lose value because each
unit of the currency is no longer able to buy as much.  It is worth less.  But what if
the exchange rate does not change to account for this?  If that happens, A's currency
will be overvalued compared to B's.  The exchange rate will be the same as it had been
before even though A's currency is no longer worth as
much.


So, if exchange rates do not adjust, a country with
high inflation will see its currency overvalued compared to a country with low
inflation.

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