Relative Inflation

Relative Inflation

If a country experiences a relatively high inflation rate compared with other economies, then the buying power of its currency is eroding, which will tend to discourage anyone from wanting to acquire or to hold the currency. This figure shows an example based on an actual episode concerning the Mexican peso. In 1986–87, Mexico experienced an inflation rate of over 200%. Not surprisingly, as inflation dramatically decreased the purchasing power of the peso in Mexico, the exchange rate value of the peso declined as well. As shown in this figure, demand for the peso on foreign exchange markets decreased from D₀ to D₁, while supply of the peso increased from S₀ to S₁. The equilibrium exchange rate fell from $2.50 per peso at the original equilibrium (E₀) to $0.50 per peso at the new equilibrium (E₁). In this example, the quantity of pesos traded on foreign exchange markets remained the same, even as the exchange rate shifted.

Exchange Rate Markets React to Higher Inflation

If a currency is experiencing relatively high inflation, then its buying power is decreasing and international investors will be less eager to hold it. Thus, a rise in inflation in the Mexican peso would lead demand to shift from D₀ to D₁, and supply to increase from S₀ to S₁. Both movements in demand and supply would cause the currency to depreciate. The effect on the quantity traded is drawn here as a decrease, but in truth it could be an increase or no change, depending on the actual movements of demand and supply.