Relationship Between Inflation and Depreciation: Its Complicated

Its understandable to think inflation (price increases within a country indicating the dollar has weakened in purchasing power for domestic goods purchases) would lead to depreciation weakening of the dollar against other currencies. The logic of this common misunderstanding is not too complex; if the dollar has weakened for a foreign import, say a $20,000 car, why shouldnt we expect the foreign company to charge more dollars for the same good, thus indicating depreciation has occurred for the American currency? The reality is quite different and in many ways the opposite of this simplified story. Lets say both the imported and domestic cars start at $20,000. Then there is inflation in the U.S. and the price of domestic cars, once US automakers include inflation, increases to $23,000. The imported car is still $20,000. This tends to cause U.S. buyers to switch to the 20,000 dollar import over the 23,000 equivalent domestic car, increasing the foreign firms market share in the U.S. It can be worth it for the foreign central bank to buy foreign reserves to maintain this favorable exchange rate. Citing research by economists Richard Clarita of Columbia University and Daniel Waldman of Barclays Capital, Nobel Laureate (Nobel Prize Winner in Economics) and international finance expert Princetons Paul Krugman reports that the Clarida-Waldman study confirms that inflation leads to appreciation, and the effect is stronger for core inflation (excluding food and energy) than for headline inflation (overall CPI). 1 Much of the reason for this and other changes in a currencys value (appreciation or depreciation) is due to interest rates. When global investors expect inflation, they expect the Central Bank of that country will raise real interest rates (interest rates adjusted for inflation) enough to decrease the excess inflation. Higher real interest rates make global investors wish to hold financials in that currency. In order to buy US bonds or stocks, they must buy the US currency in that process, causing the dollar to appreciate. Even in the cases where they dont think the Central Bank is committed enough to minimizing inflation, then the lower real interest rate in that country still creates some demand for their currency as global investors seek to do business there. Bottom line: does inflation tend to cause depreciation? No, it tends to cause appreciation.
In contrast to the other findings,

How about in reverse, does depreciation cause inflation? Research by the Saint Louis Federal Reserve District Bank reports that in a typical year such as 1988, less than one half of one percentage point of the 4.4 percent rise in the CPI during 1988 is attributable to the pass-through from a falling dollar.2 Less than half a percent of the
1 2

Krugman, Obstfeld: International Economics, 8th Ed., Pages 375-377 http://research.stlouisfed.org/publications/review/89/07/Dollar_Jul_Aug1989.pdf

4.4% U.S. inflation rate was estimated to be caused by our overall depreciating against the worlds currencies. This was during a period when the dollar was undergoing substantial depreciation. The Saint Louis Fed concludes that the dollars depreciation does not cause widespread or sustained inflation: Does a falling foreign exchange value of the dollar mean higher U.S. inflation? commentators would argue in the affirmative. The analysis in this paper, however, indicates that this view is off the mark. Inflation is a persistent increase in the general level of prices. This definition provides a consistent framework in which to distinguish inflationary trends from transitory relative price shocks. While a depreciating dollar price of some imported goods and services, these relative price increases are not inflationary nor do they promote an upward spiral of wages and prices in the future. The St. Louis Fed cites studies that back up estimates that, once oil price shocks are accounted for, a 10 percent depreciation in the dollar produces a mere 0.02 percent increase in the price level in the first year, with no longer term effects. This bears an interesting echo to the Clarida-Waldman finding that inflation announcements led to appreciation. They said it was stronger for core inflation that means excluding food and energy costs, so when you include energy, inflation corresponds with some depreciating effects. The Fed also is saying the studies that show inflation corresponds with depreciation are being overly impacted by oil price shocks, exactly the element which Clarida and Waldman said youd have to exclude to get an appreciation/inflation correlation. Now take a look at the Mankiw graph. In the Mankiw graph, the left-side vertical axis reads Percent change in nominal exchange rates. Almost contradictorily, Economist Gregory Mankiw cites research that when countries have higher inflation rates than the U.S., that correlates with more depreciation for those currencies. The apparently contradictory studies look at many of the same countries as each other. The seemingly irreconcilable split between Princeton Professor and Nobel Laureate Krugman and Harvard Professor, as Chairman of the Council of Economic Advisors for President George W. Bush appears primarily due to two factors: 1. The long-term nature of the Mankiw measure hes looking at the relationship between inflation and depreciation over thirty years, while Krugman cites a study that is looking at currency trading immediately following an inflation announcement. This very short-run trading in foreign exchange seems assumed to encompass rational expectations by currency traders in the minutes after the inflation jump has been announced, and he doesnt give any reason to think they will be wrong in the longer term and the currency will only decline.

2. The Mankiw study measures inflation as the difference between, say, Italys inflation rate (lets say its 8%) and the U.S. for that year (lets say thats 3%). The difference is 5%, so that is the number (the inflation differential) this study would record for Italy. The dollars role as a reserve currency seems to cause some of the end-result that those currencies who have higher long-run inflation than the dollar will show, over a period of decades, higher rates of depreciation. In brief then: 1. Inflation can definitely cause appreciation, although this is largely based on what investors think a Central Bank will do, increasing interest rates, to combat that inflation. 2. Depreciation is a minimal cause of inflation in most years.