The sky’s the limit: The economics of inflation and hyperinflation

4 The exchange rate

Our discussion of the terms of trade did not mention the exchange rate because the terms of trade can be analysed simply by comparing relative international prices of imports and exports. This means we can think in terms of dollar prices and ignore domestic currency. But as in the case of Argentina in the introduction, the price of foreign currency in terms of domestic currency can also have a profound impact on inflation.

nominal exchange rate

The number of units of the home currency that have to be exchanged to obtain one unit of a foreign currency—that is, the market exchange rate—is described as a nominal exchange rate to distinguish it from the real exchange rate, which is the relative price of foreign and domestic goods and services. See also: real exchange rate.

The nominal exchange rate, \(e\), is the price of foreign currency in terms of domestic currency. So if the home country is India and the foreign country is China then the nominal exchange rate might be 12 rupees per yuan. A rise in \(e\) from 12 to 13 means a depreciation of the home currency: foreign currency has become more expensive.

When the exchange rate is floating, it is determined by the supply and demand of different currencies in the market. The market here means both major investors who can easily buy and sell large quantities of currency based on expected financial returns, and domestic residents who have a certain demand for their own currency. When the exchange rate is fixed, the government promises to buy and sell foreign currency (most often, US dollars) at a specified price.

While the two types of exchange rate regime seem rather different, they have an important similarity: in both cases, a substantial decline in the domestic interest rate relative to international interest rates will lead to a decline in demand for domestic currency. That will lead to a depreciation in the case of a floating regime, and is likely to lead to a devaluation in the case of a fixed regime.

To learn more about how policy interest rates influence demand for a country’s currency in global financial markets, read Section 7.8 in The Economy 2.0: Macroeconomics.

How does this work? Suppose that the Central Bank of India reduces the interest rate, meaning that Indian government bonds now pay a lower return. International investors will therefore want to reduce their holdings of rupee bonds relative to other international assets. This reduces their demand for rupees because they would rather exchange them for another currency where they can get a higher return. (Since most international assets are denominated in US dollars, we will often use the price of the dollar as the key comparator.)

If the exchange rate is floating, then the decline in demand for rupees leads to a rise in the rupee price of dollars: a rupee depreciation. If the exchange rate is fixed, then the decline in demand for rupees means that investors want to sell their rupees to India’s central bank in return for dollars, and the central bank is required to give them dollars at the fixed exchange rate. But central bank reserves of foreign currency are limited. At some point—perhaps not immediately, and sooner for bigger shifts in the interest rate—they will run out. At that point, or more likely earlier and in anticipation of reaching that point, the government is forced to devalue the currency, that is, raise the rupee price at which they sell dollars.

Thus the effect of a decline in the domestic interest rate, or rise in foreign interest rates, sooner or later ends up being the same under a floating or fixed regime: a decline in the value of domestic currency. In this section we will generally assume a floating exchange rate, but remember that this mechanism has an equivalent outcome for a fixed exchange rate (even if it might occur with a delay).

real exchange rate, competitiveness

The relative price of foreign and domestic goods and services; specifically, it is the price of foreign goods and services, converted into domestic currency at the market (nominal) exchange rate, divided by the price of domestic goods and services. The real exchange rate is a measure of competitiveness.

Where the nominal exchange rate is just the price of foreign currency in domestic currency, the real exchange rate tells us the price of foreign goods and services relative to domestic goods and services, when compared with using the nominal exchange rate. So it is defined as

\[c \equiv \frac{eP^*}{P}\]

where P* is the price level in the foreign country and P is the price level at home. A rise in \(c\) means that when prices are converted using the nominal exchange rate, foreign goods have become more expensive relative to domestic goods. It is therefore a measure of the competitiveness of domestic goods internationally. The value c can fall because the nominal exchange rate, e, appreciates or because the price of domestic goods, \(P\), rises faster than the price of foreign goods, P*. Either way, domestic goods become more expensive for foreigners and foreign goods become cheaper for domestic residents. As explained in Unit 5 of The Economy 2.0: Macroeconomics, this will tend to imply lower exports and higher imports.

Like a decline in the terms of trade, a nominal depreciation implies that imports become more expensive in domestic currency. But unlike a decline in the terms of trade, it means exports also become more expensive in domestic currency, so domestic exporters are better off. It therefore implies a redistribution of income: those who are net purchasers of imports become poorer while those who are net producers of exports become richer.

From the perspective of inflation, however, this is not helpful: the depreciation makes workers worse off because prices rise for imported goods and for goods with imported inputs, and they receive no direct benefit from more expensive exports. While exporting firms could accept the wage increase without further raising their prices, other firms will not. This sends the economy back into the same wage–price spiral we discussed in Section 2.

This example is another illustration of the fact that inflation is grounded in social conflict: when a shock leads to redistribution, the reaction of those who lose out can lead to inflation in much the same way as shocks that reduce aggregate real income.

The depreciation–inflation spiral

Moreover, depreciation has its own disadvantage: unlike a decline in the terms of trade, a depreciation can occur again and again without limit, forming a depreciation–inflation spiral, or a devaluation–inflation spiral in the case of a fixed exchange rate. We discussed one version of this in the example at the start of the Insight: in Argentina, every time the currency depreciated and \(e\) rose, prices, \(P\), rose by an equivalent amount, and so did wages.

This occurred because the dollar had become the price anchor. But how did this happen? The explanation is that Argentines had faced chronic negative real interest rates in pesos for two decades, meaning nominal interest rates were lower than inflation. The interest rate on savings might be 15% while annual inflation was 30%, implying a real interest rate of –15%. This worsened when inflation took off after the pandemic of 2020, and in mid-2023 the 12-month inflation rate had reached 115% while the interest rate was about 90%. In this context, the problem was not so much international investors seeking a return as the fact that Argentine citizens found they could not save in their own currency: it had lost its function as a store of value. They found that it was better to save by buying dollars, which preserved their value better than peso savings. This is why the dollar became the anchor that people used in their pricing decisions. Why was this policy followed? Most likely because growth was already weak and policymakers feared reducing it even further. Unfortunately they did not take into account the implications for the currency.

But the depreciation–inflation spiral has also affected many countries where the dollar is not the price anchor. This takes place through the Phillips curve. To understand how this process works, suppose the home country is India and the unemployment rate is at \(u^*\), inflation is on target, and the exchange rate is floating. Consider the shock of a rise in the US interest rate. This makes US bonds more attractive to international investors, increasing demand for US dollars relative to Indian rupees. (For the short run and small changes, international investors are usually far more reactive than domestic residents.) This raises the price of dollars in terms of rupees from \(e\) to \(e′\).

The rise in the price of the dollar raises the prices of imports. This reduces real wages. Next, workers bargain for higher wages, and firms then raise their prices as in the WS–PS model. So the Phillips curve has moved upwards because the initial level of unemployment is now associated with higher inflation, initiating a wage–price spiral.

Moreover, the depreciation would be expected to increase net exports (assuming inflation caused by higher import prices has not occurred yet), increasing aggregate demand and reducing unemployment. In that case, not only has the Phillips curve shifted upwards (higher inflation at a given unemployment rate), but the economy also moves rightwards along the Phillips curve, further increasing inflation. This situation is illustrated in Figure 6. As long as unemployment stays either at its starting level or lower, the wage–price spiral will continue.

A depreciation raises prices, shifting the Phillips curve upwards. It also stimulates output, reducing unemployment, moving the economy rightwards along the new Phillips curve.

What has happened to the real exchange rate? Inflation implies a rise in domestic prices, meaning the real interest rate appreciates. This counteracts the nominal depreciation. It also increases nominal rupee incomes for Indians, increasing the supply of rupees relative to dollars, which pushes down the price of rupees again, meaning a further nominal depreciation. This sets off the same process again, leading to further price rises and further depreciations in a depreciation–inflation spiral.

Each time, there is a nominal depreciation which implies a short-term real depreciation, but rising prices continually undo the real depreciation, leading to further nominal depreciation. Both domestic prices, P, and the price of the dollar, e, keep on rising. The outcome would be similar for a fixed exchange rate: the government would be forced to devalue repeatedly in a devaluation–inflation spiral.

How can a depreciation–inflation spiral be avoided? In the case of Argentina, a positive real interest rate that sustained the peso as a store of value would have avoided the chronic problem. In the more usual case that we analysed for India, the process involved a rise in the Phillips curve, so the model suggests that either fiscal or monetary tightening will increase unemployment and reduce inflation, moving leftwards along the Phillips curve.

The process has an added complication, however. Suppose the Central Bank of India raises the interest rate by the same amount as the rise in the US interest rate. This will return the nominal exchange rate to e because the attractiveness of rupee bonds relative to USD bonds will return to what it was previously. If this is done immediately then there will be no increase in the price of imports and no rise in inflation, the real exchange rate will remain at the original level of c, and there will be no impact on net exports.

However, the rise in the domestic interest rate will also have the effect of reducing aggregate demand (AD) through the usual domestic channel of falling investment and consumption spending. So a careful balance will have to be struck: raising interest rates by such an amount that the fall in AD through the domestic channel is offset by the rise in AD through the trade channel via depreciation. For instance, if the US raised interest rates by three percentage points then the Central Bank of India might raise its interest rate by two percentage points, allowing a mild depreciation that stimulates AD, offset by a mild decline in AD via domestic channels. Or, as we will discuss in the next section, they might combine the rise in the interest rate with a fiscal expansion. Getting this balance right, however, is extremely tricky.