The impact of inflation in an economy and the exchange rate between that economy's currency and the currency of another nation are often strongly correlated. The relationship is indirect, however, and -- even more confusing -- can fluctuate significantly depending upon the period of time an observer wishes to examine.
Interest Rate Parity
In order to understand the relationship between inflation and exchange rates, it is crucial to first understand the economic concept of interest rate parity. In brief, interest rate parity assumes that a country's exchange rate is directly correlated with the risk-free interest rate an investor can receive for lending in that country. The concept assumes that since different risk-free interest rates are offered in different countries or economies, investors will always attempt to invest in the country or economy offering the highest interest rate.
Function of Interest Rate Parity
When investors try to invest in the country or economy offering the highest risk-free interest rate, they sell the currency of their home country or economy and buy the currency of the foreign country or economy offering the higher rate of interest. The action of buying and selling increases the value of the foreign currency and decreases the value of the home currency. Thus interest rate parity holds that by offering a higher risk-free interest rate, the value of a country's or economy's currency will increase.
Relationship to Inflation
Economists also believe that, particularly over longer periods of time, inflation and interest rates are correlated. This relationship especially holds when inflation and interest rates are higher. Since interest rates are the "fee" that lenders charge borrowers in order to forgo current consumption, lenders will charge higher "fees," or interest rates, when they expect inflation to increase the cost of future consumption. In this way, inflation leads to higher interest rates, which in turn may increase the value of a country's currency, changing exchange rates.
Caveat
The relationships between inflation, interest rates and foreign currency exchange rates can be highly volatile. These relationships often only show a clear trend after a period of many years. In fact, many traders and arbitrage investors have made substantial money betting that the concept of interest rate parity will not hold over shorter periods of time.
In addition, governments and central banks often enact policy directly aimed at influencing exchange rates that can corrupt these relationships over shorter periods of time.
