inflation rate & exchange rate

8/6/2019 Inflation Rate & Exchange Rate

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Assignment

on

Effect analysis of Inflation on Exchange rate movements

Date of submission: 17th February, 2010

Md. Mukhlesur Rahman

Lecturer

Department of Finance

Faculty of business studies

University of Dhaka

Submitted to

Mahadi Hasan Sagor

Department of Finance

University of Dhaka

Section: A

Roll: 14-017

Submitted by


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Inflation:

Inflation is a rise in the general level of prices of goods and services in an economy over a period

of time. When the price level rises, each unit of currency buys fewer goods and services;

consequently inflation occurs. Inflation is also an erosion in the purchasing power of money a

loss of real value in the internal medium of exchange and unit of account in the economy. A

chief measure of price inflation is the inflation rate, the annualized percentage change in a

general price index (normally the Consumer Price Index) over time.

Exchange rate:

Exchange rates between two currencies specify how much one currency is worth in terms of the

other. It is the value of a foreign nations currency in terms of the home nations currency. For

example an exchange rate of 68 BDT (TK) to the United States dollar (USD, $) means that BDT

68 is worth the same as USD 1.

General theory of relationship between Inflation and Exchange rate:

If we define inflation as an increase in the price of goods and or an increase in the price of living as

measured in the currency of the country in question then an increasing inflation rate will be seen as an

apparent decrease in the value of the currency. Assuming that other countries experience LESS price

increase then the value of the subject country's currency will fall relative to the other currencies.

As prices increase so do percentage markups such as profits and dividends which in this way

increase automatically in line with increasing prices. The higher prices are felt by wage and

salary earners who demand increases in line with increasing prices, in line with the increasing

cost of living. Prices increase as a result, the increase depending both on the extent to which

wage and salary demands are satisfied and on how much of the price consists of labour costs.


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Our prices have increased, our exports have become more expensive, we sell less abroad, our payments deficit gets even worse. When this condition persists and gets worse then we candevalue our currency, the extent of the devaluation depending on whether we are devaluing

(1) to stay competitive or(2) to become more competitive.

As a result of the devaluation our exports become cheaper abroad but we have to pay more forimports. The increased cost of imports in turn increases our own prices but only to the extent to

which imports figure in the price. However, this has already been allowed for when deciding theextent to which we devalue.

The devaluation reduces our standard of living relative to others abroad as they find our producecheaper while we find their more expensive.

Thus increase in price level increases exchange rate of the given country.


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Practical case analysis:

In practical scenario if we look at the inflation rate of the country as well as the exchange rateover last 10 years we can observe it clearly.

Lets take the exchange rate of BDT with Indian Rupee and the inflation rate of Bangladesh overlast 10 year.

Fiscal

Year

Inflation

rate

BDT exchange rate

with IR

2000 9 1.14

2001 5.8 1.22

2002 5.8 1.17

2003 3.1 1.22

2004 5.6 1.3

2005 61.47

2006 7 1.47

2007 7.2 1.68

2008 9.1 1.58

2009 8.9 1.43

From the chart we can observe, with little ups and downs, a positive turn in the inflation rate inthe country. Hence as the price level of the country goes up, domestic demand for Indian goodsincreases. Consequently, the demand for the Indian currency increases. And the value of BDTdepreciates over the Indian currency. The exchange rate increases.

In the graph we can easily visualize that whenever the inflation rate is rising the exchange rate isalso rising correspondingly. In 2003 there was a decline in the inflation rate similarly theexchange rate also decreases.

0

5

10

15

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Inflation rate BDT exchange rate with IR


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To strengthen our arguments we are here by taking 8 countries exchange rate and the inflation

rate. Here we can also see the same result.

For our convenience, we are using the percentage change of the inflation rate as well as the

change of the exchange rates over the last year.

Year inflation USD GBP IDR Yen Yuan SR Euro Aus Do

2001 -35.56 6.3 3.51 2.61 6.38 6.17 6.3 0.42 -2.61

2002 0 0.72 11.5 1.7 9.09 0.73 0.72 18.69 11.16

2003 -46.56 2.13 13.28 7.5 14.58 2.17 2.09 22.73 36.65

2004 80.65 1.74 9.18 6.2 5.46 1.7 1.73 9.27 5.37

2005 7.14 11.12 -0.23 7.3 3.45 14.03 11.14 -2.8 4.28

2006 16.67 1.19 18.62 6.12 3.57 7.67 4.19 16.1 12.19

2007 2.86 1.96 0.36 12.18 5.17 5.77 -0.5 9.55 10.22

2008 26.39 1.25 -25.48 -18.86 24.59 8.34 0.82 -3.47 -19.47

2009 -2.2 -0.3 10.31 4.93 -2.63 -0.3 -0.43 2.68 28.24

To see the relationship we have putted this in a line graph

Here blue color line denotes percentage change in Inflation rate. We can see it started from

(-) 35.56% and ended at (-) 2.2%. Different colored lines denote different currencies percentage

change over last 9 years. Here most significant fact is that whenever we see raise in inflation rate

-60

-40

-20

0

20

40

60

80

100

120

140

1 2 3 4 5 6 7 8 9

Aus Do

Euro

SR

Yuan

Yen

IDR

GBP

USD

inflation


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we also see rise of foreign currency value over BDT. And also whenever we observe decline in

inflation we also quite similarly notice declining trend in exchange rates. If we closely look at

graph of inflation rate changes and 8 currencies changes we will see from a starting point in 2001

the trend was decline values of foreign currencies and unchanged inflation and in 2002 same

trend continues for all 9 values (one inflation rate & 8 exchange rates). In 2003-2004 values were

in the rise and fallen in 2005. There were changes in degrees but trend was same for almost all

values. 2006 also witnessed rise but 2007 saw declination. 2007-2008 was an exceptional period,

though inflation raised currencies values response were mixed. Again in 2009 we saw upward

trend. From graphical presentation it is undoubtedly clear that inflation rate and exchange rate

follows same pattern. Here we select those currencies those have high transaction with BDT; if

that was not the case result would have been different. So from our study we can deduce a

conclusive statement, that inflation rate plays significant if not most significant role in shaping

exchange rate movements.

Conclusion:

As undergraduate student our level of knowledge is not that vast, so our study may not address

all issues related to our study. Inflation rates of Bangladesh are collected from a data providing

website viz, www.indexmundi.com. and is subject to doubt as world recession tells us lowerinflation rates in 2007, 2008 and 2009 years. But here case is different and their information is

based on commodity price level which may be the reason of the difference. However, we have

come to that point; we are examining the truth that inflation affects exchange rates in a precise

manner and from Bangladesh perspective we have tried to prove the fact.

inflation rate & exchange rate

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