Especially when we want to study exchange rate changes between developing countries, differences in inflation rates can play an important role. In most cases, developing countries have a structurally higher inflation rate than industrialized countries (cf. e.g. Balassa-Samuelson effect). Moreover, periods of high- or hyper-inflation and unexpected inflation spurts (shocks) are much more common in developing countries.

The chart below illustrates the effects of such an inflation shock. The regulator produces an index for the inflation abroad relative to the domestic. High means that inflation abroad is higher than the domestic inflation ${\pi }^{\ast }>\pi$. Low means that inflation abroad is lower than the domestic inflation ${\pi }^{\ast }<\pi$. The index does not refer to a difference in %, but is an unspecified scale.

If the inflation abroad is higher than the domestic inflation, the domestic currency should appreciate recording to the purchasing power parity theory. The foreign exchange markets react very quickly and the exchange rate adjusts to the new equilibrium even before the goods markets or prices react. Sometimes the reaction of the foreign exchange markets is so strong that the exchange rates overshoot.

A drastic change in foreign price levels, e.g. an unexpected inflation shock or even hyper-inflation, can be illustrated by shifting the PPP line. The PPP line is a straight line of origin with slope ${P}^{\ast },$ , as can be seen from the equation $P=S{P}^{\ast }$. The adjustment can be made using the slider, whereby the "inflation index abroad" is not measured in %, but serves as a qualitative indicator. If ${P}^{\ast }$ increases due to inflation abroad, the curve becomes steeper. The old equilibrium is now in the range below the curve, in which the domestic economy has competitive advantages. However, since the exchange rate reacts very quickly, it adapts to the new balance before real effects arise. At most, there are temporary imbalances or a short-term overreaction of the exchange rate.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743
E-mail: Bauer@uni-trier.de
URL: https://www.cbauer.de