Currency Depreciation and Inflation: The Vicious Cycle

 For a long time, I have suspected the existence of a vicious cycle between inflation and currency depreciation. I had to find some clarity on how this is:

1. Currency depreciation: This refers to a fall in the value of a country's currency relative to one or more foreign currencies. This often happens due to market forces in a floating exchange rate system.
2. Inflation: This is the rate at which the general level of prices for goods and services is rising and subsequently, purchasing power is falling.

Now, let's explore the interrelated effects.

The effect of currency depreciation on inflation:

Currency depreciation can lead to higher inflation. Here's why:

• Imported inflation: When a currency depreciates, the prices of imported goods and services rise because it takes more of the home currency to purchase the same quantity of foreign currency. This can lead to an overall increase in the price level, causing inflation.
• Demand-pull inflation: A weaker currency can make a country's exports more competitive (cheaper for foreigners). This can lead to an increase in demand for the country's goods and services, and if the demand outstrips supply, it can lead to higher prices and thus inflation.
• Cost-push inflation: Companies that rely on imported materials for their production might face higher costs due to a depreciated currency, and they might pass these costs onto consumers, again leading to inflation.

The effect of inflation on currency depreciation:

Inflation can also lead to currency depreciation. Here's how:

• Eroding purchasing power: If a country has a high inflation rate relative to other countries, its purchasing power falls. This means that you can buy less with the same amount of that currency. As a result, demand for that currency may decrease on foreign exchange markets, leading to its depreciation.
• Interest rates and foreign investment: Central banks often increase interest rates to combat high inflation. While this might attract foreign investors seeking higher returns, in some cases, high inflation could discourage foreign investment due to uncertainty and perceived economic instability. If foreign investors withdraw or avoid investing, they sell the home currency, contributing to its depreciation.