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I'm a complete newbie to this foreign exchange stuff and was reading about the impact a country's price levels have on exchange rates.

So from what I understand, the general idea is that inflation leads to a decrease in value of a country's currency (depreciation).

increased prices in goods in a country --> the country's exports will be less competitive --> so demand for the exports fall --> demand for the country's currency falls --> and this leads to depreciation of currency

however, it's also said that:

with a depreciated currency -> imports will be more expensive BUT the country's exports will be cheaper and more competitive --> then won't demand for currency rise instead?

If so, doesn't this contradict the first statement? It seriously confuses me. Inflation that leads to depreciation will then lead back to appreciation of the currency again? I know I'm probably missing something here, but this just makes no sense from the way I picture it.

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  • $\begingroup$ You should read about the Real Exchange Rate (which in theory is what consumers would care about), and about the Law of One Price. They might help you understand this. $\endgroup$ – luchonacho Apr 4 '17 at 8:52
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Your confusion might be mitigated if you thing about these as short- and long-term effects.

That is, the more immediate effect of inflation is that exports fall, demand for currency falls, and so the value of currency falls.

This causes imports to fall, domestic spending to increase, and foreign demand for domestic goods to increase. That is, exports rise. This increase in exports causes an increase in demand for the home currency and this puts upward pressure on the currency.

The short-term effect of inflation is that we have currency depreciation. The long-term effect is less clear cut, since the depreciation should trigger an increase in foreign demand which should counteract the initial effect of inflation.

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  • $\begingroup$ You could also explore the hypothesis that in the long-run the Law of One Price holds, which might counterbalance effects of inflation on the Real Exchange Rate. $\endgroup$ – luchonacho Apr 4 '17 at 8:53
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We need to be clear about what is a cause and what is an effect. Figure out what changed and why, then follow the results. Results do not cause causes. As a general example, think of a demand/supply relation (for anything). If demand shifts left (reduced demand) and nothing else changes, then the equilibrium price goes down. That means the good is cheaper, but this cheapness doesn't cause increased demand. It's the result of decreased demand.

In the first statement, prices rose. Why? An increase in the domestic money supply, presumably? If so, then essentially we have changed numeraire. What used to be a dollar's worth of goods now costs $1.10, both domestically and abroad. If the numeraire did not change abroad and nothing changed about the economy, then a unit of the foreign currency now buys the same amount of goods but more dollars. That's depreciation of the currency. Depreciation is the effect, not a cause.

In the second statement, there has been depreciation. Why? Because of an increase in the money supply as mentioned above? If so, then demand for currency will only rise inasmuch as an importer of the same amount of goods will need more dollars, but this numerical increase in demand doesn't translate to making the dollar worth more abroad. The depreciation is the equilibrium result of the change in the money supply. Again, depreciation is the effect.

For depreciation to be a cause, rather than an effect, you would need to provide an economic change that directly affected depreciation. Depending on what changed economically, there could be lots of possible outcomes.

For any economic analysis, start with an equilibrium result, change one economic thing (the cause), then see how the equilibrium changes (the effect). Then you are done. Don't look at how the equilibrium is different from what it was before and treat that as if it was an economic cause.

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