I have a trouble understanding the following text from my textbook. I bolded the fragments that don't make sense to me.

"Disadvantages of a floating exchange rate: A floating exchange rate regime may worsen existing levels of inflation. If a country has high inflation relative to other countries then this will make its exports less competitive and its imports relatively less expensive. The exchange rate will then fall, in order to rectify the situation. However, this could lead to even higher import prices of finished goods, componetns, and raw materials, and thus cost-push inflation, which may further fuel the overall inflation rate."

If there's high inflation, exports become less competitive and imports become less expensive - that's obvious. But why do they say that it would make imports' prices even higher? Why "even" and why "higher"? They've said that imports are cheaper after inflation, so imported raw materials, etc. should be cheaper as well so the costs of productions should be cheaper too and don't cause cost-push inflation but totally opposite.


2 Answers 2


The passage quoted is (at least) sloppy as regards language, in that it writes first "relatively less expensive", and then uses "even more", which would be correct if previously it had described a "more" expensive rather than a "less" expensive situation.

What happens here is that, under the assumption that Purchasing Power Parity holds (or tends to hold), we have

$$\pi = \pi^* - \dot S/S$$

Where $\pi$ is local inflation, $\pi^*$ is "foreign" inflation, and $\dot S/S$ is the growth rate of "local" exchange rate (units of foreign currency per unit of local currency).

Then, if $\pi > \pi^* \implies \dot S/S <0 \implies \dot S <0$, at least as a tendency, and the local currency will, eventually, depreciate.

For clarity, assume that we start from a situation where both inflation rates are zero. Then, local positive inflation happens, for some local reason.

Initially, before the exchange rate starts to adjust, local exports become more expensive for the foreigners (as the answer by @user3522240 describes), while imports (whose nominal price in terms of foreign currency has not changed, due to zero foreign inflation) become relatively less expensive, with "relatively" referring to the relative contribution of imported resources to local costs of production, compared to the cost of local resources. Imports do not become "cheaper" in nominal terms, in either currency. Only their percentage contribution to total costs becomes smaller.

But since eventually, we assume that the exchange rate will depreciate, weakening the local currency, the nominal cost of imports in terms of local currency will increase. But this will now increase the total cost of production in terms of local currency, and it will tend to add inflation to the already existing, locally generated, inflation rate, as firms will attempt to pass this imports-linked increase in costs to consumers.

The Purchasing Power Parity in terms of inflation rates is derived as follows: Denote $P$ the local price level and $P^*$ the foreign price level. Then PPP is expressed as

$$P\cdot S = P^*$$

Differentiate with respect to time,

$$\dot PS + P\dot S = \dot P^*$$

Manipulate (and use the PPP relation)

$$\implies \frac {\dot P}{P}S + \frac {P}{P}\dot S = \frac {\dot P^*}{P^*}\frac {P^*}{P} \implies \pi S + \dot S = \pi^* S$$

Divide by $S$ and re-arrange to obtain

$$\pi = \pi^* - \dot S/S$$

  • $\begingroup$ Thanks, I understand it all but one thing - why $\dot S/S <0$ if $\pi-\pi^*>0$ according to the formula? $\endgroup$ Jul 20, 2015 at 6:51
  • $\begingroup$ @RichardSmith How else will you achieve the equality? $\endgroup$ Jul 20, 2015 at 9:13
  • $\begingroup$ $\pi - \pi^* = \dot S/S$. Shouldn't LHS be positive? $\endgroup$ Jul 20, 2015 at 14:54
  • 1
    $\begingroup$ @RichardSmith Ah, the ever-present sign mistake. Corrected, and to punish myself I added the exact derivation of the PPP. $\endgroup$ Jul 20, 2015 at 15:23

I would imagine that a falling exchange rate causes the price of imports to rise as the foreign currency becomes stronger against the local currency.

With high inflation exports become more expensive because foreign buyers have to exchange more of their currency to account for the increase in price. This means they cost more per unit in terms of the foreign currency and consequently become less competitive.

The subsequent fall in demand for exports causes the fall in the exchange rate as the demand for exports and local currency are complementary. A weaker local currency means that one unit of local currency is now worth fewer units of foreign currency.

Thus the result is that imports become more expensive as any given amount of imports now costs more in terms of the local currency. Imagine that the exporting nation, say England, sells teddy bears for £5.00 a piece. If the dollar weakened against the pound from \$1.50 to a pound to \$1.56, then as far as a buyer from the United States is concerned, the price of a teddy bear increases from \$7.5 (i.e. 1.50 * 5.00) to \$7.8 (i.e. 1.56 * 5.00).


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