If inflation is increasing in the US, how does that affect the value of the US dollar?
Best Answer: Hi, thought I might add my two cents worth:
Classical Economic Theory would say that when there is inflation in a country, the currency would lose value.
The exchange rate with other currencies would then reflect the decrease in value.
For example, if we look at the US$ vs. the Euro, from the current $1.30 per Euro, the dollar exchange rate should move to $1.43 per Euro (using a very simplified assumption of a 10% inflation in the US and no inflation in Europe, and the net value of the imports and exports are maintained).
This also means that the exchange rate of Euros per US$ would decline from 0.77 Euro per US$, to about 0.70 Euros per US$, making it easier for European producers to export their products into the US,
For the US producers, the decrease in the value of the UD$ would mean that they would have to raise their European prices to maintain the same level of profitability, making it more difficult to export.
The US producers would then have an increased incentive to sell domestically, thereby inflation in the US should hopefully be reduced.
The real world is somewhat more complicated. The complicating factors would include:
i. Many products are qouted in US$, The prime example is crude oil. Just about ALL the crude
oil contracts have been in US$. So when the US$ is devalued, the price of crude will merely increase proportionately.
Since the short term demand for petroleum products is relatively inelastic, the increase price of crude would increase inflationary pressures.
ii. Many other currencies are somewhat pegged to the US$. Therefore, the loss of value in the US$ may not actually occur because other countries would maintain the same relative exchange rate against the US$.
So the Chinese renminbi (also called the yuan) which is about 6.8 yuan per US$, would probably not change much. The Chinese monetary authorities would have to buy more US$ to maintain this informal 'peg'.
The net, net outcome is somewhat indeterminate.
Classical Economic Theory would say that with the increased imports of goods and the decrease exports, the supplies in the US would therefore increase.
So with increase supplies, the prices should drop, thereby curtailing the inflationary pressures.
In actuality, much of the benefits of the loss in value in the US$, may not be fully realized because of the factors outlined above.
It would still be the responsibility of the US Federal Reserve to tighten the money supply by raising interest rates through the discount window or open market operations, or increasing reserve requirements.
This should lower demand and therefore, decrease the inflationary pressures.Source: answers.yahoo.com