Impact of Currency float on Inflation
The term “currency float,” or “floating exchange rate,” refers to an exchange rate regime in which the value of a currency is permitted to vary in response to the processes of the foreign exchange market. Contrast this with a fixed exchange rate, in which the government has complete or substantial control over the rate. Currency float may have profound and varied effects on inflation.
First, a depreciating currency under a floating exchange rate can cause inflation. Import prices rise when the value of one country’s currency falls against that of other countries’ currencies. If firms have to pay more to import goods, they may have to pass those costs on to customers in the form of price hikes.
Second, because of its effect on monetary policy, a floating exchange rate may also affect inflation. Inflation is often managed by central banks through the use of interest rates. In a currency with a floating exchange rate, the central bank may increase interest rates if depreciation causes inflationary pressures. However, slower economic development due to higher interest rates might cause price increases due to demand.
Finally, the unpredictability of fluctuating currency rates might have an impact on inflation. Companies may raise prices if they anticipate a decline in the value of the currency. Inflation may result, even if the value of the currency stays about the same.
To sum up, while a floating exchange rate system has the potential to allow for adaptability and the automatic adjustment of the balance of payments, it also carries the risk of inflation through a number of different pathways. A floating exchange rate system need vigilant monitoring and proper monetary policy measures to prevent inflation from spiralling out of control.
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Impact of Currency float on Inflation