Exchange RatesThose who work at currency exchange centres have their hands full, mainly because they have to keep up with the world’s extremely varied and dynamic monetary exchange rates. In fact, ‘extremely varied’ is still putting it lightly. For instance, one NZ dollar is close in terms of value to one Aussie dollar (1=0.89). But, this can take a sharp turn in other currencies, like North Korean Won, where one NZ dollar is equivalent to about 620 NKW.

The question is, why? Numerous factors play a part in exchange rate variation, but one is considered among the most major: inflation. shares more information below:

Inflation At a Glance

In general, inflation is defined as a sustained increase in the general pricing of goods and services. The gist behind inflation is simple: if it increases, the country’s currency loses value and is able to buy a smaller portion of a good or service. Inflation is a gradual process, though a few countries have experienced an extreme variant known as hyperinflation. One good example is Zimbabwe, which has already phased out its local currency when the exchange rate for 1 USD peaked at 35 quadrillion Zimbabwean dollars.

How Does It Affect Exchange Rates?

The Zimbabwean dollar example is extremely rare, though its concept still proves the connection between inflation and exchange rates. High inflation rates in a country leads to a decrease in the perceived quality of that country’s goods; thus, causing a dip in demand. In turn, this leads to a decrease in the demand for local currency (i.e. gradual devaluation).

The closest link between inflation and exchange rates is via interest rates, with the latter able to influence exchange rates directly. Countries try to balance inflation and interest, but it’s a difficult proposition altogether. High interest may attract foreign investment (and increase demand for local currency), but can also cause inflation to go up.

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When such a situation happens, the local consumers will eventually find it more attractive to buy imported goods. Local currency will then be used to buy foreign currency and goods, which then leads to an increase in the supply of local currency. Here’s where the basic economic principle of supply and demand comes into play. When there’s too much of it around and no one wants it, it’s worthless.