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Inflation in the US is 2% and in Indonesia it is 13%. How does this affect the exchange...

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lxsptter | Student, Undergraduate | (Level 2) Valedictorian

Posted September 12, 2013 at 2:08 PM via web

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Inflation in the US is 2% and in Indonesia it is 13%. How does this affect the exchange rate between the two currencies?

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justaguide | College Teacher | (Level 2) Distinguished Educator

Posted September 12, 2013 at 2:29 PM (Answer #1)

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Inflation in the US is at 2% and in Indonesia it is at 13%. Let us assume the exchange rate between the US dollar and the Indonesian Rupiah is 100, i.e 1 USD can buy 100 Rupiah.

There are several factors that play a role in determining the exchange rate between the currencies of different nations. Purchasing power parity is the theory that the exchange rate between two currencies should be such that it costs the same in terms of either of the currencies to buy an item in either of the nations. If this were not the case, an arbitrage opportunity is created with a person able to make an unlimited profit by exporting goods from where they are cheaper to the other nation.

If an item is priced $1 in the US, its price in Indonesia should be 100 Rupiah. As the price of products in the US rise by 2% every year, the price of the item after a year is $1.02. In Indonesia, on the other hand, the rate of inflation is 13%, as a result the same item after a year cost 113 Rupiah. If the exchange rate conforms to purchasing power parity, after a year 1.02 USD is equal to 113 Indonesian Rupiah. The exchange rate is now 110.78. The Indonesian currency has depreciated by around 10% with respect to the US dollar.

The currency of nations with a high rate of inflation tends to depreciate when compared to nations with relatively lower inflation. 

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