How does inflation cause a country's currency to be overvalued with regard to the exchange rate?

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pohnpei397 eNotes educator| Certified Educator

If two countries experience different rates of inflation and the exchange rate does not adjust, then the exchange rate between the two will overvalue the currency of the nation that has the higher inflation.

Let us imagine that Country A has high inflation and Country B does not.  As A's currency inflates, it should lose value because each unit of the currency is no longer able to buy as much.  It is worth less.  But what if the exchange rate does not change to account for this?  If that happens, A's currency will be overvalued compared to B's.  The exchange rate will be the same as it had been before even though A's currency is no longer worth as much.

So, if exchange rates do not adjust, a country with high inflation will see its currency overvalued compared to a country with low inflation.