A viewer asked this question on 5/21/2000:
I was given a graph concerning a flexible or floating exchange rate
system. Let us assume that the French inflation rate is significantly higher than the German rate of inflation. Which nation will experience an appreciation of its currency? Explain why this appreciation will occur?
JesseGordon gave this response on 5/21/2000:
If French costs go up relative to German costs, the French franc will fall in value compared to the Mark. Assumptions are that there's free trade and free currency exchange between them.
Reason: French inflation will make French wine increase in price from 10 francs to 30 francs per bottle, while German strudel increase at less inflation from 10 marks to 20 marks per serving. Prior to the inflation, let's say one bottle of wine traded for one serving of strudel, in other words that 10 francs traded for 10 marks. After the inflation, since the same amount of work and costs went into the production, the wine would trade for the same amount of strudel still, so in other words 30 francs would trade for 20 marks (I'm assuming that the rest of costs in the economy got similarly inflated).
Before the inflation, 1 mark traded for 1 franc, in other words the exchange rate was 1:1. After, 1 mark would get you 1.5 francs -- the mark went up in value compared to the franc. The mark hence appreciated against the franc.
Of course, the simplification here is that the rest of the economy follows the one commodity in the example. That doesn't always work - sometimes inflation affects one segment of the economy more than others. And it also assumes that trading with the rest of the world doesn't matter, while in fact it does.
A viewer asked this question on 5/21/2000:
I was given a graph concerning a flexible or floating exchange rate
system. Let us assume that the French inflation rate is significantly higher than the German rate of inflation. Which nation will experience an appreciation of its currency? Explain why this appreciation will occur?
budgetanalyst gave this response on 5/21/2000:
The nation with the lower inflation rate will appreciate its currency because a unit of its currency will be able to purchase more goods and services than a unit of the currency of the higher inflating currency.
In your example, assume that one French unit of currency (franc) and one German unit of currency (DM) buy a loaf of bread. After inflation, eventually it will take two francs to buy a loaf of bread and it may still only take one DM to do so. In this case, what used to be parity, i.e., one franc equals one DM, has become a devaluated French currency in relation to the German currency strictly due to inflation.