influence of inflation on exchange rate

External question — Economics Stack Exchange Author: C.F.G Original post: https://economics.stackexchange.com/questions/60044 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. This is my observation: If the inflation rate in country A is 12%, the value of goods increases by 12% each year in that country. At the same time, the same good in the US maintains a constant value. So to fill this price gap, exchange rate of country A would need to appreciate by about 12% - US inflation rate . Am I right? If this is true, one can say that if the inflation rate of Country A is lower than the inflation rate of the US, then the exchange rate of country A must decrease over time. but why this is not true about China? and china exchange rate is almost constant?

External answer — Economics Stack Exchange Author: 1muflon1 Original post: https://economics.stackexchange.com/a/60045 License: CC BY-SA 4.0 — https://creativecommons.org/licenses/by-sa/4.0/ Adaptation: HTML converted to plain text; contact email addresses removed. If the inflation rate in country A is 12%, the value of goods increases by 12% each year in that country. At the same time, the same good in the US maintains a constant value. So to fill this price gap, exchange rate of country A would need to appreciate by about 12% - US inflation rate. Am I right? Not exactly, let's break it down; If the inflation rate in country A is 12%, the value of goods increases by 12% each year in that country. It is actually other way around value of money decreases by 12% while people still keeping the same value of goods. So to fill this price gap, exchange rate of country A would need to appreciate by about 12% - US inflation rate. This is correct only if you assume that there are no transaction and transportation costs, no barriers to trade and no significant differences in market structure and market power. In that case you use law of one price to say that $S= P/P^*$ if you take logs and time derivatives of both sides you can say that change in exchange rate equals difference between inflation rates. If this is true, one can say that if the inflation rate of Country A is lower than the inflation rate of the US, then the exchange rate of country A must decrease over time. but why this is not true about China? and china exchange rate is almost constant? No; China doesn't have free floating exchange rate, but government managed exchange rate. As a result, in principle, as long as China's central bank is willing to sink enough reserves into supporting particular exchange rate they could do so. Since their central bank doesn't have unlimited amount of reserves there is some limit on how much they can 'sustainably' influence their exchange rate, but the point is it is not necessarily given by market forces. China does have significant capital controls, there are significant tariffs etc. Hence the law of one price would not apply to begin with.