Chapter 18.2, Problem 4R

To determine

To explain: The affect of inflation on exchange rate of the currency.

Explanation of Solution

The inflation reduces the exchange rate of the currency because the rise in inflation will make the domestic goods costly so the export of the domestic goods will fall because the foreigner will find the domestic goods costly so they will demand less.

Consequently, the exchange rate will fall. Similarly, on the supply side, the domestic buyers will also find the domestic goods costly so the demand for foreign goods will increase and the import will rise. Resulting, there will be a tremendous fall in the exchange rate.