Which of the following can help to explain why higher inflation may lead to currency appreciations?

Question

BlackTom AI · Accepted Answer

When considering why higher inflation might be associated with currency appreciations, we need to evaluate each statement in light of monetary policy mechanisms and exchange-rate dynamics.
Option 1: 'Most central banks adjust their policy interest rates expressly so as to keep inflation in check.' This suggests that even if inflation rises, central banks respond by raising policy rates to combat inflation. Higher interest rates can attract capital inflows, increasing demand for the domestic currency and potentially leading to an appreciation, at least in the short to medium term. The presence of credible, proactive policy can thus explain why inflation does not always coincide with a weaker currency.
Option 2: 'Inflation will increase the purchasing power of a currency.' This is incorrect in standard economics. Inflation erodes the real purchasing power of money within a country, and generally does not increase currency value; higher inflation tends to weaken a currency’s value in real terms, all else equal.
Option 3: 'The interest rate is not the prime target of monetary policy.' In most central banks, policy interest rates are a primary instrument of monetary policy, used precisely to influence inflation and stabilize the currency. This statement contradicts mainstream practice and provides a poor rationale for inflation leading to currency appreciation.
Option 4: 'Central banks increase the money supply leading to overshooting of the exchange rate.' Expanding money supply tends to devalue the currency rather than appreciate it, especially if it outpaces economic fundamentals. An overshooting effect would more likely imply depreciation, not appreciation, making this option unlikely as an explanation for the phenomenon in question.

In sum, option 1 aligns with the mechanism by which credible, rate-driven responses to higher inflation can support currency strength via attractive real returns, while options 2 and 4 describe effects opposite to currency appreciation, and option 3 misstates the role of policy instruments. The reasoning hinges on the link between inflation dynamics, policy credibility, and interest rate differentials influencing capital flows.

2025SM-ECON-442-801 Quiz 2

Which of the following can help to explain why higher inflation may lead to currency appreciations?

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