How does the "Falling Dollar" and the exchange rate affect Inflation?

Updated- November 15, 2007

by Tim McMahon

With all the recent talk about the "falling dollar" will that affect the inflation rate?

Let's start with the basics.

1) Price inflation is primarily caused by monetary inflation.  In other words as the money supply increases things cost more. See What is Inflation? for a full explanation. 

2) The government controls the money supply to a certain extent through tightening or loosening credit. 

3) The economy is extremely complex and many other factors come into play. Such as international exchange and the supply and demand for goods and services.

At first blush it might appear that the falling dollar would cause deflation because the dollar is going down.  But if the dollar is going down that means the purchasing power of the dollar is decreasing on a worldwide scale. In other words, a U.S. dollar would buy less if you traveled to another country. That is another way of saying that it takes more dollars to buy the same thing.  That sounds pretty much like inflation.

However, does that mean that things at your local grocery store will cost more? Probably not (at least not at first).  If the groceries are produced locally the value of the dollar on the world market will have little effect.

However, if the apples come from Peru they will be more expensive.  Because the dollar is worth less in Peru.  So you might choose to buy Washington apples instead. 

But longer term as more foreign raw materials and imported items circulate through the economy the effect will begin to be felt in everything. 

On the flip side however, a weaker dollar, means that foreigners find our products cheaper.  China has artificially kept their currency low for years  boosting their ability to export cheap goods to the US. 

We have been trying to get them to raise their exchange rate through diplomatic means to very little avail.  However by lowering the value of the dollar we have achieved much the same thing and have reduced the currency exchange advantage the Chinese have had against us. 

This means that the U.S. should be able to increase it's exports.  In other words imports will become more expensive while exports become cheaper.  This should encourage more people to "Buy American" both domestically and over-seas. This will boost our economy by creating jobs. 

But what effect will it have on our money supply?  Remember the rule of inflation is that it is primarily a function of  the supply of money compared to the supply of goods.

 The value of the dollars on the world exchange does not have an effect on the quantity of those dollars so money supply will not be affected. What about supply of goods?  Well the supply of goods will also stay the same although some substitution might occur as people buy Washington apples instead of Peru apples.

The major change will be in the demand for goods as people make those substitutions.  Washington apples might rise in price a bit because of the increase in demand while Peru apples fall a bit until they reach a new equilibrium. 

But since the majority of products purchased by American consumers are produced overseas the net effect will still be that we are paying more dollars for the same goods.  So although the money supply is unaffected prices are higher so it might appear as inflation but in a way it is pseudo-inflation.

But the effect is still the same... a year from now you will be paying higher prices.