The internal value of currency and its relation to inflation

The internal value of a currency reflects its ability to buy goods and services within its own country. This value is closely tied to economic factors like inflation, which can erode what each unit of money can purchase domestically.

Internal value

Internal value measures the purchasing power of money in the home market, determining how much can be bought with a given amount. When inflation occurs, the internal value decreases because prices rise, meaning each unit of currency buys fewer goods and services inside the country.

The internal value often links to the external value, which is the currency's worth in international markets.

How inflation affects the external value through demand and supply

Inflation in one country compared to others can alter the external value of its currency, mainly through changes in international trade patterns.

Effects of higher relative inflation

• Reduced demand for products - If a country's inflation rate exceeds that of its competitors, its goods become more expensive, leading to lower foreign demand for exports.
• Decreased demand for currency - With fewer exports, foreigners need less of the country's currency to buy its products, reducing overall demand on the foreign exchange market.
• Increased supply of currency - Higher inflation often encourages more imports, as domestic goods are pricier, increasing the supply of the home currency as it's exchanged for foreign ones.
• Resulting depreciation - The combination of falling demand and rising supply causes the currency's external value to depreciate.

The impact of depreciation on internal purchasing power

When a currency depreciates externally, it affects the internal economy by making foreign goods more expensive. This change directly and indirectly influences how much people can buy with their money at home.

Direct impact on purchasing power

Depreciation increases the cost of imported items in the home currency, reducing what each unit can purchase from abroad. This leads to a decline in internal purchasing power, as consumers and businesses face higher costs for essential or desired foreign products.

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Worked example - Calculating import price changes due to depreciation

A UK company imports goods from the US priced at $2,500. Initially, the exchange rate is £1 = $1.35. Later, due to depreciation, the rate changes to £1 = $1.20. Calculate the cost in pounds for both exchange rates.

Step 1: Identify the values

• Cost in dollars = $2,500
• Initial exchange rate = £1 = $1.35
• New exchange rate = £1 = $1.20

Step 2: Calculate cost at initial exchange rate

Cost in pounds = $2,500 ÷ 1.35 = £1,851.85 (rounded)

Step 3: Calculate cost at new exchange rate

Cost in pounds = $2,500 ÷ 1.20 = £2,083.33 (rounded)

Step 4: Interpretation

The cost increases from £1,851.85 to £2,083.33 when the pound depreciates from $1.35 to $1.20, demonstrating reduced purchasing power for imports.

Direct and indirect effects of depreciation

Depreciation not only raises the immediate cost of imports but also has broader consequences that further diminish internal purchasing power through supply chains and market dynamics.

Indirect effects on purchasing power

• Imported raw materials - Higher prices for foreign inputs increase production costs for domestic firms, which may pass these on to consumers through elevated prices.
• Reduced competitive pressure - With imports becoming more expensive, local producers face less rivalry, allowing them to increase prices without losing market share.

The relationship between internal and external values

The internal and external values of a currency are interconnected, often moving in the same direction due to economic pressures. A decline in one typically triggers a similar fall in the other, creating a cycle that affects the overall economy.

Nature of the relationship

Internal value (purchasing power at home) and external value (exchange rate) tend to be positively related; a drop in internal value from inflation often leads to external depreciation. For instance, high inflation reduces internal value, which can cause depreciation, further eroding internal purchasing power through higher import costs.