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Why Inflation Alone Does Not Explain Exchange Rate Movements

Article Quant Q&A · Author: Eduardo J. Sanchez
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Summary

The document questions why the USD/CNY exchange rate does not appear to move in step with US inflation in a historical comparison. It also notes potential confusion about quote direction: an increase in USD/CNY means more yuan per dollar under the usual convention, so the interpretation of appreciation or depreciation must match the units used. Inflation measures changes in purchasing power, but the answer emphasizes that exchange rates reflect many influences and need not track one country’s inflation series closely over a selected period.

Potential explanatory variables listed include productivity, terms of trade, government deficits or debt, and real interest rates, alongside inflation. The response points toward broader exchange-rate modeling literature rather than proposing a specific forecasting model or estimating the contribution of each factor. No dataset analysis or empirical evidence is supplied, so the factor list is a starting framework, not a validated explanation for the observed USD/CNY pattern. Exchange-rate quotation conventions and the bilateral nature of currency values also matter when interpreting correlations.

Key ideas

  • A single inflation series is insufficient to explain bilateral exchange-rate movements.
  • Exchange-rate interpretation depends on whether the quote is expressed as yuan per dollar or dollars per yuan.
  • Potential drivers include productivity, terms of trade, fiscal conditions, real rates, and inflation.
  • The document offers a list of candidate factors rather than a fitted or tested exchange-rate model.
  • Observed correlations depend on the sample period and the bilateral context of the currency pair.

Tags

ForexStatistics
Full text
# Relation between inflation rate and the exchange rate of the currency


# Relation between inflation rate and the exchange rate of the currency












I have been studying the relation between exchange rates and the inflation of the currencies, but I am far from understanding the most relevant factor in driving FX market players from pricing currency pairs. I dowloaded US inflation percentages and data for the price of the USD/CNY currency pair. I have used this data to create the following plot:

If inflation is the rate at which the USD depreciates, why isn't the USD/CNY behaving in a more correlated manner in these data? An increase in USD/CNY implies more USD can be bought per unit of CNY, meaning the appreciation of the CNY with respect to the USD, i.e. the depreciation of the USD with respect to the CNY... But why is this value increasing in periods of decreasing inflation, such as the one preceding 1986? Is there any other factor missing in this picture? Maybe interest rates?

## Answer by user42108 (score 1)

https://quant.stackexchange.com/a/63084

Is there any other factor missing in this picture?

There is a large body of academic and practitioner literature on modeling exchange rates. Factors might include inflation, productivity, ToT, government deficits or debt, real rates... You might start by reading this piece, for example - https://www.imf.org/external/pubs/ft/wp/wp9867.pdf

You could also try the economics StackExchange.

HTH.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.