How does inflation affect the exchange rate between two nations?

The rate of inflation in a country can have a major impact on the value of the country's currency and the rates of foreign exchange it has with the currencies of other nations. However, inflation is just one factor among many that combine to influence a country's exchange rate.

Inflation is more likely to have a significant negative effect, rather than a significant positive effect, on a currency's value and foreign exchange rate. A very low rate of inflation does not guarantee a favorable exchange rate for a country, but an extremely high inflation rate is very likely to impact the country's exchange rates with other nations negatively.

Inflation is closely related to interest rates, which can influence exchange rates. Countries attempt to balance interest rates and inflation, but the interrelationship between the two is complex and often difficult to manage. Low interest rates spur consumer spending and economic growth, and generally positive influences on currency value. If consumer spending increases to the point where demand exceeds supply, inflation may ensue, which is not necessarily a bad outcome. But low interest rates do not commonly attract foreign investment. Higher interest rates tend to attract foreign investment, which is likely to increase the demand for a country's currency. (See also, The Mundell-Fleming Trilemma.)

The ultimate determination of the value and exchange rate of a nation's currency is the perceived desirability of holding that nation's currency. That perception is influenced by a host of economic factors, such as the stability of a nation's government and economy. Investors' first consideration in regard to currency, before whatever profits they may realize, is the safety of holding cash assets in the currency. If a country is perceived as politically or economically unstable or if there is any significant possibility of a sudden devaluation or other change in the value of the country's currency, investors tend to shy away from the currency and are reluctant to hold it for significant periods or in large amounts.

Beyond the essential perceived safety of a nation's currency, numerous other factors besides inflation can impact the exchange rate for the currency. Such factors as a country's rate of economic growth, its balance of trade (which reflects the level of demand for the country's goods and services), interest rates and the country's debt level are all factors that influence the value of a given currency. Investors monitor a country's leading economic indicators to help determine exchange rates. Which one of many possible influences on exchange rates predominates is variable and subject to change. At one point in time, a country's interest rates may be the overriding factor in determining the demand for a currency. At another point in time, inflation or economic growth can be a primary factor.

Exchange rates are relative, especially in the modern world of fiat currencies where virtually no currencies have any intrinsic value, say, as defined in terms of gold, for which the currency could be exchanged. The only value any country's currency has is its perceived value relative to the currency of other countries or its domestic purchasing power. This situation can influence the effect that an input such as inflation has on a country's exchange rate. For example, a country may have an inflation rate that is generally considered high by economists, but if it is still lower than that of another country, the relative value of its currency can be higher than that of the other country's currency.

You may want to read further on the macro fundamentals that affect the economy. Read Inflation and Interest Rates and Understanding Interest Rates.