Department of Economics

Subject: Intermediate Microeconomics

Submitted by:
Muhammad Zeshan Ali (BSECO-21-08)

Submitted to: Dr. Rana Adeel Farooq

Topic: What factors affect Inflation? Do Inflation

and Exchange Rate affect each other?

Dated: February 08, 2023

University of Sahiwal, Sahiwal

Table of Contents:
1. Factors affecting Inflation
2. Factors affecting Exchange Rate
3. Relationship between Exchange Rate and Inflation

1. What are the factors that effect Inflation?

Factors that may affect inflation in a country can be divided into to categories as follow:
1. Policy Factors
2. Exogenous Factors
1. Policy Factors:
Policy Factors are those factors by which a country's financial and economic institutions take
several decisions which directly or indirectly effect Inflation making it high or low.
Those factors are as follow:
1) Interest Rate
Higher rate of interest will lead to contraction in money circulation as people will choose to
lend their money to Banks rather than holding or investing in low profitable business than
lending to the banks. Thus higher interest rate causes lower inflation and vice versa.
2) Money Supply
More supply of money will fed up the market thus demand for goods at existing price will
increas. Thus to satisfy higher demand, prices will be increased automatically causing
inflation or general price increase in the country.
3) Exchange Rate
Lower exchange rate increase import bill of the country thus increases the price of all that
imports which are brought to the country. So lower exchange rate will increase inflation rate
and vice versa.
4) Government's Fiscal Measures
If government increases taxes and duties on industries and production technologies, this will
definitely cause a cost-push inflation and vice versa.
5) Costs of Production
Factors of Production, production technologies, energy prices all constitute cost of
producing a good. Thus higher input's cost will cause higher cost-push inflation and vice
versa.
2. Exogenous Factors:
Exogenous Factors are those factors which are not intentionally created by the government and other
financial institutions of the country rather they are created due to some sudden or accidental circumstances
such as natural disasters etc, are as follow:
1) Natural Disasters- Shortage
If an earthquake or a flood situation has wasted all the crops and infrastructure, this will cause
shortage of commodities and services thus increasing their prices due to their demand higher than
supply.
2) Political Instability- Low reliability for producers
Political instability will discourage producers to produce if no regulatory and production-friendly
policies are made due to political turmoil, their will be no enough production to satisfy demand
thus increasing price of goods and services being sold.
3) Higher Demand due to some national or religious festival
Inflation can also be due to over-increasing demand of specific commodities may be due to some
religious or social importance of that goods. For example, Gold's price increases during Diwali due
to religious importance of gold for Hindus.
4) International Price Increase
One of the key cause may be an international increase in prices of goods and services which may
be due to several factors or issues. Thus increasing international Price will lead to an inflationary
situation in a particular country trading with international market.

2. What are the factors that affect Exchange Rate of Country?

Here are several factors which affect the Exchange Rate of a country as follow:
1) Interest Rate
Higher interest rate will tend the investors to invest in that country thus will increase Demand of
that country in the market causing exchange rate to boost and vice versa.
2) Trade Balance
A country having higher exports than imports, make them earn inflows of dollars or currency for
which exchange rate is to be determined. Thus higher exports will lead to appreciation of currency
and vice versa.
3) Terms of Trade
Good and investor-friendly trading terms and conditions makes a country accept a huge amount of
FDIs thus increasing demand of country's currency will increase exchange rate or will cause
appreciation of currency and vice versa.
4) Political Stability
Political turmoil and unstable market environment will discourage investors and producers to bring
their capital to that country making country's currency cheaper due to lesser demand which in turns
causes depreciation in the currency of that country.
3. Do Inflation and Exchange Rate affect each other?
Absolutely Yes.
Inflation and Exchange Rate have correlations or interrelated with each other. Because higher inflation
which can be due to lower interest rate, will lead to lower exchange rate or depreciation in domestic
currency.
Similarly, lower rate of exchange or depreciation in currency leads to a higher rate of inflation or general
price hike in the domestic market.
Interest Rate, Trade Balance, Terms of Trade and Political Stability affect exchange rate in negative or
positive way which causes higher or lower rate of inflation in domestic market respectively.

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