Inflation is a currency losing purchasing power at home. An exchange rate is a currency’s price abroad. It would be strange if the two never met, and they do meet, in two directions at once. Inflation can push an exchange rate down. A falling exchange rate can push inflation up. Which effect dominates depends heavily on the country, the size of the numbers and the time period.
So start with the cleanest version of the idea, then see how much of it survives contact with data.
The basic logic: a currency buys less, so it is worth less
Say a basket of everyday goods costs 1,000 units of currency A in country A, and 10 units of currency B in country B, and the exchange rate is 100 A per B. In purchasing terms the two baskets are even. Nothing is cheaper to buy in one place than the other.
Let a year pass. Prices in country A rise 10%. Prices in country B rise 2%. Illustrative numbers, but let’s follow the arithmetic carefully:
- The basket in A now costs 1,100 A.
- The basket in B now costs 10.20 B (10 times 1.02).
- To make the two baskets equal in price again, the rate would have to be 1,100 divided by 10.20, which is 107.84 A per B.
So currency B gets more expensive in A terms by about 7.8%, and currency A loses about 7.3% of its value against B. Both figures describe the same move. The first measures it in A per B, the second in B per A.
Economists call this idea relative purchasing power parity: over time, exchange rates adjust to offset differences in inflation. It is a tidy mechanism. The question is whether it actually happens.
What the evidence says: sometimes a lot, sometimes hardly at all
A Bank of Canada review of the theory puts numbers on this. It looked at 1975 to 2001 and asked how much of the Canadian and Mexican currencies’ declines against the US dollar inflation differences explained. For Canada the answer was about 6%. For Mexico it was 92%.
That gap tells you most of what you need. When a country has high and volatile inflation, prices are the dominant story and the currency tends to follow them down. When inflation is low and fairly stable, as in many richer economies, other forces swamp it. Interest rates, trade flows, investor mood and commodity prices all push the exchange rate around much more than a few points of inflation do.
The same review adds that departures from parity are frequent and persistent. In plain words: a currency can look “too expensive” or “too cheap” by the price-level test for years. Parity is a gravitational pull, not a leash. And absolute versions of the idea, which say prices should be identical everywhere once converted, do not hold in practice, partly because many things, such as haircuts and rent, are not traded across borders.
Why the pull exists at all
Here is the chain of events, assuming a country’s inflation runs well above its trading partners’.
- Its goods get more expensive in its own currency every year.
- Foreign buyers find those goods less attractive, so export demand softens, and local buyers find imports relatively cheaper, so they buy more of them.
- More local currency is sold to pay for imports and less is bought to pay for exports.
- The currency weakens until the price gap closes.
There is a second channel that runs through confidence. People holding a currency that loses value every month have a reason to swap it for something steadier, whether a foreign currency, a hard asset or a foreign bank account. That selling pressure can push the rate down faster than the trade story alone would predict.
The reverse direction: a weak currency raises prices
Run it backwards. Suppose the exchange rate falls first, for any reason at all. Imported goods and imported inputs cost more in the local currency. Fuel, food, machinery, phone parts. Some of that reaches shop prices.
Economists call this exchange rate pass-through. How much of a currency drop turns into higher consumer prices varies enormously, and that variation is the interesting part. The Bank of Canada’s staff estimated in 2015 that a 10% fall in the Canadian dollar added roughly 0.3 percentage points to one core measure of inflation in the long run and about 0.6 points to the total price index. Three to six per cent of the drop, in other words. The paper’s explanation: import costs are only part of what a shop pays, and the rest is local wages, rent and distribution. It also found services are relatively insulated, while energy and fresh produce respond faster.
Canada is one rich country with a mostly stable inflation record. In an economy that imports most of its fuel, food and machinery, pass-through is likely to be larger. For any given country, the real number is something you would take from that country’s central bank, not from a general guide.
A second worked example: money sent home
Stay with the made-up currencies. A worker abroad sends 50 B a month to family in country A. At 100 A per B that’s 5,000 A.
Suppose the year passes with the exchange rate unchanged and prices in A up 10%. Those 5,000 A now buy what 4,545 A bought a year ago (5,000 divided by 1.10). The family is about 9% worse off in real terms, even though the transfer didn’t change. The sender didn’t send less. The money just did less.
Suppose instead the currency adjusts to the textbook 107.84 A per B. The same 50 B becomes 5,392 A, up 7.8%. Prices rose 10%, so the family is still about 2% behind (1.0784 divided by 1.10 is 0.98), but far less than before. In this case the exchange rate rescued most of the damage. In real life it might do more, less, or the opposite, and rarely on a neat schedule.
Inflation also changes what interest rates mean. A deposit paying 5% sounds fine until prices rise 10% in the same year: 1.05 divided by 1.10 is 0.955, a loss of about 4.5% in real purchasing power. Savers in high-inflation countries often compare the two numbers before deciding whether to hold local money at all, and that decision, repeated by millions of people, is part of the confidence channel described above. Central banks often respond by raising their own rates, which feeds back into the exchange rate by a separate route.
Reading it in practice
Two warnings are worth keeping, and then a use.
First, don’t read a high inflation rate as a prediction for next week’s exchange rate. Markets already know about inflation. The surprise is what moves a rate, and the tidy parity result operates over years.
Second, don’t assume a low-inflation currency is automatically strong. The Canadian result above is a good reminder that plenty else is going on.
The use: when you compare two currencies on USD to MXN or scan the whole rates grid, a slow persistent slide in one currency against many others is worth reading alongside that country’s inflation. It is context, not a trading signal. Rates refreshed hourly, so check back rather than assuming a rate you saw last month still holds. For anything large, ask your provider or a qualified adviser.
Sources
- Purchasing-Power Parity (Bank of Canada review)
- Bank of Canada discussion paper 2015-91 on exchange rate pass-through to consumer prices
- The shocks matter: improving our estimates of exchange rate pass-through (Bank of England)
Checked: November 2026
