Inflation is one of the factors that have an impact on a nation’s economy. Therefore, inflation has an effect on the value of a nation’s currency. In this post we will be examining what correlations exist between inflation and the forex market.
What is Inflation?
Inflation refers to the increase in the price of goods coupled with a decrease in the purchasing power of the nation’s currency. In essence, inflation causes the same amount of money to be able to buy less.
Because inflation leads to a reduction in the purchasing power of the currency, it impacts the cost of living. This causes a decrease in economic growth.
Causes of Inflation
Inflation is caused by imbalances in demand and supply. The types of inflation are demand-pull inflation, cost-push inflation, and built-in inflation.
Demand-pull Inflation: This is caused when demand outweighs supply. This imbalance causes competition for limited resources, leading to an increase in prices.
Cost-pull Inflation: This occurs when the cost of production increases and as a result supply falls. The reduction in supply causes it to be less than supply resulting in inflation.
Built-in Inflation: This occurs when as a result of perceived inflation, workers request more wages. The increase in wages causes an increase in production costs, raising the price of goods. This continues in a loop, leading to more and more inflation.
Inflation when measured by taking into account different parameters, results in different indexes. The types of inflation indexes are the consumer price index, the wholesale price index, and the production price index.
The consumer price index (CPI) is gotten from the average of a basket of goods and services comprised of consumer needs. Different goods in the basket have differing weights. The consumer price index takes into account this difference.
The wholesale price index (WPI) is also a widely used measure of inflation. It measures and tracks the changes in the price of goods in the stages before the retail level.
The producer price index measures price changes from the perspective of the seller. It differs from the CPI which measures price changes from the perspective of the buyer.
Inflation and the forex market
Inflation measured as the consumer price index has high impact on the value of the currency. When inflation is increasing, the value of the nation’s currency decreases.
Conversely, reduction in inflation causes a strengthening of the currency value. The CPI is a metric that really affects the value of currencies in the forex market.
In summary, a strong negative correlation exists between inflation and the value of a nation’s currency. Therefore, in forex trading, it pays to be aware of the metrics.
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