How do weak currencies exacerbate imported inflation?

How do weak currencies exacerbate imported inflation?

Subject: Economy

Section: External Sector

Context:

The surge in the dollar has set Asian currencies on course for their worst quarter since 1997, creating a dilemma for central bankers- this would add to the pressure of  the monetary policy tightening as weak currencies exacerbate imported inflation.

What is the dilemma?

• Weather to curtain inflation or curtail growth/employment?
• As stated by the Phillips curve- explaining the inflation unemployment trade off:
• The Phillips curve states that inflation and unemployment have an inverse relationship. Higher inflation is associated with lower unemployment and vice versa. As a result, high levels of employment can only be obtained when inflation is high.
• Curtailing inflation involves raising the rate of interest which makes borrowing expensive thus, reduces investment, output and employment. 

How Depreciation leads imported inflation?

• When the general price level rises in a country due to the rise in prices of imported commodities, inflation is termed imported inflation. 
• Inflation may also rise due to depreciation of the domestic currency, which pushes up the landed rupee cost of imported items.
• For example, if the rupee depreciates by 20% against the US dollar in a particular period, the landed rupee cost of an imported product will also go up by the same proportion and will affect the price levels and inflation readings.

Depreciation of the Currency

• Depreciation of a country’s currency refers to a decrease in the value of that country’s currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system.
• In a floating exchange rate system, market forces (based on demand and supply of a currency) determine the value of a currency.
• Example: $1 used to equal to Rs.60, now $1 is equal to Rs. 72, implying that the rupee has depreciated relative to the dollar i.e. it takes more rupees to purchase a dollar.

East Asian Crisis 1997

• The crisis originated in Thailand following a stark devaluation of Thai baht,
• It began as a currency crisis when Bangkok unpegged the Thai baht from the U.S. dollar, setting off a series of currency devaluations and massive flights of capital.
• In the first six months, the value of the Indonesian rupiah was down by 80 percent, the Thai baht by more than 50 percent, the South Korean won by nearly 50 percent, and the Malaysian ringgit by 45 percent.
• Collectively, the economies most affected saw a drop in capital inflows of more than $100 billion in the first year of the crisis.
• Causes:
  • Export-led growth in many East Asian economies- initiated through currency devaluation.
  • Pegging of currency to the US Dollar.
  • The 1995 reversal of Plaza Accord led to a rise in the rate of interest and   appreciation of the US Dollar and consequently the East Asian currencies.
  • Decline in corporate profits due to relative decline in exports and rate of interest causing capital flight.
  • It was the result of overheating in the economy, stock market bubbles due to the “East Asian miracle”.
• All these led to a reversal of market sentiment, massive capital flight and bank-runs triggering a currency crisis
• The IMF stepped in to bail out South-East Asian economies, in lieu of reforms. Within a few years, these economies restored growth to pre-crisis levels, as the East Asian crisis was more of irrational self speculation by South-East Asia economies than major fundamental flaws in macroeconomic management.