US inflation weakens the dollar

The chain in words

1. Step 1

   Before the inflation gap

   This is the market for US dollars, priced in euros per dollar. The horizontal axis is the quantity of dollars traded and the vertical axis is the exchange rate. The market is at E₀.

2. Step 2

   Demand for dollars shifts left

   American goods now cost more, so Europeans buy fewer of them and need fewer dollars at every exchange rate. Demand for dollars shifts left.

3. Step 3

   Supply of dollars shifts right

   At the same time, European goods look cheap to Americans, who sell more dollars to buy them. The supply of dollars shifts right. Both moves push the same way: the dollar depreciates to E₂.

4. Step 4

   Certain and uncertain

   The fall in the exchange rate is certain, the change in the quantity of dollars traded is not, because one shift lowers it and the other raises it. Over time the depreciation restores the competitiveness that inflation took away. This is purchasing power parity at work.

Takeaway. Higher relative inflation shifts demand for the currency left and supply right, and the currency depreciates.

Draw it yourself

More on the foreign exchange market graph