Forex Trading: Studying Fundamental Analysis Part 1
Inflation, the interest rate and currency exchange rate – that is what we are going to talk about in these series of articles.
Today we will consider interrelation of inflation, interest rates and currency exchange rate changes, applying all the same simple model.
What is the inflation?
By consideration of the theory of parity of purchasing capacity we already touched the questions connected with inflationary tendencies. Now I suggest to talk about inflation in more details.
What, as a matter of fact, represents such phenomenon as inflation?
The answer seems obvious. It is a rise in prices for the various goods or, speaking more a language of science, overall price level growth. For inflation measurement there are various indexes, such as a deflator of a total national product, a consumer price index, a price index of manufacturers. And it is accepted to explain growth of value of this or that index from the point of view of its structural changes, and also behind a deduction from them various groups of the goods, for example, cars or energy carriers. We will admit, this or that index has grown in connection with growth of its component connected with a rise in prices for oil, etc.
Such approach really is based on the information on events in economy changes, but it loses sight of the main thing: inflation represents the phenomenon which, first of all, concerns value of a currency (money) used in economy.
The general price level can be considered from two points of view. On the one hand, when the price level increases, the population is forced to pay for the acquired goods and services great sums of money. With another – price level increase means decrease in value of money as now one monetary unit allows acquiring a smaller goods quantity and services.
Supply and demand of money
Cost of money, also as well as cost of the usual goods and services is determined by supply and demand. The offer of money (the quantity of the money which is in circulation) basically is determined by a credit policy conducted by the Central Bank. Demand for money (the quantity of the money, which population wishes to keep around in a liquid form – in the form of cash or on current accounts) is determined by many factors, such as trust to credit establishments or an interest income which can be received having transformed them into those or other financial assets. But a primary factor determining demand for money is the average level of the prices in economy. The above is the price, the more money it is required for fulfillment of each transaction, and the more means will hold the population in purses or on current accounts.
Thus, price level growth (decrease in value of money) leads to increase in demand at money and on the contrary. In the long-term period the overall price level corresponds to value at which demand for money is equal to their offer. I.e. any deviation of a price level from equilibrium should be eliminated in due course.
The offer of money is determined by a Central Bank policy and consequently is size fixed. Demand for money can act as function as price level, and cost of money which as we have seen earlier consist among themselves in inversely proportional dependence.
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