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How does inflation affect the Balance of Payments?

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    My textbook says an increase in inflation (the price level) decreases exports. This would have a negative effect on the balance of payments.

    However, doesn't an increase in inflation weaken the pound? And from the acronym SPICED (Strong Pound, Imports Cheap, Exports Dear), shouldn't a weak pound make imports expensive, and exports cheaper, hence increasing the demand for exports, which would have a positive effect on the balance of payments?

    Thanks in advance
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    Two things cause inflation:

    1. An oversupply of the currency
    2. The country importing more than it exports

    I think you have misunderstood what is meant by a weak pound. The currency exchange is not determined by inflation instead it responds to it. So if inflation was at 5% you would not be able to buy 5% more in France for instance because to them the pound is less valuable and therefore they would raise their prices to accommodate this.

    High inflation would certainly decrease a countries exports because businesses would be less willing to trade with them because of the risk involved with a volatile inflation rate.
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    (Original post by tinto99)
    My textbook says an increase in inflation (the price level) decreases exports. This would have a negative effect on the balance of payments.

    However, doesn't an increase in inflation weaken the pound? And from the acronym SPICED (Strong Pound, Imports Cheap, Exports Dear), shouldn't a weak pound make imports expensive, and exports cheaper, hence increasing the demand for exports, which would have a positive effect on the balance of payments?

    Thanks in advance
    Actually, there are two types of inflation: (1) demand-pull inflation, which is caused by an increase of aggregate demand in the economy and (2) cost-push inflation which is caused by rising costs of production for firms which shifts aggregate supply left.

    The reasons for inflation are not relevant for your question, however. To understand why it causes exports to decrease, you just have to understand that an increase in the price level means a country's goods or services become less internationally competitive.

    Take an example: if one country 'X' could supply a car for £100 and so could country 'Y' then to a different country, both would be equally competitive. However, if country 'X' experiences 10% inflation, then the next year it would cost £110 from there, and still £100 from 'Y'. Therefore, 'X' has become less competitive internationally.
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    The person above has got it right. Inflation is a rise in the price level. If prices rise at a faster rate here than elsewhere our exports become less competitive (hence, we sell less).

    However, it is useful to know that the extent to which our exports decrease in volume depends on the P.E.D of our exports and whether our firms lower prices to absorb the effects from inflation.
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    (Original post by Barksy)
    The person above has got it right. Inflation is a rise in the price level. If prices rise at a faster rate here than elsewhere our exports become less competitive (hence, we sell less).

    However, it is useful to know that the extent to which our exports decrease in volume depends on the P.E.D of our exports and whether our firms lower prices to absorb the effects from inflation.
    Nice addition!
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    (Original post by Barksy)
    The person above has got it right. Inflation is a rise in the price level. If prices rise at a faster rate here than elsewhere our exports become less competitive (hence, we sell less).
    This is true if we have a fixed exchange rate or a shared currency eg the Euro. However with a floating exchange rate, the purchasing power parity hypothesis would suggest that inflation in one country would be cancelled out by a corresponding depreciation in the exchange rate so to foreigners, British goods would be no more expensive due to inflation in the UK, as the pound would just be worth less.
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    http://www.youtube.com/watch?v=yCjwXz7ZXwU
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    (Original post by MagicNMedicine)
    This is true if we have a fixed exchange rate or a shared currency eg the Euro. However with a floating exchange rate, the purchasing power parity hypothesis would suggest that inflation in one country would be cancelled out by a corresponding depreciation in the exchange rate so to foreigners, British goods would be no more expensive due to inflation in the UK, as the pound would just be worth less.
    This is not needed in AS level Economics

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