Explain how, in normal circumstances, inflation results in a reduction in the exchange rate.

Inflation is defined as a sustained rise in the price level. Inflation is generally undesirable for a country; while low and stable inflation does little harm, high levels of inflation have many negative implications such as fiscal drag, price uncertainty and inflationary noise. Most central banks have an interest rate target that they use their control over monetary policy to achieve (changing interest rates, quantitative easing and OMOs).

One of the effects of inflation is also to reduce the exchange rate. This occurs in normal circumstances as international competitiveness reduces due to prices rising relative to other countries. As investment in the country decreases, the demand for the currency follows suit and the exchange rate deteriorates.

Another way in which the exchange rate and the inflation rate are related is when the exchange rates are fixed against another currency. Say the pound was fixed against the dollar, and the dollar's inflation increased, the inflation rate for the pound would increase the same amount, this is because as the value of the dollar falls, the value of the pound falls. The pound's inflation rates would also also, then, be tied to the dollar's.