Association of Chartered Certified Accountants (ACCA) Certification Practice Test

What tends to happen to currency exchange rates during inflation?

1. They typically rise

2. They remain constant

3. They are likely to fall

4. They are unaffected

The correct answer is: They are likely to fall

During periods of inflation, the purchasing power of a currency decreases, meaning it takes more of that currency to buy the same goods and services. This decline in purchasing power often leads to a depreciation of the currency against other currencies in the foreign exchange market. As domestic inflation rises, it can make exports more expensive for foreign buyers and imports relatively cheaper for domestic consumers. This imbalance can result in a weakening of the currency, causing it to fall in value compared to stronger or more stable currencies. Consequently, it is anticipated that inflation will generally lead to a decrease in currency exchange rates in relation to other currencies. This understanding helps contextualize why currency exchange rates are likely to fall during inflationary periods.