Question

It has been abundantly demonstrated that nominal interest rates, exchange rates, and inflation are very tightly linked. In Italy, during the 1970s and 1980s, the inflation rate of the Italian lira was very erratic, changing each year in a range of 7% to 20% per year. Predict the effect on Italy's nominal interest rates and its exchange rates with other nations during that period.

Answer 1

Indeed, inflation is closely related to interest rates and exchange rates, since it is ultimately the loss of value of a currency.

Regarding nominal interest rates, the higher the inflation, the higher the interest rates. This is so because it seeks to cover the loss of value generated by inflation through the interest generated by investments, with the aim that they do not leave the country. Therefore, in the case of the Italian lira, if it had an inflationary rate of between 7% and 20%, interest rates would probably be around 10% and 25%.

At the same time, inflation also affects exchange rates, as this process breaks price parity and generates an imbalance between currencies. Thus, using US dollars, if a product is worth 100 lire and the exchange rate is 100 lire for one dollar; In the case of 20% inflation, the most logical thing would be for the exchange rate to move in the same direction: it would be 120 liras for 1 dollar.