How does inflation generally affect currency value?

High inflation typically devalues a currency because it erodes purchasing power, meaning that each unit of currency buys fewer goods and services over time. When inflation rises, it often signals that the economy is experiencing instability, which can lead to a lack of confidence among investors and consumers. This decreased confidence can result in investors seeking to sell off their holdings in the affected currency, leading to a reduction in its value on the foreign exchange market.

Additionally, when inflation is high, central banks may respond by raising interest rates to curb inflation. However, if inflation remains persistently high despite these efforts, it can result in sustained depreciation of the currency. Countries with higher inflation rates compared to their trading partners will typically see their currency weaken relative to those with lower inflation.

Understanding this relationship is crucial in foreign exchange and economic analysis, as fluctuations in currency values can have widespread implications for trade balances, investment flows, and economic growth.