The Vicious Circle of Inflation and Depreciation

Abstract

The increasing frequency of interacting episodes of inflation and depreciation in many industrial countries since the adoption of floating exchange rates has prompted the concern that exchange-rate flexibility is liable to cause vicious (or alternatively, virtuous) circles. The vicious circle hypothesis states that a floating exchange-rate regime, in allowing a higher rate of domestic inflation than prevailing abroad, could set in motion a cumulative, self-reinforcing process leading to a vicious circle between currency depreciation and inflation. It is argued that exchange-rate fluctuations, arising from real or monetary causes, could sponsor disequilibrating changes in domestic costs, wages and prices which, in turn, are apt to induce further changes in the exchange rate. A depreciation of the domestic currency initially aggravates the rate of domestic price inflation through an immediate rise in the price of traded goods expressed in domestic currency, which is quickly fed into the domestic price level. This inflation, in turn, requires a depreciation of the exchange rate, which causes further inflation.