Interrelationships Between Inflation Rate, Exchange Rate, Interest Rate and Current Account Balance (AS Economics)

Question from a student of mine: Can you please explain the interrelationships between inflation rate, exchange rate, interest rate and current account balance?

a) Inflation rate and exchange rate

A country has relatively higher rates of inflation --> home-made goods become less price competitive in both domestic and international markets --> rise in imports and fall in exports --> increase in the supply of local currency & fall in the demand for local currency to facilitate transactions --> excess supply --> currency depreciation

b)  Exchange rate and inflation rate

Currency depreciation --> imported raw materials, semi-finished goods and finished goods become artificially more expensive --> increase in the costs of production --> leftward shift of SRAS --> an increase in general price level --> rise in cost-push inflation

Currency depreciation --> local goods become artificially cheaper in international market and foreign goods become artificially more expensive for domestic market --> assuming PEDx > 1 and PEDm > 1, export value would increase while import value fall --> rise in net exports --> rightward shift of AD --> increase in general price level --> higher demand-pull inflation

c) Inflation rate and interest rate

An increase in the rates of inflation --> exceeded the targeted level --> monetary authority would have to intervene pre-emptively --> raise interest rates to slow down economic activities

d) Interest rate and inflation rate

Higher interest rates --> cost of borrowing will increase --> households and firms will reduce spending into the economy --> fall in AD --> decline in price level --> reduce demand-pull inflation

e) inflation rate and current account balance

Relatively higher inflation rates --> home-made goods become less price competitive in both domestic and international markets --> assuming that PEDx > 1 and PEDm > 1, value of exports would fall while value of imports rise --> worsening of current account balance

f) Current account balance and inflation rate 

Say, if a country has current account deficit --> value of imports is greater than the value of exports --> a decline in net exports --> lower AD --> fall in average prices --> lower demand-pull inflation

g) Exchange rate and interest rate

Currency depreciation --> imported raw materials, semi-finished goods and finished goods would become artificially more expensive --> an increase in costs of production --> fall in SRAS --> rise in general price level --> triggers cost-push inflation --> if this exceeds the targeted inflation rate, then monetary authority may have to intervene by raising interest rates

Currency depreciation --> local goods would become artificially cheaper in international markets while foreign goods would become artificially more expensive in domestic market --> assuming PEDx > 1 and PEDm > 1, value of exports would increase while imports fall --> higher net exports --> rise in AD --> higher price level --> triggers demand-pull inflation --> if this exceeds targeted rate of inflation, then the central bank may have to raise interest rates

h) Interest rate and exchange rate

An increase in interest rates --> commercial banks and financial institutions offer higher rates of return on savings --> attract very wealthy foreigners and pension funds to deposit/ save money in this said country while at the same time there will be lesser outflows of hot money --> demand for local currency would increase while supply of local currency in money market would fall --> excess demand causes appreciation

i) Exchange rate and current account balance

Currency depreciation --> foreign goods become artificially pricier in domestic market while local goods cheaper in international markets --> assuming that the both exports and imports are price elastic in demand --> value of exports would increase while imports fall --> net inflows of money --> improvement in current account balance

j) Current account balance and exchange rate

Say, a country has current account deficit --> imports are greater than exports --> supply of local currency would increase while demand for local currency to facilitate transactions would fall --> excess supply causes depreciation

k) Interest rate and current account balance (has two possibilities where one can become the evaluation of the other)

Rise in interest rates --> higher cost of borrowing --> spending by households and firms into the economy would fall including buying imports --> lesser outflows of money --> improvement in current account balance

Rise in interest rates --> rise in inflows of hot money while a fall in outflows of hot money --> demand for local currency increases while its supply falls --> excess demand leads to appreciation --> foreign goods eventually become more price competitive --> buy more imports --> worsening of current account balance (assuming imports are price elastic in demand)

l) Current account balance and interest rate

Say, a country has large and persistent current account deficit --> value of imports is greater than value of exports --> fall in net exports --> leftward shift of AD --> fall in general price level --> lower demand-pull inflation --> may fall below targeted rate of inflation --> monetary authority may be forced to cut interest rates pre-emptively

This should be a comprehensive guide. Do use it wisely and please refrain yourself from memorising them at all costs! Think logically :)