Impact of Inflation on Exchange Rates in Switzerland
The intensity to which globalization is taking place has greatly increased over the past years. This has been geared by several factors that favour international trading activities and investments(Engel et al., 2017). As the sole objective of many firms is to make the maximum profit, therefore, it has been of great benefit to the firms involved in the international trading system. However, the government has been able to facilitate such activities by the removal of the bottlenecks that would deter another international firm to carry out trading activities the certain economies.
It has been achieved by the removal of trade barriers by the government. The trade barriers include the tariffs and quotas which eventually have facilitated trading between various countries. However, there are several spillovers that affect the international market in relation to the exchange rates (Thomas, 2015). The international trading system thus can affect a country’s national income and such cases should be examined by the affected countries in order to combat unfavourable terms of trade. For instance, increasing income rates implies that there is an increase in the consumer goods and thus increase in imports. Switzerland having an ardent connection with the international national is exposed to such effects of spillovers (Jordan, 2010). Consequently, government interventions and the national income greatly affect the international trade. In the attempt to correlate such factors, the inflation and the exchange rates also show some relations.
When there is inflation in a country, it implies that there is the rise in the currency value as the purchasing power goes higher in comparison to the foreign currencies(Oliver, 2017). Depreciation or appreciation of the commodities to be exported would determine whether the price of goods would be expensive or less expensive. In comparing imports and exports, the imports are thus higher than the exports as the value of the country’s commodities go higher, therefore, the goods of the country become less competitive and the demand goes down (Hwang, 2007). The increase of the imports leads to a devaluation of the currency and thus reduction of the monetary value. The economy would thus be driven into a state of low income from the exports which may serve greatly the source of income. Consequently, changes in the inflation rates would lead to changes in the exchange rates between the trading countries (Thorbecke, 2017). Inflation thus has a great impact on the value of the currency and the rate of foreign exchange (Moore, 1995). It, therefore, serves as one of the factors that influence a country’s exchange rates. Significantly, it has a negative impact rather than a positive result on the exchange rate and the country’s currency value(Friedman, 2017).
The government and the international companies, therefore, would impose a common exchange rate to combat the disparities in the inflation rates as experienced by the various countries. This is to ensure that a country’s currency is of value in relation to other foreign currencies to encourage the bilateral and multilateral trading transactions (Thorbecke, 2017). The prices of commodities are thus affected in the adoption of the common exchange rates as the countries facing inflation would have a depreciating price of goods and hence devaluation of the currency. However, the affected government may tend to increase interests rates in order to attract foreign investors and would lead to the demand of the country’s currency (Sato, 2013). This presents a direct way in which inflation affects the exchange rates.
However inflation has an impact on every determinant of the exchange rates and thus it also affects the government interventions(Parsva and Lean, 2017). For instance, the governments involved may adopt certain policies such as fixed exchange rates in order to combat the effects of the inflation. As the effects are slowly regained, the affected countries become more stable in terms of their currency. In the estimated inflation in Mexico, because of the slow adjustment nature of inflation, it would result in an elevated real exchange rate (Circarelli, 2010). There is a strong connection between the interest rates and inflation. In a country where there is inflation the government, may tend to increase the interest rates in order to stabilize the purchasing power and attract foreign investors hence increasing the demand for the currency of that particular country. This would finally result in the appreciation of the country’s currency. When the interest rates are low the country’s currency may lose value as compared to the other foreign currencies hence the government may intervene in such cases (Jon, 1980).
The relation between the exchange rates and inflation is essential in the determining the terms of trade between the trading partners. These two related items, however, determine whether the terms are trade is favourable or not as they may worsen or make better the terms of trade. To impose a change in the exchange rates, the government may decide to adopt either a fixed exchange rate or a flexible exchange rate (Rodrick, 2008).
The terms of trade as used in the assessing of the performance of the economic growth of a country is based on the value of imports and exports. The fixed exchange rates comply with the same conditions as the Marshal’s conditions in the terms of trade. This implies that when the terms of trade are favourable then there is an increase in the value of exports as compared to the imports and vice versa (Marshall, 2005). However, this would not cause an increase in the current account when the elasticities are high. On the contrary, when there are low terms of trade (there are more imported products than exports) would increase the current account when the elasticities are maintained high (Calvo and Reinhart, 2002). The fixed exchanges are recommended for the young growing economies as they may not benefit from the benefits accrued by the flexible exchange rates due to lack of reliable governments. The fixed exchange rate serves a means of stabilizing the economies (Barro, 1985). Therefore the central bank imposes a fixed rate that provides a ground for the countries undergoing inflation to regain their economic value. The fixed exchange rates also help to reduce unpredictable fluctuations in the currency thereby providing a reliable and a more predictable system. This eventually motivates exporters and the investors as it even maintains the inflations at lower levels. These rates also help maintain a stable current account (Thorbecke, 2017).
Flexible exchange rates are mainly adopted through government intervention in order to provide a favourable term of trade. When the terms of trade are low, the firms will tend to lower the price of their commodities hence lower prices of exports than imports and when the terms of trade are high, the government would apply an appreciation in the price of the exports which results in increased prices of exports than the imports (Miller, 1998). The flexible exchange rates, therefore, provide a country to seek an independent monetary system.
However, there are several benefits that are accrued upon adoption of a flexible exchange rate. The greatest benefit of the flexible exchange rate is that it allows a country to adopt an independent monetary policy instead of being constrained by the fixed exchange rates. In cases of global inflation, therefore, it the country will be able to avoid a state of recession by applying to the flexible changes. (Meande, 1951) , the developing countries have been able to use the flexible rates effectively hence avoiding trade shock. They argue that the deliberate changes in the external market do not affect these countries since they are able to adjust to the changes.
In accessing the economic production of a country, it is expedient to take in notice the fluctuations in the exchange rates (Thorbecke, 2017).the economy of Swiss has greatly changed since 2007. Switzerland has a population of about 8.1 million and a Gross Domestic Product of 684.4 billion dollars per capita is ranked among the countries with high per capita income. Switzerland majors in the production of sophisticated products, maintain low inflation and shows a positive progress in wealth managed hence being ranked the 10th country with the largest GDP (Thorbecke, 2017). Switzerland has a widespread trade link all over the world. The goods and services exported account for about half its gross domestic product. The exporters having known the market trends they have come up with innovative ideas and entered new markets.
Consequently, real and financial connections are both responsible for the dynamics of inflation in Switzerland and therefore the monetary poly system(Eichenbaum et al., 2017). The changes in exchange rates that arise due to inflation can, therefore, be obtained by deducting the real exchange rate from the nominal exchange rate. The appreciation value which has been by 50% over the past years (FT, 2016), is therefore calculated from the nominal one. This shows that the appreciation value that does not account for inflation has been above 20%. This has seen Switzerland undergoing a tranquil inflation as compared to other foreign countries in Europe(Bhatnagar et al., 2017).
However, the state has enjoyed a long period of low inflation rates between 1994 to mid-2008, marked by a worldwide decline in inflation with little success by the central banks in ensuring price stability. Amid the short-lived imported goods inflation, the country remained favourably volatile but later was less persistent (Thomas, 2015). The financial crisis began after 2008 and the SNB, therefore, reduced the interest rates to lower levels in order to improve the monetary conditions. However this period the worldwide inflation has greatly reduced and in Switzerland adopted measures to mitigate global effects of inflation. During the crisis period, the SNB domain has been narrowed continuously for gearing monetary policies through the interest rates. This was achieved through monetary policy around the world.
However, the small economies like Switzerland have often been faced with the challenge of monetary policy between the open capital accounts and the independence on the other side amid application of the flexible exchange rates (Rey, 2015). Rey argued that the worldwide financial cycle often affects the monetary policy in the small open economies. Although the global inflation has been in quiescent over time, there has been very low positive rates of inflation in Switzerland. Kaufman and Egger (2014) noted that frequent price reductions to increase after inflation rate had gone down to zero. The pattern of price flexibility has however been found crucial in the reduction of the inflation rates thereby strengthening of the Swiss franc.
In assessing the correlation between the exchange rates and inflation, the two are found to have a weaker correlation as the exchange rates do not solely influence the inflation rates in Switzerland. The stability of Switzerland was mainly attributed by the foreign investors who invested heavy initial capital in the country thus making it stable(Aldcroft, 2017). Therefore this has often led to the demand of the Swiss franc despite the rise in inflation in other countries. The Switzerland economy thus has attained the success in stability by adopting of the flexible exchange rates(Ilzetzki et al., 2017).
The Swiss franc has also ensured achieving of economic balance even when there is a global inflation. Consequently during the period of economic crisis, 2003 to 2008, the depreciation did not affect the Swiss franc but rather boosted sales (exports) thereby causing a massive surplus to other economies. This lead to great demand for the Swiss franc. This also encouraged foreign investments and by so lead to increase in monetary value of Switzerland. Increasing demand for the Swiss franc, however, has facilitated innovation drives that have resulted in the competitiveness of the various firms hence availing more surplus (Thomas, 2015). This has ensured that even in appreciation the Swiss franc is maintained at an equilibrium.
Based on the economic status of Switzerland, the sophisticated exports which ensure maximum profit and stock return. Based on the (Haussmann 2002) methods, Switzerland has the best export structure in the world even in the preceding years. Therefore in terms of sophistication, the watches and pharmaceutical products are ranked to be the first and third product. In 2014, 41% of the exported products were found to be among the sophisticated products. Therefore no record of threat has been noted in examining the exports and the returns obtained. The inelasticity of the products of Swiss has enabled the firms in Switzerland to rule out inflation. Although the prices of commodities may go high due to appreciation for inflation effects from other countries does not affect the value of Swiss franc.
Regression analysis also shows that appreciation by 10% of the Swiss nominal exchange rate leads to a decline in the price of the capital goods exported by 4%. However, these do not affect the Swiss franc especially to the companies that produce high technology products such as watches. It does not even affect the pharmaceutical companies in comparison to euro. This shows that the Swiss franc can still maintain a stable equilibrium despite inflation. The chart below shows the nominal and effective exchange rate of Switzerland in comparison with trading partners(Engel et al., 2017).
In conclusion, the exchange rates even though it affects the inflation does not apply the same as compared to Switzerland. However, the exchange rates are of great importance to the economy of Switzerland in dealing with these products(Bhatnagar et al., 2017). Over the past, the inflation rates in Switzerland has been reported low as opposed to the constantly changing exchange rates. In the attempt to curb inflation firms in the various economies should be able to adjust according to the situations. Switzerland, however, has proven flexible by adjusting quickly on several occasions as seen in the past years.
Production of inelastic products has also contributed to the success of Switzerland. These are due to price inelasticity of the products produced. In collaboration with the innovations that are currently going, it ensures that the firms that are involved in production in Switzerland remain to be competitive. The innovations also help in ensuring availability of surplus goods that are ready for exports.
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