Inflation, Interest Rates, and Exchange Rates

Relative inflation rates or the rates of inflation in foreign countries compared with that in the home country, have many implications for multinational financial decisions. Obviously, relative inflation rates will greatly influence future production costs at home and abroad. Equally important inflation has a dominant influence on relative interest rates and exchange rates. Both of these factors influence the methods chosen by multinational corporations for financing their foreign investments and both have an important effect on the profitability of foreign investments.

The currencies of countries with higher inflation rates than that of the United States by definition depreciate over time against the dollar. Countries where this has occurred include France, Italy, Mexico and all the South American nations. On the other hand the currencies of Germany, Switzerland, and Japan, which have had less inflation than the United States, have appreciated against the dollar. In fact, a foreign currency will, on average, depreciate or appreciate at a percentage rate approximately equal to the amount by which its inflation rate exceeds or is less than our own.

Relative inflation rates also affect interest rates. The interest rate in any country is largely determined by its inflation rate. Therefore, countries currently experiencing higher rates of inflation than the United States also tend to have higher interest rates. The reverse is true for countries with lower inflation rates.

It is tempting for a multinational corporation to borrow in countries with the lowest interest rates. However this is not always a good strategy. Suppose for example, that interest rates in Germany are lower than those in the United States because of Germany’s lower inflation rate. A U.S. multinational firm could therefore save interest by borrowing in Germany. However, because of relative inflation rates, the mark will probably appreciate in the future, causing the dollar cost of annual interest and principal payments on German debt to rise over time. Thus, the lower interest rate could be more than offset by losses from currency appreciation. Similarly, multinational corporations should not necessarily avoid borrowing in a country such as Brazil, where interest rates have been very high, because future depreciation of the Brazilian cruzeiro could make such borrowing end up being relatively inexpensive.