Explain how exchange rates adjust to inflation

What will be an ideal response?

An important component of the concept of purchasing power parity is that exchange rates adjust to different rates of inflation in different countries. Such adjustment is necessary to maintain purchasing power parity between nations. Suppose that at the beginning of the year the exchange rate between the Mexican peso and the U.S. dollar is 8 pesos/$ (or $0.125/peso). Also suppose that inflation is pushing consumer prices higher in Mexico at an annual rate of 20 percent, whereas prices are rising just 3 percent per year in the United States. To find the new exchange rate (Ee) at the end of the year, the following formula can be used:
Ee=Eb(1+i1)/(1+i2),
where Eb is the exchange rate at the beginning of the period, i1 is the inflation rate in country 1, and i2 is the inflation rate in country 2. Plugging the numbers for this example into the formula, gives the following value: Ee=8pesos/$[(1+0.20)/(1+0.03)]=9.3pesos/$
Because the numerator of the exchange rate is in pesos, the inflation rate for Mexico must also be placed in the numerator for the ratio of inflation rates. Thus, it can be noticed that the exchange rate adjusts from 8 pesos/$ to 9.3 pesos/$ because of the higher inflation rate in Mexico and the corresponding change in currency values. Higher inflation in Mexico reduces the number of U.S. dollars that a peso will buy and increases the number of pesos that a dollar will buy. In other words, whereas it had cost only 8 pesos to buy a dollar at the beginning of the year, it now costs 9.3 pesos.
For example, companies based in Mexico must pay more in pesos for any supplies bought from the United States. But U.S. companies will pay less, in dollar terms, for supplies bought from Mexico. Also, tourists from the United States would be delighted, as vacationing in Mexico becomes less expensive, but Mexicans will find the cost of visiting the United States more expensive.
This discussion illustrates at least one of the difficulties facing countries with high rates of inflation. Both consumers and companies in countries experiencing rapidly increasing prices see their purchasing power eroded. Developing countries and countries in transition are those most often plagued by rapidly increasing prices.