The exchange rate channel has an impact on inflation partly because imported inflation is affected by a change in the exchange rate and partly because the krona exchange rate influences exports and imports, and thereby also demand for Swedish goods.
Normally, an increase in the repo rate leads to a strengthening of the krona. In the short term, this is because higher interest rates make Swedish assets more attractive than investments denominated in other currencies. The result is a capital inflow and increased demand for kronor, which strengthens the exchange rate.
Monetary policy also plays an important part for the exchange rate in the long term. By definition, the exchange rate is the price of a country’s currency expressed in terms of another country’s currency, which means that it is affected by differences in inflation between countries. Tighter monetary policy means lower inflation, which in the long run can be expected to be reflected in a stronger exchange rate.
A stronger exchange rate – an appreciation – has an impact on the economy in two main ways. First, foreign goods become cheaper compared with domestically produced goods. This leads to a rise in imports and a decline in exports. Lower demand for domestic goods contributes to a reduction in resource utilisation and dampens inflationary pressure.
Second, the exchange rate affects inflation through changes in the krona prices of goods for cross-border trade. Firms that import goods to Sweden pay a lower price in kronor for their imports. In this way, an appreciation tends to lower the inflation rate, since imported goods and import-competing goods become cheaper. This reinforces the dampening effect on inflation of falling demand.