It is argued that a strong dollar attracts foreign capital and investment enhancing domestic output and supply and thereby lowers the inflation. Since imports constitute a significant percentage of US GDP, a strong US dollar is also expected to lower the cost of imports and thereby US inflation. Also, a relatively high interest rate lowers the domestic private investment and consumer spending especially on durable goods and thereby the aggregate demand, which in turn lowers the rate of inflation. However, an appreciation of the dollar increases capital inflow and raises the Fed’s monetary base, which in turn increases the money supply and thereby the price level causing inflation. To find out which channel of influence dominates the other, we applied the vector error correction model with inflation rate (INF) as the dependent variable and change in US dollar index (š¯›æUSDX) as the independent variable. We find that when US dollar index rises by one percent, US inflation rate falls by 0.13 percent in the long run but any movement in US dollar index has no impact on US inflation rate in the short run.
