How inflation in China makes real exchange rate between China and US to rise?
Chinese currency is not freely convertible. Its exchange rate is not determined by the market but rather by the Chinese government. Thus the counter-intuitive result. In essence, the Chinese government is subsidizing exports (which is reasonable since exports is what drives the Chinese economy).
"Where goes the Delta? To the sea, of course.  Your question is very valid and for once, I think most of the answers are too involved into mechanical details and are badly missing the big picture.  At the risk of over simplifying things, let me try to describe the situation in broad strokes: Inflation: the volume of money grows faster than production (including services).  Deflation: production increase faster than the volume of money.  Imagine an economy with 10 products and $10. 1 product = $1. In an inflationary scenario, money available increase: $20 for 10 products. 1 product = $2.  In a deflationary scenario, money available decrease: $5 for 10 products. 1 product = $0.5.  So far, it's pretty textbook. Now onto the stuff that you don't usually read in textbooks: Time.  Say 10 people are attending an auction, each with $10 bucks. 10 items are for sale. $100 and 10 items. Item price is $10. Now, if just before opening the bidding, you go around and give each person $40, every one has $50. Each product sells for $50. That's the picture people have of inflation. Prices have increased, but everybody has more money, so it comes down to the same thing.  Now, let's bring this example closer to reality: You have to distribute $400, so the total amount of money is $500, which means that the normal price of each item should be $50. Now, imagine that instead of giving money to everyone at the same time, you started by giving $40 to 1 guy who was hanging out in front. The auction starts. While you go around distributing the money, the first guy manages to buy 2 items at $10 each. Now, there is $480 in the market, and only 8 items, making each item $60 on average. The next guy to get money manages to snap 2 items at $15. 6 items left and $450 in play. Each item now costs $75....and keep increasing in price as things move along. People who get the money early buy items under their real value, and people who get paid at the end pick up the tab, because by then, there are only a few items left. Back to reality, while inflation means that wages eventually increase (and they do), actual purchasing decrease for most people due to this simple trick. Employees are pretty much at the end of the chain. Income tax Another major source of ""signal loss"" is income tax. It works by brackets, as you certainly know. Simplifying again because I am lazy: Take a guy who earns $100. Pays no taxes. Can buy 100 products at $1 each. Now, put in some inflation... He earns $500. He pays $50 in taxes and can buy 90 products at $5 each. By the time he earns $10,000, he can only buy 50 products on account of income tax. So this is another area where you are bleeding purchasing power, and why income tax, which was originally presented as a tax for the ultra-rich is now a fact of life for most people (except the ultra-rich, of course).  Money as debt Next stop: Money itself. Money is created as debt in our society. At the risk of over-simplifying things again, let's say Bank A has $1000 in assets. In the fractional reserve system (our current system), Bank A can lend out many times over that amount. Let's say $9,000, for a total of $10,000 (much more in reality). And of course, it lends that money at interest. When bank A has made $10,000 available through 10% interest loans, the total amount of money has increased by $10,000, but when the loans are paid back, $11,000 must be paid to the bank, so the net result of the operation is that $1,000 get taken out of the market.  This system explains why almost all companies and governments have huge debts, and why most of the world's large companies belong to financial institutions of some kind, and why most of the world's wealth rest in very very few hands.  To fully answer your question and provide details and references and names, one would have to write a book or 5. There is a lot more than can be said on the subject, and of course, all the examples given here are extremely simplified, but I think they illustrate the key issues pretty well.  Bottom-line is that our system is designed that way. Our economic system is rigged and the delta bleeds out on automatic." The measure of change of value of a currency in relation to itself is inflation (or deflation). Inflation is theft!  It is caused when banks lend money that someone deposited, but still has claim to - called fractional reserve banking.   On top of that, the Federal Reserve Bank (in the US) or the Central Bank of the currency (i.e. Bank of Japan, European Central Bank, etc.) can increase the monetary base by writing checks out of thin air to purchase debt, such as US Treasury Bonds. Inflation is not a natural phenomenon, it is completely man-made, and is caused solely by the two methods above. Inflation causes the business cycle.  Lower interest rates caused by inflation cause long-term investment, even while savings is actually low and consumption is high.  This causes prices to rise rapidly (the boom), and eventually, when the realization is made that the savings is not there to consume the products of the investment, you get the bust. I would encourage you to read or listen to The Case Against the Fed by Murray N. Rothbard - Great book, free online or via iTunes. The only reason inflation has yet to show in the CPI is because the dollar is the global reserve currency and is the best house in a bad neighborhood, but that just means the rest of the world is becoming poorer at the same time as the U.S. - QE was 4 trillion. That's a debasement of the currency even if, for the reason I've already stated, it's not reflected in CPI. As pointe out by @quid, inflation figures are almost always quoted as a comparison of prices last month, and prices a year ago last month.  So 10% inflation in August means that things cost 10% more than they did in August a year ago.  This can lead to some perverse conclusions. Consider an imaginary economy where prices stay constant over years.  Annualized inflation is zero. Then something happens on January 2nd, 2018.  Some crop fails, a foreign cheap source of something becomes unavailable, whatever.  Prices rise, permanently, as more expensive sources are used. This is the only disruption to prices. Nothing else goes wrong. So, in February, 2018, the authorities find that prices in January, 2018 rose by 1% over January 2017. Inflation! Politicians pontificate, economists wring their hands, etc. In March, again, prices for February, 2018 are found to be 1% higher than for February, 2017.  More wailing... This goes on for months.  Every month, inflation (year over year) is unchanged at 1%.  Everyone has a theory as to how to stop it... Finally, in February, 2019, there's a change!  Prices in January, 2019, were the same as in January 2018.  Zero inflation!  Everyone takes credit for bringing down inflation... The Hong Kong Dollar is based on the US dollar.  The Hong Kong central bank recognizes the US dollar as its reserve currency.  That is, the Hong Kong central bank keeps US dollars as its main reserve.  Not long ago the reserve currency of choice would have been gold.  Central banks of each country would need to have enough gold to back up any currency they issued.  Now central banks use the US dollar instead.  This is what is meant when people mention the US dollar being the reserve currency for most countries. From wiki regarding the HK dollar: A bank can issue a Hong Kong dollar only if it has the equivalent   exchange in US dollars on deposit. So you're assumption is correct: as the US Federal Reserve prints more money and that money finds its way to Hong Kong banks, the Hong Kong banks will be able to issue more Hong Kong dollars which will have an inflationary affect. What to do?  If you look around enough on this site you'll find some suggestions.  Here is one. Typically in a developed / developing economy if there is high overall inflation, then it means everything will rise including property/real estate. The cost of funds is low [too much money chasing too few goods causes inflation] which means more companies borrow money cheaply and more business florish and hence the stock market should also go up.   So if you are looking at a situation where industry is doing badly and the inflation is high, then it means there are larger issues. The best bet would be Gold and parking the funds into other currency. Yes - it's called the rate of inflation. The rate of return over the rate of inflation is called the real rate of return.   So if a currency experiences a 2% rate of inflation, and your investment makes a 3% rate of return, your real rate of return is only 1%. One problem is that inflation is always backwards-looking, while investment returns are always forward-looking. There are ways to calculate an expected rate of inflation from foreign exchange futures and other market instruments, though. That said, when comparing investments, typically all investments are in the same currency, so the effect of inflation is the same, and inflation makes  no difference in a comparative analysis.  When comparing investments in different currencies, then the rate of inflation may become important. "My answer is specific to the US because you mentioned the Federal Reserve, but a similar system is in place in most countries. Do interest rates increase based on what the market is doing, or do they solely increase based on what the Federal Reserve sets them at? There are actually two rates in question here; the Wikipedia article on the federal funds rate has a nice description that I'll summarize here. The interest rate that's usually referred to is the federal funds rate, and it's the rate at which banks can lend money to each other through the Federal Reserve. The nominal federal funds rate - this is a target set by the Board of Governors of the Federal Reserve at each meeting of the Federal Open Market Committee (FOMC). When you hear in the media that the Fed is changing interest rates, this is almost always what they're referring to. The actual federal funds rate - through the trading desk of the New York Federal Reserve, the FOMC conducts open market operations to enforce the federal funds rate, thus leading to the actual rate, which is the rate determined by market forces as a result of the Fed's operations. Open market operations involve buying and selling short-term securities in order to influence the rate. As an example, the current nominal federal funds rate is 0% (in economic parlance, this is known as the Zero Lower Bound (ZLB)), while the actual rate is approximately 25 basis points, or 0.25%. Why is it assumed that interest rates are going to increase when the Federal Reserve ends QE3? I don't understand why interest rates are going to increase. In the United States, quantitative easing is actually a little different from the usual open market operations the Fed conducts. Open market operations usually involve the buying and selling of short-term Treasury securities; in QE, however (especially the latest and ongoing round, QE3), the Fed has been purchasing longer-term Treasury securities and mortgage-backed securities (MBS). By purchasing MBS, the Fed is trying to reduce the overall risk of the commercial housing debt market. Furthermore, the demand created by these purchases drives up prices on the debt, which drives down interest rates in the commercial housing market. To clarify: the debt market I'm referring to is the market for mortgage-backed securities and other debt derivatives (CDO's, for instance). I'll use MBS as an example. The actual mortgages are sold to companies that securitize them by pooling them and issuing securities based on the value of the pool. This process may happen numerous times, since derivatives can be created based on the value of the MBS themselves, which in turn are based on housing debt. In other words, MBS aren't exactly the same thing as housing debt, but they're based on housing debt. It's these packaged securities the Fed is purchasing, not the mortgages themselves.  Once the Fed draws down QE3, however, this demand will probably decrease. As the Fed unloads its balance sheet over several years, and demand decreases throughout the market, prices will fall and interest rates in the commercial housing market will fall. Ideally, the Fed will wait until the economy is healthy enough to absorb the unloading of these securities.  Just to be clear, the interest rates that QE3 are targeting are different from the interest rates you usually hear about. It's possible for the Fed to unwind QE3, while still keeping the ""interest rate"", i.e. the federal funds rate, near zero. although this is considered unlikely. Also, the Fed can target long-term vs. short-term interest rates as well, which is once again slightly different from what I talked about above. This was the goal of the Operation Twist program in 2011 (and in the 1960's). Kirill Fuchs gave a great description of the program in this answer, but basically, the Fed purchased long-term securities and sold short-term securities, with the goal of twisting the yield curve to lower long-term interest rates relative to short-term rates. The goal is to encourage people and businesses to take on long-term debt, e.g. mortgages, capital investments, etc. My main question that I'm trying to understand is why interest rates are what they are. Is it more of an arbitrary number set by central banks or is it due to market activity? Hopefully I addressed much of this above, but I'll give a quick summary. There are many ""interest rates"" in numerous different financial markets. The rate most commonly talked about is the nominal federal funds rate that I mentioned above; although it's a target set by the Board of Governors, it's not arbitrary. There's a reason the Federal Reserve hires hundreds of research economists. No central bank arbitrarily sets the interest rate; it's determined as part of an effort to reach certain economic benchmarks for the foreseeable future, whatever those may be.  In the US, current Fed policy maintains that the federal funds rate should be approximately zero until the economy surpasses the unemployment and inflation benchmarks set forth by the Evans Rule (named after Charles Evans, the president of the Federal Reserve Bank of Chicago, who pushed for the rule). The effective federal funds rate, as well as other rates the Fed has targeted like interest rates on commercial housing debt, long-term rates on Treasury securities, etc. are market driven. The Fed may enter the market, but the same forces of supply and demand are still at work. Although the Fed's actions are controversial, the effects of their actions are still bound by market forces, so the policies and their effects are anything but arbitrary." I've always understood inflation to be linked to individual currencies, although my only research into the subject was an intro economics course in undergrad and I don't recall seeing why that would be the case.  I guess the basic principle is that currency traders are watching the printing presses and trading in exchange markets to the point that the exchange rates fall in relation to increases in money supply. There's probably something about the carry trade in there as well, but it's late and I took some medications, so someone else will have to carry that torch. I must admit I've not really paid attention to foreign currencies like HKD, but the proximity and political relationship with China probably greatly complicates your question, since part of the problem has been China's currency peg. Rates are arrived at by the cumulative buying and selling on the foreign exchange market, much the same way that stock prices are arrived at.  If there are more people wanting to buy dollars with euros, EUR/USD goes down.  If more people want to buy euros with dollars, then EUR/USD goes up. The initial rate was about $1.18 per euro when it began trading on January 1st, 1999.  It replaced the European Currency Unit at that time, which was a weighted basket of currencies of (more or less) the participating countries. You're correct about the printing press in the US and other countries.  The exchange rates do reflect in part how much of a relative workout those printing presses get. I don't think this can be explained in too simple a manner, but I'll try to keep it simple, organized, and concise. We need to start with a basic understanding of inflation. Inflation is the devaluing of currency (in this context) over time. It is used to explain that a $1 today is worth more than a $1 tomorrow. Inflation is explained by straight forward Supply = Demand economics. The value of currency is set at the point where supply (M1 in currency speak) = demand (actual spending). Increasing the supply of currency without increasing the demand will create a surplus of currency and in turn weaken the currency as there is more than is needed (inflation). Now that we understand what inflation is we can understand how it is created. The US Central Bank has set a target of around 2% for inflation annually. Meaning they aim to introduce 2% of M1 into the economy per year. This is where the answer gets complicated. M1 (currency) has a far reaching effect on secondary M2+ (credit) currency that can increase or decrease inflation just as much as M1 can... For example, if you were given $100 (M1) in new money from the Fed you would then deposit that $100 in the bank. The bank would then store 10% (the reserve ratio) in the Fed and lend out $90 (M2) to me on via a personal loan. I would then take that loan and buy a new car. The car dealer will deposit the $90 from my car loan into the bank who would then deposit 10% with The Fed and his bank would lend out $81... And the cycle will repeat... Any change to the amount of liquid currency (be it M1 or M2+) can cause inflation to increase or decrease. So if a nation decides to reduce its US Dollar Reserves that can inject new currency into the market (although the currency has already been printed it wasn't in the market). The currency markets aim to profit on currency imbalances and in reality momentary inflation/deflation between currencies. Because we need energy in the form of oil.  If more of our money is spent on oil, there is less money to spend on other items especially luxuries like dining out and new cars (ironically) Since there is less money available, the price of other things shift with it and the whole economy moves.  Since less money is available, the value of a single dollar goes up. Basically, it is because we as a species (let alone nations) are unbelievably dependent on having oil at this point in our existence. How do currency markets work? What factors are behind why currencies go up or down? "Wikipedia talks about the Chinese currency: Scholarly studies suggest that the yuan is undervalued on the basis of purchasing power parity analysis. so despite it appearing cheaper due to the official exchange rate, the price in China might actually be fair. There are also restrictions on foreign exchange (purportedly ""to prevent inflows of hot money""), which, in concert with any other legal obstacles to owning or trading on the Chinese exchange, may also explain why the high-frequency traders aren't tripping over each other to arbitrage away the difference." Heh, Argentina's inflation numbers these past few years are [basically lies](http://en.mercopress.com/2012/02/02/imf-warn-argentina-on-lack-of-progress-in-addressing-inflation-data). The IMF data is based off of this data, so it doesn't prove what you think it proves. Not to say they haven't done okay, but when they've done well it's been purely because of China's demand for natural resources.