What role does inflation play in currency exchange rates?

Inflation can significantly impact currency exchange rates, primarily through its effect on purchasing power and overall economic stability. When inflation rises in one country relative to another, the currency of the country experiencing higher inflation tends to devalue. This happens because increased prices reduce the currency's purchasing power; therefore, it takes more of that currency to buy the same goods and services as before.

Investors and traders in the foreign exchange market respond to these changes in purchasing power by moving their investments to countries with lower inflation rates, as they seek to preserve the value of their investments. Consequently, an increase in inflation can lead to a decline in demand for a country's currency, causing its value to drop in comparison to others. This relationship highlights how inflation can lead to a devaluation of a currency, making it the correct explanation in this context.