Of Exchange Rates, Interest Rates and Inflation

The rupee has breached 41 against the dollar after many years now and the RBI is not doing what it is best at, which is going in the market and buying dollars to maintain a comfortable exchange rate.

What is stopping the central bank from doing this, is the inflation rate. Which is already quite perturbing for all politicians, some economists and quite certainly RBI.

The rupee to dollar rate is decided by the relative demand and supply between the two, so historically whenever the RBI wanted to push the price of the dollar higher, it used to go out in the market and buy dollars using rupees. This ensured that the relative demand of dollar became higher vis-a-vis the rupee.

What this would also imply is that the supply of rupees in the economy became greater. And greater money supply causes higher inflation in the economy. Simply put, if earlier there were a thousand rupees in the economy, and now the supply is equal to a couple of thousand rupees the value of a single rupee halves (ceteris paribus of course). In case you are wondering how the thousand became two thousand, unlike you and me, RBI can pretty much print money and circulate in the economy jacking up the monetary base of the economy or what is called in Economics text books as – too much money chasing too few goods.

The other major head-ache that RBI has is to control what is now started being referred as over-heating of the Indian economy. The most potent weapon for controlling the over-heating was to increase the interest rates and making borrowing costly and slowing down the investment and consumption in the economy.

However the central bank has avoided this measure as well because higher interest rates offered by domestic banks are enticing NRIs and other institutions to deposit the dollar holdings that they have in India. What that means is that there would be more dollars in the Indian economy weakening the dollar further and then the RBI would have to print more rupees to buy more dollars and in the process push the inflation higher as well.

It is a tricky situation that is being faced by RBI and one that is being dealt with using a different nature of solution this time around that of allowing more dollar investments by Indian companies and Indian individuals and other factors which look at pushing out dollars from the economy. However by its very nature this measure is more longer term than the previous short term measures and hence the current exchange rate.

Whether the new exchange rate is a temporary phenomenon or Indian exporters will have to adjust to lower realizations is anybodys guess. For now it seems that most of the Indian companies focusing on export revenues will bear this brunt in fiscal 2007 – 08.

Manshu Verma

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