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Photo: Mint

RBI looks to tame inflation with a stronger rupee

The RBI hinted that allowing the rupee to strengthen could help India deal with imported inflation. The rupee has been gaining strength over the past few weeks and, unlike before, RBI has let it appreciate. Mint looks into the matter in detail.

The Reserve Bank of India hinted that allowing the rupee to strengthen could help India deal with imported inflation. The rupee has been gaining strength over the past few weeks and, unlike before, RBI has let it appreciate. Mint looks into the matter in detail.

How are the exchange rates determined?

There are two kinds of exchange rates—floating and fixed. A floating rate is determined on the basis of market forces of demand and supply in the global currency markets. Fixed exchange rates are usually determined by the government through the central bank. India initially had a fixed exchange rate pegged to the pound sterling, which shifted to a basket peg during 1970s and 1980s and now follows the market-determined exchange rate system. However, the Reserve Bank does intervene from time to time to ensure stability of the exchange rate, given India’s high dependence on imports.

Why is the rupee gaining strength?

The reason behind the rupee’s sudden appreciation is the extent of foreign capital that is coming in, in the form of both institutional and direct investments (FIIs and FDIs). Foreign investors have been keen to invest in the Indian market which has resulted in huge dollar inflows. However, despite these high inflows over the last few months, the rupee did not gain much value because the central bank regularly bought dollars through state-run banks to avoid appreciation of the rupee. However, over the last few days, RBI has effectively stopped this purchase, thus allowing the rupee to appreciate.

Gaining streak
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Gaining streak

How do we define concept of imported inflation?

Imported inflation is the sudden rise in prices due to a rise in the cost of imports, on the back of inflation in the exporting country or a hike in custom duties. There has been a steady hike in Indian duties with the government trying to protect the domestic industry. RBI recently stated that rupee’s appreciation could help keep price pressures and imported inflation in check.

What exactly is the impossible trinity?

RBI’s actions seem to indicate that it has given up on maintaining a stable rate of the rupee which benefits exporters as it tries to allow for capital mobility and maintain its domestic monetary policy. This is known as the impossible trinity in international economics—where a central bank cannot simultaneously have a fixed exchange rate, a sovereign monetary policy and free capital mobility. By allowing the rupee to appreciate, RBI has has hinted at its willingness to look at exchange rates to ward off inflationary stress.

Why is exchange rate used against inflation?

The typical policy instrument used by RBI or the Monetary Policy Committee to target inflation is interest rates. However, increasing interest rates at a time when the economy is contracting can have catastrophic effects. This ties the hands of RBI as it attempts to fight inflation while supporting revival. By allowing rupee to appreciate, it is allowing imports to become cheaper which could offset the impact of an increase in duties or any inflationary pressures in the global market on India’s inflation.

Karan Bhasin is  a  policy researcher.


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