Friday, September 16, 2016

Arriving at the correct value of the rupee

by Ajay Shah.

A recent front page story in the Indian Express came as a surprise examination for many economists in India. When currency policy is proposed, four ideas are useful:

  1. Nobody knows what is the correct exchange rate. Asking a government official the correct price of the rupee is as pointless as asking him the correct price of steel or the correct level of Nifty.
  2. We were once in a complicated world where RBI openly said that it had no framework. RBI governors heard pleas from importers and exporters, played favourites, and earned political capital. That period (1934-2015) is now behind us. Now, for the first time, RBI is accountable. It has an objective: inflation. The instrument (control of the policy rate) is used up in giving us the outcome (4% inflation).
  3. Chasing an exchange rate objective can lead to small problems (e.g. the exchange rate management of 2002-2007 kicked off an inflation crisis from 2006) or big problems (the rupee defence of 2013). Wisdom in public policy involves avoiding such adventurism.
  4. While an inflation targeting central bank should not pursue exchange rate policy, the exchange rate is an important input for an inflation targeting central bank. Changes in the exchange rate feed into domestic inflation through the price of tradeables. Thus, changes in the exchange rate are a useful input for forecasting inflation. The essence of good monetary policy is forecasting inflation [example]. RBI should consume the exchange rate, made by the market, as an input into its monetary policy process.

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