- Chellamuthu Kuppusamy
There was a remark made in the previous post on Chidamaram's book.//Why is the government increasing the interest rate to curb liquidity and at the same time inject money by heavily buying dollar to maintain exchange rate? Are the FM and RBI of the view that Indian economy is not resilient enough to absorb strong rupee? //
This statement has beome obsolete within days. Rupee has peaked to its 9 year high. It is alledged that RBI has pulled back from obsorbing excess dollat floating in the market. Government has apparently decide to keep aside economy aside & cool down inflation. Well..how does exchange rate find its relation to inflation?
We have seen multiple interest rate hikes in the recent past to curb liquidity & thus arresting inflation. A good move indeed. But, there is other side effects too. Due to relatively attrative interest rates, foreign money - read dollar - flows towards India. This raises the demand for rupee and brings down the demand for dollar making exchange rate climbe (say from 44 to 42). RBI normally buys such incoming dollar and makes an attempt to maintain greenback demand constant, meaning weaker rupee. Having a stroung rupee is not good for our exports and eonomy as a whole. That is precisely the comment made in the book review.
When RBI buys dollar and injects more rupee into the system, it adds to liquidity and subsequently giving raise to inflation. The oroginal goal is defeated? May be, true. It is duty of the government to maintain moderate inflation as well as exchange rate. But, managing ecconomy is not that simple. They always try to strike a balance.
Having said that, RBI not going ahead in its normal act of sucking dollar is not a surprise. State elections in the north is onsidered to be a reason. One cant help thining that inflation is more of a politivcal factor than eonomic one at this junccture. Otherwise there is no need to let rupee gain strength. I dont have any reason to believe that FM and RBI are confident that Indian economy is resilient enough to absorb strong rupee?