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Why is it essential to contain domestic inflation?

GS Paper 3

Syllabus: Indian Economy and related issues

 

Source: IE

 Direction: This article throws light on the basic economic concept of rupee depreciation, its impacts and how to curb it, in the context of the present scenario in India. The article is important as it is an analysis by C Rangarajan

  

Context: According to former RBI Governor C Rangarajan, containing domestic inflation is critical to halting the rupee depreciation.

 

Inflation: It is a rise in prices, which can be translated as the decline of purchasing power over time.

Depreciation: It reduces the value of a country’s currency when compared with the currency of other countries (say $, measured by an exchange rate of the local currency wrt $).

 

The value of the currency and its depreciation:

  • The current account (export and import of goods and services) and capital account (inflow and outflow of funds) in the balance of payments are important elements to determine the value of the currency.
  • The value of a currency can be strong despite the high current account deficit because there is enough capital flowing from outside into the country.
  • Therefore, the supply of foreign currency increases not because of trade but because of the decision to invest or because of the decision to keep deposits in the country.
  • The main reason for the rupee depreciating in its value (against the dollar) is because of the capital account – the outflow of funds and the lack of funds coming from outside.
  • That is because the US Fed, with a view to controlling inflation in the US, really raised the rate of interest. Therefore, investors find the US more attractive.

 

Impact of depreciation of rupees:

 

  • An undervalued currency is better because it is more attractive for exports and reduces the current account deficit.
  • It discourages imports because the imported goods become more expensive (due to the reduction in the value of the rupee) and which leads to rising inflation.
  • Because India imports more than exports, the steady deterioration in the value of the rupee is not helping the economy.
  • So long as inflation in India is higher than the inflation in other countries, the value of the rupee will continue to depreciate.

  

Steps to be taken to stabilise the rupee’s exchange rate:

  • Must reduce inflation rate: The RBI and the government must work together to keep the inflation rate in the margins set under the inflation targeting scheme (4+/-2%).
  • Raising the rate of interest: It helps to control inflation while also having an impact on the value of the rupee.

 

Challenges ahead for India:

  • Poor outlook for exports: This is mainly due to the global slowdown driven by the confluence of stubbornly high inflation, rising borrowing costs and geopolitical tensions.
  • Rising risks of stagflation: Stagflation is a period when slow economic growth and joblessness coincide with rising inflation.

  

Some relief for the Indian economy: Resilient domestic demand and a revived investment cycle will propel the economy’s growth and create more jobs in the coming months.

 

Insta Links:

Currency Depreciation

  

Mains Links:

Q. Examining the current account balance of a country’s BOP can provide a good idea of its economic activity. Discuss.

 

Prelims Links:

Consider the following statements:

  1. When the value of the currency is made cheaper by the central bank it is called the devaluation of the currency, and when the market forces bring down the value of the currency due to falling demand it is called depreciation of the currency.
  2. In the Balance of Payments, the movements of money without an exchange for goods or services and charities are part of the Capital account.

Which of the above statements is/are correct?

a) 1 only

b) 2 only

c) Both 1 and 2

d) Neither 1 nor 2

 

Solution: a)

The exchange rate of a currency may be fixed by a central bank or left to the market forces of demand and supply. When the value is changed by the central bank it is devaluation if it is made cheaper and revaluation if it is made stronger. Cheaper means more rupees for a dollar and stronger means fewer rupees for a dollar. If market forces bring down the value due to demand falling behind the supply of the currency, it leads to depreciation.

In the Balance of Payments, the movements of money without an exchange for goods or services called remittances and charities are part of the Current account.