An Analysis of Impact of Exchange Rate on Inflation Rate in Indian Economy

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The effects of the uncertainties caused by the volatility in exchange rates and inflation on macroeconomic variables have been subject to extensive theoretical and empirical research. Empirical findings indicate significant impact of exchange rate uncertainty on macroeconomic variables such as output, trade and investment. Similarly, inflation uncertainty appears to affect variables such as output, employment and interest rates. The relationship between exchange rate and inflation uncertainties, on the other hand, has been largely overlooked in the literature. This paper attempts to investigate the impact of exchange rate on inflation rate in India.

India in the past has mostly been a closed economy, following protectionist policies of development. Foreign exchange management and control has been an important tool of lending protection to the domestic economy, checking capital flight, maintaining a comfortable reserve of valuable foreign exchange for development needs and import of essential goods and encouraging exports. To attain these objectives India followed a 'fixed exchange rate' system till the economic crisis of 1991.

The Indian forex market had been heavily controlled since the 1950s, along with increasing trade controls designed to foster import substitution. Consequently, both the current and capital accounts were closed and foreign exchange was made available by the RBI through a complex licensing system. India's post-independence development strategy was both inward-looking and highly interventionist, consisting of import protection, complex industrial licensing requirements, financial repression, and substantial public ownership of heavy industry. However, macroeconomic policy sought stability through low monetary growth and moderate public sector deficits. The current account was in surplus for most years until 1950, and there was a reasonable cushion of official reserves.

Since 1950, India ran continued trade deficits that increased in magnitude in the 1960s. Furthermore, the government of India had a budget deficit problem and could not borrow money from abroad or from the private corporate sector; due to that sector's negative savings rate. As a result, the government issued bonds to the RBI, which increased the money supply.

In 1966, foreign aid was finally cut off and India was told it had to liberalise its restrictions on trade before foreign aid would again materialize. The response was devaluation accompanied by liberalization.

The foreign Exchange Regulation Act (1973) was consolidated and amended in 1947 to regulating certain payments, dealings in foreign exchange and securities, transactions indirectly affecting foreign exchange and the import and export of currency, for the conservation of the foreign exchange resources of the country and the proper utilization thereof in the interests of the economic development of the country.

During the first half of the 1980s, the current account deficit stayed below one and a half percent of GDP. While export growth was slow, the trade deficit was kept in check, as a rapid rise in domestic petroleum production permitted savings on energy imports. At the same time, the high proportion of concessioner external financing kept debt service down.

In the second half of the 1980s, current account deficits widened. India's development policy emphasis shifted from import substitution towards export-led growth, supported by measures to promote exports and liberalize imports for exporters. The government began a process of gradual liberalization of trade, investment, and financial markets. Import and industrial licensing requirements were eased and tariffs replaced some quantitative restrictions. Export growth was rapid, due to the initial measures of deregulation and improved competitiveness associated with the real depreciation of the rupee.

By 1990-91, India was increasingly vulnerable to shocks as a result of its rising current account deficits and greater reliance on commercial external financing. …