Why the inflation-Forex trap lead to

Policy rate hikes?

TABLE OF CONTENT

1. Why the Inflation-Forex trap lead to Policy rate hikes?

 Impact of Inflation on Exchange Rate
❑  inflation → goods more expensive → Less
competitive compared to country with low inflation
→  Demand → Rupee Depreciation
❑  inflation (with no  in ‘i’) → investors would take
out money from India → sell Rupee → Rupee
Depreciation  [Interest Rate Differential]
❑  inflation will  money buying power → PPP  →
depreciation of the Rupee
❑  inflation will  interest rates →  Foreign
Investment → appreciation of the Rupee
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Not always the case:
✓ Investors evaluate whether a rate
hike is due to a healthy economy
or exclusively to tame inflation.
✓ Investors prefer to move their
money into healthy economies.
✓ A strong, stable economy makes
their investments less risky and
more profitable.
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 Inflation-Exchange Rate loop
How does Rupee ❑ Domestically → inflation MPC task of
lose value? ❑ Externally → through depreciation against US Dollar Financial stability

❑ Domestic and external values of rupee are interlinked

and feed into each other

❑ Relation: A prolonged period of high and rising

India, which imports most of its crude
inflation weakens the rupee by hurting India’s growth
oil, is especially at risk of being trapped
and competitiveness and a declining exchange rate
in this inflation-exchange rate loop.
sets off inflation because of higher import prices.

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 Reasons for Inflation-Exchange Rate loop

❑ The REASONS for the fall in the

❑ Sustained high inflation in the US means the
Rupee’s value can be grouped into 2
Federal Reserve may continue to tighten rates.
categories:
❑ Factors that mainly drive up
❑ Inflation differentials between India and the US
domestic prices →  food & fuel
is narrowing.
prices (R-U war) and  input
prices
❑ In such circumstances, another interest rate
❑ Factors that mainly impact Forex
hike by India will help attract foreign
markets →  US interest rates →
investments and consequently dollar inflows,
returns on US assets already
which will support the rupee.
attractive (safe haven)

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 Inflation or Growth? → RBI has to pick one
❑ Pandemic + Govt Revenue (tax)  → RBI  ’i’ +
printed and pumped money into the financial system

❑ Led to excess money or

❑ ’i’ (bank)  → encourage
liquidity in the financial
individuals to borrow more
system → more money going
and spend, for firms to
around than there was
borrow more and expand,
adequate use for (2 years).
and stimulate economic
❑ April 2022 → > ₹8.1 trillion
activity in the process
❑ September 2022 → NIL

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 Inflation or Growth? → RBI has to pick one
Sell $,
Reasons buy Rupee

❑ RBI trying to maintain the value of rupee at a level $550bn –

lower than 80 to a dollar → imports → inflation $490 bn

❑ Sucking liquidity that hadn’t been put to use by banks

and other FIs → Excess liquidity 

❑ Non-food credit (NFC) growth → robust @ 14.8%

❑ 𝑵𝑭𝑪 = 𝑂𝑣𝑒𝑟𝑎𝑙𝑙 𝐵𝑎𝑛𝑘 𝐿𝑜𝑎𝑛 − 𝑀𝑜𝑛𝑒𝑦 𝑙𝑒𝑛𝑡 𝑡𝑜 𝐹𝐶𝐼/
𝑜𝑡ℎ𝑒𝑟 𝑠𝑡𝑎𝑡𝑒 𝑝𝑟𝑜𝑐𝑢𝑟𝑒𝑚𝑒𝑛𝑡 𝑎𝑔𝑒𝑛𝑐𝑖𝑒𝑠 to buy rice and
wheat directly from farmers at the government-
mandated MSP

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 Inflation or Growth? → RBI has to pick one
❑ 2 things →
Competing
✓ Non-food credit growth  ‘i’
for money
✓ RBI selling dollars and buying rupees

❑ Weighted average interest rate in the call money Only tool to

market → ~5.47% (Sept 2022) → 4.41% (August 2022) control inflation

Linkage in the economy: RBI will have to sacrifice

❑ If RBI keeps intervening in FEM →  ‘i’ → impacting some growth or let
credit growth → economic recovery some inflation run. It is
But difficult to target both
❑  ‘i’ needed → control inflation at the same time

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Q.1) which of the following is/are the likely reasons for depreciation of
Rupee?
1. Decreasing interest rate in the US
2. Increasing inflation in the domestic economy
3. Narrowing of the interest rate differential between India and the US

[a] 1 and 2
[b] 2 and 3
[c] 1 and 3
[d] 1, 2 and 3
[e] None of the above
Q.2) Which of the following is a likely impact of rising prices in India
on FOREX Rate?
1. Rising prices will make exports competitive
2. It will result in attracting more FOREX flows in the economy
due to rising interest rates
3. Ceteris paribus, it will discourage foreign investments in India
due to narrowing interest rate differential
4. Rising prices will result in weakening the rupee

[a] 1 and 3
[b] 2 and 4
[c] 1, 3 and 4
[d] 2, 3 and 4
[e] 1, 2, 3 and 4
 Answers

❑ Question 1: [b]
❑ Question 2: [d]

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