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The question on everyone’s mind is why this sudden fall in the value of the rupee and is there any end to this? In order to explain this story, we will have to connect a few dots—exchange rate, inflation rate, fiscal deficit, CAD, exports, imports and the US economy.
Under a floating exchange rate regime, the market determines the value of the exchange rate. In economics, there are two ways to determine the correct exchange rate. One, the goods market approach where the correct value of the exchange rate is based on the assumption of law of one price (LOOP) using the concept of purchasing power parity. Two, the asset market approach, where the value of the exchange rate is conditional upon the inflow and outflow of capital into and from the domestic economy.
LOOP states that in the absence of transport and other costs such as tariffs, similar goods will sell for the same price. Because of the combined activities of arbitrageurs, identical goods, primarily financial assets, cannot sell for different prices for long. The prices of homogeneous goods once converted to common currency should be same in different markets. In fact, The Economist publishes the Big Mac Index, which serves as an informal way of measuring PPP between two currencies. The index takes its name from the Big Mac of McDonald’s.
If LOOP holds true then the real exchange rate (nominal exchange rate times the relative price between two nations) is one. Using this relation, it is easy to show that if domestic inflation is higher than the US inflation, the rupee is expected to depreciate against the dollar.
Now, why inflation in India? One school of thought is arguing inflation in India is because of factors such as increased payment through MGNREGA, higher minimum support price for farmers, and recently, the government committing to spend around R1.3 lakh crore per annum on account of the food Bill. Money spent without increase in storage capacity in the case of the food Bill, and many infrastructure projects not getting completed under MGNREGA, is bound to cause inflation.
Questions are also raised about the