Exchange Rate

Exchange rate problems have usually occupied centre stage in policy discussions
in reforming economies. In fact, it has often been argue that the inadequate
economic performance of various countries has been the result of inappropriate
exchange rate policies. It is now well accepted at the theoretical level that
excess volatility in real exchange rates, and in particular situations of real
exchange rate (RER) misalignment, will be translated into important welfare
costs. Maintaining the RER at the ‘wrong’ level generates wrong signals and
greatly hurts the degree of competitiveness of the tradable sector. Determining
whether a country’s RER is at a particular time out of line with its long-run
equilibrium level is, both theoretically and practically, one of the most difficult
challenges faced by macroeconomic analysts and policy makers under both
predetermined and floating nominal exchange rates. Two broad strands can be
discerned in the literature on real exchange rates. One line of research
emphasises parsimonious models that investigate the influence of several
macroeconomic, financial and structural (policy) variables — investment ratio,
capital controls, changes in government expenditure or (higher/lower) fiscal
deficit, tariffs, seigniorage and so on — in determining the RER. These models
are obtained from a general equilibrium framework that explicitly recognises the
influence of policy choices by the government in determining the RER.
Establishing whether observed RER measurements are a result of structural
changes, or a response to macroeconomic instability, or both is an empirical
issue that is investigated in this paper. The other strand emphasises RER
targeting, that is, the effectiveness of nominal devaluations as a policy tool.
From a purely operational point of view, the RER is probably the most popular
real target in many developing countries, in no small part because of the recent
emphasis on export-led growth in the context of policy reforms in developing
countries. A policy of ‘real exchange targeting’ usually aims at controlling the
level of the real exchange rate, either in an effort to keep it at a constant level in
the face of domestic or external shocks, or achieve a different (typically more
depreciated) level to increase growth by enhancing incentives for higher exports.
It is found that India is no exception in this regard, especially since 1980/81
when the first tentative steps towards reform were initiated, and which
culminated in policies during 1991-1993 designed to substantially liberalise both
the trade and external payments systems.

The following plot of graph shows the Indian Rupee (INR) comparison against the
US Dollar (USD) for all months beginning from Jan 2001 to Dec 2010

200 200 200 200 200 200 200 200 200 201
1 2 3 4 5 6 7 8 9 0
46.6 48.3 47.9 45.4 43.6 44.2 44.2 39.2 48.7 45.9
Jan 1 5 5 5 1 3 1 7 3 2
Fe 46.5 48.7 47.7 45.2 43.5 44.2 44.0 39.6 49.1 46.3
b 6 1 4 7 7 2 12 7 7 4
Ma 46.6 48.7 47.6 44.9 43.5 44.3 43.7 40.1 45.4
r 5 6 7 6 8 3 93 4 51.2 9
Ap 46.7 48.9 47.3 43.8 43.6 44.5 42.0 39.9 40.0 44.4
r 8 3 9 9 4 2 1 6 5 7
Ma 46.9 49.0 47.1 45.1 45.2 40.5 41.8 48.5 45.8
y 4 15 1 7 43.4 2 5 8 4 7
Jun 47.0 48.9 46.6 45.5 43.5 45.8 40.5 42.7 47.7 46.5
 4 8 9 2 8 9 6 4 7
47.1 48.7 46.2 46.0 43.4 46.3 40.2 42.7 48.4 46.8
Jul 7 8 2 5 3 6 8 2 3 3
Au 47.1 48.6 45.9 46.3 43.5 46.4 40.6 42.9 48.3 46.5
g 6 1 5 2 5 4 7 2 3 7
Se 47.7 48.4 45.8 46.0 43.8 46.0 40.1 45.4 48.3 45.9
p 3 6 4 5 4 2 7 2 6 9
Oc 48.0 48.3 45.7 44.7 45.3 39.3 48.6 46.7 44.4
t 4 8 45.4 3 3 5 6 1 1 2
No 48.0 48.2 45.5 45.0 45.6 44.7 39.3 48.7 46.5 44.9
v 4 8 5 3 3 2 1 9 6 9
De 47.9 48.1 45.5 43.8 45.5 44.4 39.3 48.4 46.5 45.1
c 3 4 7 4 4 7 7 8 9 1

As evident from the graph we observe that the value of Rupee stays between 40-
50 to a dollar. The manimum value of USD:INR was observed in the month of
January 2008 with a value of 39.27 and the maximum was in the month of March
2009 was 51.2.

However, following this peak in value, the Dollar crashed significantly to 40.05 to
a Re in the next month. The reasons were Dollar inflows had been rising for some
years. RBI made sure this did not lead to rapid appreciation of the rupee, since
that could hurt exporters. With inflation being a worry, RBI had gone easy on
buying up the dollars since that would pump more rupees into the system and
fuel prices.