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How inflation affects exchange rate (and vice versa)
There is a direct link between exchange rate and inflation. Suppose the exchange rate increases from Rs 40 a dollar to Rs 50. Then the price of a product that costs $100 in the world market goes from Rs 4,000 to Rs 5,000 in the Indian market. So, rupee depreciation directly hits inflation.
The full impact is much more than that suggested by the share of imports in the GDP. This is because of a phenomenon called the “import-parity pricing”. Many goods produced in India are now sold at the world price. For instance, an Indian company might make benzene or steel and sell it to an Indian customer, which means there are no imports. Yet, this local transaction takes place at the world price of benzene or steel (in US dollars) multiplied by the exchange rate. Thus, the full footprint of the exchange rate is bigger than the share of imports in the GDP.
Very simply, rupee appreciation will combat inflation.
Why the RBI is not using the exchange rate as a tool to moderate inflation
One factor is the keenness to subsidise exporters. Any Member of Parliament will tell you that low and stable inflation is more important than subsidising exporters. But the RBI has focused on the exchange rate and has been unconcerned about the inflationary consequences of these policies.
The RBI leadership needs to assimilate modern macro-economics and devise ways in which monetary policy can serve the needs of a new India in a better way. So far, such an effort has not commenced. The RBI has run a pegged rupeedollar exchange rate for many years now. Large inward looking bureaucracies are slow to analyse problems and change strategies.
Whether India should have inflation protection bonds
Given that inflation is so uncertain, people should not keep their money in savings bank accounts, where the nominal interest rate of 3.5% is swamped by a 10% inflation. They should also not be satisfied holding government bonds, where the real return fluctuates with inflation. The best fixed-income investment, given the uncertain Indian inflation, is an inflation-indexed bond.
The Ministry of Finance is in the process of setting up a new Debt Management Office. This will be a professional investment banking agency that will manage resource mobilisation for the government. This agency would devise product structures for inflation indexed bonds and distribute them to the public.
