Answer to Question #117787 in Macroeconomics for Karan Bhanot

Question

India's central bank has a higher inflation target than America's central bank. Does this tend to appreciate or depreciate the Indian rupee against the American dollar? Explain

Answer 1

Inflation is the general rise commodity prices. It can be brought by several factors some of which include general fall in the value of the currency. In this case when the Indian rupee falls compared to the United States dollar it will eventually lead to inflation. This will affect the Indian economy in several ways or in several fields some of which include;

1. Due to an increase in inflation, the central bank increases the interest rates. People will borrow less money from financial institutions and will less money to spend and transact. Reserve Bank of India (RBI) might resort to increased interest rates too further increasing the effect on corporates.

2. The value of the currency will depreciate.

3. The prices of goods will rise dramatically. For instance when the oil prices rise it will lead to general rise in prices of all commodities since most people depend on oil in almost everything like cooking not forgetting transportation.

4. The Indian market will be affected due to an increase in prices of imports.                      However the Reserve Bank of India's bid to sell dollars in the open market to restrict the rupee slide has failed in the past few weeks and months this worsens the situation even more since once the currency traders know that India's central bank is unable to manage its exchange rate, and reduce the adverse impact on its currency.

The Indian rupee will depreciate because of the following reasons when compared with the United States dollar;

1) The Lira connection Turkey the middle-eastern country, is going through a financial turmoil right now. Its relations with the US leads to a very weak currency. The Lira crisis has made the global market curious about the spillover effects.

2) Relying on oil import. Since Indian is among the largest importers of crude oil, inflation rate will affect it so much. It will lead to a sudden rise in prices of commodities.

3) Huge current account deficit Current account deficit is the difference between imports and exports of goods and service of a country. A huge dependency on crude oil imports and its increasing price affects our current account health, making the deficit larger. An increasing current account deficit (Rupee) leads to an increase in the demand for Dollar simply because more dollars are needed than before to finance the growing deficit and also paying for the imports.

4) United States federal rate changes. An increase in federal rate changes will have an impact on the Indian rupee. The value of the rupee is going to fall (depreciate) while the United States dollar is going to rise (appreciate).