DOMESTIC INFLATION 

1. Context

According to former RBI Governor C Rangarajan, containing domestic inflation is critical to halting the rupee depreciation

2. Rupee falling against the dollar

2.1 Purchasing power parity theory

• It explained how the value of any currency is determined.
• The idea was that the external value of a currency is determined by its internal value meaning that the rate differential between one currency and another depends upon the difference in inflation in the two countries.
• That was a time when the balance of payments of a country was dominated by what we call the current account which is the export and import of goods and services. But over time, this has changed.

2.2 Inflow and outflow of funds

• An important element is the capital account in the balance of payments which means the inflow and outflow of funds.
• The value of a currency can be strong even though it has a high current account deficit because there is enough capital flowing from outside into the country.
• Therefore, the supply of foreign currency increases not because of (trade) but because of the decision to invest or because of the decision to keep deposits in our country.

• Investors find the United States more attractive, because of the higher rate of interest. 
• Instead of sending funds outside, they are keeping the funds inside and sometimes, as has happened in the present case, they withdrew the funds from India and put them in the United States.
• The reason is the sudden decline in the value of the rupee is because of the capital account, the outflow of funds and the lack of funds coming from outside.

3. Is a stronger currency necessarily bad?

• In a sense, an undervalued currency is better because it is more attractive for exports.
• But at the same time, we have to understand that this (depreciation against the dollar) cannot go on; this cannot be a continuous process.
•  Immediately after the IMF was formed, the dollar was equal to 4.75 rupees and today in terms 80 rupees to the dollar or a little more.
• At a particular point in time, the devaluation or the depreciation in the value of the domestic currency may be advantageous because of the tough balance of payments situation and the need to export more and reduce the current account deficit.
• But this cannot go on continuously, because ultimately for getting $1 the amount of the resources that need in India is becoming higher and higher.
• Resulted, the steady deterioration in the value of the rupee is not something that one would advocate.
• And this is where the whole purchasing power parity comes in. 
• So long as inflation in our country is higher than the inflation in other countries, the value of the rupee will depreciate.

4. Stabilisation of the rupee's exchange rate

• We must reduce our inflation rate. For example, the US talks of 2 per cent as the appropriate inflation, whereas, we talk of 4 per cent as the appropriate inflation, even though our actual inflation may be higher, but at least the goal is 4 per cent.
• If you have this then every year the value of the rupee will have to depreciate.
• The point is that the current situation has been aggravated because of the capital flows.
• Over some time the inflation may not necessarily be equal to inflation at least close to it and the margin is not that high.

5. Steps to control domestic inflation

• Indian inflation had set 6 per cent as the upper limit in the inflation targeting scheme, but the inflation rate has been above 6 per cent for almost nine months.
• The raising rate of interest is serving two purposes: it moderates inflation and at the same time, it does have an effect in terms of the value of the rupee as well.

For Prelims & Mains