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Depreciation of Rupee

C Rangrajan weighs in on the factors that are driving the depreciation of rupee, and why its essential to bring down domestic inflation to stop the slide.

Value of rupee:

  • Value of the rupee is determined using purchasing power parity theory.

  • The theory states 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 the inflation in the two countries.

  • So long as inflation in our country is higher than the inflation in other countries, the value of the rupee will depreciate.

  • This theory was true when the balance of payments (BOP) of a country was dominated by the current account — that is, the export and import of goods and services.

  • Now, capital account in the balance of payments has become important — 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 of capital accounts i.e. to invest or because of the decision to keep deposits in our country.

Depreciation of rupee:

  • The  main reason for the rupee depreciating in its value is due to the capital account of BOP.

  • It is because the funds inflow into our country started diminishing.

  • That is because the US Federal reserve, with a view to control inflation in the United States, raised the rate of interest.

  • Therefore, investors find the United States is more attractive, because of the higher rate of interest.

  • Instead of sending funds outside, they are keeping the funds inside and sometimes, they withdrew the funds from India and put them in the United States.

  • Simply put, when the investment becomes more attractive domestically, foreign countries do not send funds into other countries

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