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Does the rupee's decline open the door for imported inflation?

Post by Admin,Sep 11,2019.

The weakening of the domestic currency in the past two months i.e. July and August 2019 may lead to imported inflation in the country.

Imported Inflation

  • When the general price level rises in a country because of the rise in prices of imported commodities, inflation is termed as imported.
    • Two key contributors to India’s imports are: Crude Oil and Gold. Rise in prices of these two products lead to rise in the import bill of the country.
    • It is expected that dull global growth prospects would keep crude prices benign. But, higher demand for gold can push prices higher.
  • However, inflation may also rise due to the depreciation of the domestic currency, which pushes up the rupee cost of imported items.
    • For example, if the rupee depreciates by 20% against the US dollar in a particular period, the landed rupee cost of an imported product will also go up by the same proportion and will affect the price levels and inflation readings.
    • Current Causes Behind Depreciation:
      • Growing risk aversion amongst investors has resulted in broad losses in the currencies of the Emerging Markets (EM).
      • The rupee has been further impacted by escalating tensions in Kashmir and a slightly larger-than-expected repo rate cut from the RBI.

Depreciation of the Currency

  • Depreciation of a country's currency refers to a decrease in the value of that country's currency with respect to one or more foreign reference currencies, typically in a floating exchange rate system.
    • In a floating exchange rate system, market forces (based on demand and supply of a currency) determine the value of a currency.
  • Example: $1 used to equal to Rs.60, now $1 is equal to Rs. 72, implying that the rupee has depreciated relative to the dollar i.e. it takes more rupees to purchase a dollar.
  • It happens due to supply and demand-side factors.
  • It makes exports more competitive and imports more expensive.
  • It is different from devaluation wherein the government of a country makes a conscious decision to lower its exchange rate, basically in a fixed or semi-fixed exchange rate.
    • Fixed exchange rate: This occurs when the government seeks to keep the value of a currency fixed against another currency.
    • Semi-Fixed Exchange Rate. This occurs when the government seeks to keep the value of currency between a band of the exchange rate. In other words, the exchange rate can fluctuate within a narrow band.