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

Post by Admin,Sep 11,2019.
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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.