The Hindu Business Line : Currency value and inflation

The Consumer Price Index is no doubt the best index to measure inflation. But which among the four sets of CPI is the best to arrive at the overall inflation for the country? Or is there any other methodology? Also, can you elaborate on the impact of strengthening our currency to overcome inflation?

Shonali

Regarding the first part of the question, possibly the best CPI number that can be a proxy for inflation is the CPI for Urban Non Manual Employees or CPI-UNME. Obviously, the better methodology would be if the CPI's can be combined into one index causing less confusion.

Regarding the query about the impact of strengthening the currency to overcome inflation, it would really only work in a country that has a very open economy and imports most of its goods. The concept behind this is that inflation can be imported if the currency is weak or is tending to be weak. It is easy to see why it is entirely plausible. In fact, it is widely believed that inflation in the US has been very low the past few years because of China. The reasoning is that because of the relatively weak Chinese yuan vis-à-vis the dollar and because of the huge levels of imports from China, the US has in effect been importing deflation from China. This doesn't mean that China has been experiencing deflation but because it is relatively cheaper for the US to import goods from China rather than produce locally; prices of goods have in effect become cheaper. Therefore, this is importing deflation through the exchange rate.

The concept of strengthening the currency to reduce inflation is a self-defeating one. If the currency is strengthened, then the exports will automatically drop because Indian goods will become more expensive. However, it leads to higher imports because foreign goods become cheaper. When imports are higher and exports lower, the demand for the foreign currency will increase vis-à-vis the rupee and it is back to Square One.

For the Reserve Bank of India to make the rupee stronger, it will have to sell dollars and buy rupees. This will mean that on a trade-weighted basis (real effective exchange rate), the rupee will be overvalued and make it a target for speculators. This means that the central bank will have to keep more international reserves to prevent a speculative attack. It makes no sense for the RBI to follow this policy because it will be very expensive and eventually pointless for it and the country.

(The author is Group Economist, Murugappa Group. The views expressed are personal. Send in your queries on economics to Whackonomics@gmail.com)

Sunil Rongala

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