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Controlling Appreciation of Rupee

The RBI typically controls the appreciation by manipulating demand-supply dynamics of currency market. It purchases dollars (to create more demand for dollar) and sells rupees (to increase supply of INR, thereby decreasing its value).
And precisely, there comes the dichotomy. As RBI sells more rupees, the money supply increases which means too much money chasing same (or less) number of goods, thereby leading to inflation. So in effect one act of RBI creates another problem.

Rising Inflation

As mentioned above, the measures taken by RBI to control appreciating rupee contributes to rising inflation and same was assumed this time around when recently inflation crossed 5% mark. There was criticism of RBI for not controlling appreciating rupee but the primary reason for not doing so was to control the inflation, under direction from Finance Ministry. However, the point to note here is that this time around the inflation was not primarily because of money supply dynamics alone. Supply constraints on part of many commodities (like pulses) and rising crude price (which has a trickle-down effect on transportation sector and many other commodities alongside) also played a major part in rising inflation this time around.

Controlling Inflation

The factors which contribute to rising inflation can be controlled to keep inflation in check. The Demand Pull & Cost Push induced inflation can't be controlled by RBI but it uses other monetary tools to control inflation, which primarily include manipulation of money supply by various means.

RBI can suck the excess money from the system, and apart from issuing bonds in market (method called Sterilization), it can do that by regulating interest rates. Being a Banker to banks, it regulates interest rates by changing its Reserve Requirements, etc., which leads banks to change interest rates. An increase in interest rates controls inflation (actually control money supply which may control inflation) in two ways:

a) Rising interest rates provide an incentive for saving. So the money which otherwise had been available for consumption is deposited in banks leading to a decrease in money supply.
b) Rising interest rates makes it difficult to borrow from banks, thereby decreasing consumption, thereby decreasing the demand for money.

So the RBI has to design the monetary policy to balance the interests of each and every sector of economy and to achieve a balanced economic growth.

Concluded.

* Contributed by: -
Vijay Singh Poonia,
PGDM 2007-09,
IIM Calcutta,
Has work experience of 3 years with Indian Oil Corp Ltd.