Currently, the Indian economy is producing at almost full capacity. Domestic demand plus net export demand is growing at rates which have generated sustained inflation. Inflation control requires reining in either domestic demand and/or reining in net export demand. Exchange rate policy allows the government to meddle with which element of demand is curbed. The fundamental policy question in Indian inflation control is: Should we slow down export demand or should we slow down domestic demand?

If the rupee appreciates, we curb net export demand by making Indian goods more expensive for foreigners and foreign goods cheaper for Indians. But if we prevent rupee appreciation and have higher domestic interest rates, we curb domestic demand. The present currency policy is trying to keep export demand growing while curbing domestic demand by pushing up interest rates. Keeping export growth high when the economy is at full capacity utilisation is not going to give lower domestic prices. It pushes greater pain on the domestic consumer who must bear a greater burden of adjustment in demand.

Politically, this is a recipe for disaster. The attempt to keep Indian goods cheap for the American consumer has made Indian goods more expensive for the Indian consumer. Effectively the Indian consumer subsidises the American consumer. If we continue with the policy of trying to keep Indian goods cheap for foreigners, we will end up making them more expensive for Indians. Hiking interest rates will not tackle inflation when the RBI continues taking with one hand and giving away with another. What India requires is to comprehensively open up questions of how monetary policy is conducted and give a fresh mandate to the RBI.

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