Abstract:
The paper analyzes the changing INR trends over the reform period, in the context of fundamental
determinants of exchange rates. In the early reform years the chief concern was to limit appreciation
from inflows, and from higher domestic inflation, given the trade deficit. So short-term nominal
depreciation maintained a long-term real fix. But with two-way nominal variation, more objectives can
be accommodated. We ask how the exchange rate contributed to three possible policy
objectives—maintaining a real competitive exchange rate, neutralizing inflationary oil shocks,
deepening foreign exchange markets and encouraging hedging. Depreciation allowed just before oil
prices crashed compromised the second objective. Inadequate commitment to two-way movement, prior
to the crisis, induced firms to take large currency exposures based on expected appreciation. After the
crisis, capital flows were allowed to drive the exchange rate, aggravating inflation and acting against
macro stabilization. Markets need some guidance to achieve policy objectives.
