Given the crucial importance of the exchange rate in the formulation of monetary policy and its stance, the subject of how the exchange rate is determined is one of great interest to academics and policy makers alike. In essence, the rich literature that has evolved around the subject is all about trying to read the mind of the policy maker when the exchange rate is managed to some degree, or, that of traders, arbitragers and speculators when the exchange rate is market-determined.

The Parity Principles
At a theoretical level, people have attempted to explain the behaviour of exchange rates in terms of some underlying principle or central tendency. This has then been followed by testing the hypothesis with actual data so as to model exchange rate outcomes to ratify the theoretical precept and use it for predictive purposes.

Among the oldest theories of exchange rate determination is purchasing power parity (PPP) which originated in the 16th century with Spain’s School of Salamanca and was formally developed as a modern economic theory by the Swedish economist Gustav Cassel in 1918. Simply put, it is the metric used in terms of how much a standard basket of goods and services, reflecting the average standard of living, costs in national currencies. It measures what money can buy and, thereby, prevailing living standards. An example of PPP is The Economist’s Big Mac index which tries to compare the cost of living in various countries with McDonald’s outlets via the price of a hamburger, the Big Mac. Adjustments have to be made for cheese not being in the burger in Israel because it is not kosher, and there is no beef in the Big Mac in India where it is called the Maharaja Mac.

Another popular method of explaining exchange rate determination is interest rate parity (IRP), which evolved from 19th-century banking practices in London, Paris, and Amsterdam where short-term bills of exchange were used to move money across borders. Such trading would eliminate arbitrage because the difference in interest rates between two countries is offset by the differential between the forward and spot exchange rates. This ensures that returns on equivalent assets in different currencies are equal, preventing risk-free profit. Under the classical gold standard and subsequent fixed-rate systems up to 1973, parity largely meant the direct equality of national interest rates because exchange rate fluctuations were tightly bound by gold parities. When the fixed exchange rate system collapsed in the early 1970s and currency values began to float freely, IRP matured into a tenet of formal international finance as global financial markets gained depth and sophistication. It was separated into (a) covered interest rate parity (CIP) which states that the interest rate differential between two countries is exactly equal to the percentage spread between the forward exchange rate and the spot exchange rate: and (b) uncovered interest rate parity (UIP) according to which the difference in interest rates between two countries is equal to the expected change in the spot exchange rates between their currencies. UIP is directly related to the International Fisher Effect (IFE) which suggests that the difference in the nominal interest rates of two countries is equal to the expected difference in their spot exchange rates. It posits that currencies with higher nominal interest rates will depreciate because they reflect higher expected inflation. Since the advent of floating rates, empirical data have consistently violated UIP, showing that high-interest-rate currencies tend to appreciate rather than depreciate. Moreover, since the global financial crisis, CIP has also seen persistent deviations due to market frictions, counterparty risk, and banking regulation constraints.

Real interest rate parity (RIP) suggests that, due to integrated international financial and goods markets, the real interest rates on comparable assets tend to equalise across countries over time. It combines uncovered interest rate parity and purchasing power parity, implying that differences in nominal rates reflect inflation differentials.

Exchange Rate Transmission

The exchange rate transmits monetary policy impulses to the rest of the economy in a number of ways. Let us take the case of a depreciation of the exchange rate for simplicity of exposition; appreciation produces symmetrical opposite effects.

A depreciation in the exchange rate makes exports cheaper for foreigners and imports dearer for nationals. The improvement in the trade balance increases GDP which, in turn, can cause higher inflation. Exchange rate depreciation can also directly impact inflation through higher import prices. Eventually, higher inflation can drag down GDP.

Exchange rate depreciation can affect domestic demand by shifting resources towards tradables and away from non-tradables. It can also cause interest rates to rise to offset the depreciation. This can impact other asset prices and generate expectations about future movements in exchange rates as well as other asset prices and inflation. The combined effect on domestic demand then feeds through into GDP and inflation.

Exchange Rate Regimes in India
From the 1890s, the exchange rate of the rupee evolved under the gold exchange standard under which the Indian rupee was kept equivalent to one shilling and four pence under an elaborate arrangement of council bills and sterling balances. This served India well in transiting to the Bretton Woods system.

Under the Bretton Woods system (1944–1971), the Indian rupee was pegged to the British pound sterling and indirectly to the US dollar. As a member of the IMF, India maintained a fixed par value for the rupee in terms of gold, at 4.15 grains of fine gold, establishing a value of ₹13.33 per pound (equivalent to approximately ₹4.76 per US Dollar). 

Following the collapse of the Bretton Woods system (1973), the rupee was initially linked back to the pound sterling. In September 1975, the Reserve Bank of India (RBI) abandoned the direct peg of the Indian rupee to the pound sterling, adopting instead a basket-linked exchange rate arrangement. The value of the rupee was linked to a weighted basket of currencies of India's major trading partners. While this system initially involved a wider group of currencies, it was later managed with a focus on five key currencies. 

In the context of the balance of payments crisis of 1991, a transitional Liberalised Exchange Rate Management System (LERMS) was introduced in India in March 1992. It was a dual exchange rate system aimed at preparing the country for fuller economic liberalisation. It required 40% of foreign exchange earnings to be surrendered to the RBI at the official rate, while 60% was converted at market rates.

LERMS was replaced by a unified floating exchange rate in March 1993. The exchange rate policy of the RBI since then has been to let the rupee find its level on the basis of the market forces of demand and supply, with interventions or purchases and sales of foreign exchange by the RBI only to quell undue and excessive volatility.

The RBI intervenes on both sides, buying and selling foreign exchange, and, therefore, it is even handed. This validates its objective of having no specific target around the level of the exchange rate. The volatility of the exchange rate, whether measured by implied volatility backed out of a Black-Sholes model of options pricing, or by rolling standard deviations, or by generalised auto regressive conditional heteroscedasticity measures, has declined significantly.

Those with genuine underlying exposures like it. Those who speculate or trade derivatives to price and transfer risk hate it.

This is Part 14 of the Masterclass with Michael Patra.
Masterclass with Michael Patra: Previous Sessions