Exchange Rate Regimes and Inflation: Evidence from India

Biswajit Mohanty and N R Bhanumurthy

International Economic Journal, 2014, vol. 28, issue 2, 311-332

Abstract: Exchange rate stability is crucial for inflation management as a stable rate is expected to reduce domestic inflation pressures through a 'policy discipline effect' - restricting money supply growth, and a 'credibility effect' - inducing higher money demand and reduced velocity of money. Alternatively, the 'impossibility trillema' of Mundell (1961a, 1961b) predicts that in the presence of an open capital account, a stable exchange rate may lead to lack of control on monetary policy and, hence, higher inflation. Using a monetary model of Inflation, this paper investigates the impact of the 'empirically-claimed' de facto stable exchange rate regime on inflation in India during different sub-periods of exchange rate stability. The results show that the impact of exchange rate regime on inflation is not visible in the Indian case, which could be because of the offsetting sterilization policy undertaken by the Reserve Bank of India (RBI) during expansionary money supply growth resulting from its large-scale intervention to even out exchange rate volatility.

Date: 2014
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DOI: 10.1080/10168737.2014.905618

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