Exchange rates

Much of the current debate on the exchange rate misses one link in the chain of reasoning. It proceeds on the general assumption that depreciation is good for exports and appreciation bad. Eventually, we are interested in knowing the impact on the balance of trade due to a change in the rate.

To determine the effect, the Marshall-Lerner conditions refer to the elasticities of imports and exports. The importance given to the real rate of exchange is misplaced. It is a left-over from the days of the theory of Purchasing Power Parity, which even at its height of glory was found wanting empirically. It was, however, meaningful at a time when current account decided the exchange rate. Today, it is the capital account that is at the back of exchange rate movements. In the past, despite the appreciation of the yen, Japan continued to accumulate reserves. If one looks at the records, one can find increasing exports during periods of rupee appreciation. Market intervention to stem appreciation followed by sterilisation of the additional liquidity does not help. The exchange rate