The rupee and its gyrations have impacted the performance of the economy as well as financial markets significantly over the last several years. Though we might make a case for ignoring the impact on INR movements on the Financial Markets its impact on the real economy cannot be ignored. Under the circumstances, for an economy that runs twin deficits with huge supply constraints which has led to an increasing output gap and a ballooning Current Account Deficit what should be the currency policy is an important question to answer. For this we also need to go back into history in order to see the impact of the rupee in different scenarios.
The rupee was believed to be significantly overvalued prior to the financial crisis of 1991. As such when the first round of the economy’s opening up was started in by the current Prime Ministers as the Finance Minister in the year early 1990’s one of the first steps was to devalue the rupee. This was a time period where the Current Account Deficit had exceeded a level of 2% of GDP continuously for three years. In the first devaluation cycle the INR went from a level of 18/$ to 25/$ from January 1991 to July 1991 and in the second round of devaluation from a level of 25/$ to the range of 31-32/$ by March 1992. This had two immediate impacts.
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