The exchange rate has changed from less than ₹4 a dollar in 1947 to more than ₹85/dollar in 2025. Why? And, what can be done about this? It is important to understand where an important part of the problem lies. In India, prices of most goods and services rise year after year. And, since dollar is nothing but purchasing power over goods and services abroad, its price will also rise.

It is true that the US also has inflation. However, in the long-term, inflation rate has been higher in India than in the US. So, the rupee falls relative to the dollar in the long-term. It is true that the exchange rate moves all the time for various “random causes” and that the relationship between the inflation rate and the exchange rate is quite weak. However, this is true mainly for the short term. In the context of the long term, inflation plays an important role in determining the path of the exchange rate.

If we do not want the rupee to depreciate against the dollar, at the least we need to adopt an inflation target of 2 per cent, which is the inflation target in the US. But we chose a 4 per cent inflation target in the deliberations over the period 2013-16. Given the higher inflation target in India than in the US, we need to accept depreciation of the rupee. However, we can, going forward, slow down the rate of depreciation. How?

Inflation target

We had formally chosen 4 per cent inflation target in 2016 in the backdrop of 7-8 per cent inflation in the previous few decades and around 10 per cent inflation just a few years earlier. And, subsequently the inflation rate has come down substantially though it is well above the 4 per cent target. Now, at this stage, if we are serious about reducing the long-term rate of depreciation of the rupee, we can shift from 4 per cent inflation target to, say, 3 per cent target next year when inflation targeting will be up for a review.

A reduced inflation target is anyway desirable for the less well-off and the less well-informed. So, there is a need to amend the mandate under inflation targeting. This will need approval of the Reserve Bank of India, the Ministry of Finance (MoF), and Parliament. If the inflation rate is to be brought down, then the RBI will need to slow down the rate at which it issues its money. This is because this money and inflation are related in the long-term. However, a reduced rate of growth of money will, in turn, reduce the income that the RBI “earns” from just issuing additional money.

Accordingly, the so-called dividend income from the RBI to the MoF will fall. So, the MoF needs to shift to a small extent to some other revenues, or a reduction is spending. This is not very difficult.

Also, the RBI needs to get more serious about bringing down the inflation rate to whatever is the accepted target rate. For the previous five years or so, this has not been the case. This needs to change. It is true that some of the inflation is due to a big rise in food prices, and the RBI cannot do much about this. But so long as such inflation is not global, a policy of more free trade in food helps. It can reduce the food price inflation in the country. Also, a calibrated policy of procurement, reserves, timely distribution, and a countercyclical tax-subsidy scheme can help.

So, the Ministry of Agriculture and Farmers Welfare, the Ministry of Commerce and Industry, and the MoF need to make suitable changes in policy and in implementation. All this is not easy but its not very difficult either. In the 1970s, we had a major oil price shock, which led to huge cost-push inflation. However, it is not well known that since the early 1980s though the nominal price of oil has increased considerably, the average rate of appreciation in the real price of oil is actually quite low. Of course, the real price has fluctuated considerably. So, the MoF can use a tax-subsidy scheme, or at least a policy of variable tax so as to stabilise the domestic price of oil and, thereby, minimise the cost-push inflation related to oil.

Export competitiveness

The long-term path of the exchange rate is, of course, not just a matter of a difference in the inflation rate between two countries. There is the other important issue of competitiveness in production and in exports. Exchange rate between two currencies incorporates a relative price of a bundle of goods across the two countries. If India becomes less competitive, the rupee can, ceteris paribus, decline. The relative price under consideration is not highly variable but it is, by no means, a constant. And, it is for the market to keep discovering this relative price.

This brings us to the real effective exchange rate (REER). The point is not that the RBI should somewhat target a particular REER and thereby ensure that India’s competitiveness in the international markets for goods and services. Instead, the point is that the Ministry of Commerce and Industry should try to ensure competitiveness within the economy (example, pay attention to ease of entering business). Consequently, the market determined REER will, by and large, not go against us.

All this is not to say that the RBI should not intervene in the currency market. It should intervene but do so only when it is absolutely necessary. This makes it credible. It is also consistent with flexible inflation targeting.

In conclusion, at least for now it is advisable to accept the long-term fall in the value of the rupee vis-a-vis the dollar but we can move to a slower rate of depreciation. This requires some serious work by the central bank and other public authorities but it is doable.

The writer is an independent economist. He taught at Ashoka University, ISI (Delhi) and JNU