The last few days have seen a sharp depreciation of the rupee. At a time when inflation is already high and there are significant inflationary pressures in the economy, an exchange rate depreciation is feeding into higher prices. There has recently been a lot of debate on whether there is a passthrough or not. I believe that while the magnitude and lags of the passthrough depends on the model, method of estimation and time period chosen, it is clear that there is a passthrough. Different methods such as a VAR for year-on-year changes, or for seasonally adjusted point-on -point changes, or a VECM with a number of cointegrating relationships, give different results. The graph here suggests that even if there is no agreement on the magnitude and levels of the passthrough, it is difficult to believe that there is no passthrough at all.
The figure shows inflation based on the Wholesale Price Index (WPI)and the percent change in the exchange rate. The data is monthly and the graph shows the year-on-year percentage change in each of the two variables since January 2004. Rupee depreciation (an upward movement of the exchange rate in the graph) is often associated with higher inflation. How much will the effect be, and when it will take place, depends on a number of other factors. If international prices are moving up at the same time, it is double trouble. If there is too much liquidity in the system, it means that there is a lot of demand, and so again that spells more trouble. If, on the other hand, there is a slowdown in the domestic economy, then the pressure on inflation may be low, and domestic prices may either move less or more slowly.
In the figure we see that the period when the exchange rate appreciated (a move of -12 percent last year, seen as the line showing percent change in the rupee dollar rate moving down) was associated with a period of declining inflation. The recent sharp rupee depreciation is associated with the recent acceleration in inflation.
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