Study of RBI's monetary policy & its effects on exchange rate movements

Abstract

ABSTRACT The Central Bank in any country is entrusted with a number of responsibilities – apart from acting as a banker to the Central Government, this is the body that formulates and implements policies designed to keep the domestic economy in a functioning state. These functions are performed through two main primary means – the Fiscal Policy and the Monetary Policy. Some of these goals, at times, appear to be contradictory and mutually exclusive. Hence, a good Central Bank has to constantly tread a fine line and maintain a balance between these often dichotomous pulls. In India, the Reserve Bank of India performs all of the above functions. Inspite of the rapid changes in the domestic economic scenario post liberalization, since, the local capital markets are not as developed as in the US and EU, the RBI retains its premier position. All players in the economy look at the RBI not only for specific instructions and guidelines but also for signals that might signify future courses of action. However, given the sheer range of (often seemingly) conflicting objectives, guessing is often reduced to plain speculation. This report seeks to identify the objectives of RBI’s monetary policy in the context of exchange rates. There are a number of theories in vogue that attempt to explain RBI’s actions. However, there are very few studies that have tried to use available data to explain predictions. This report is an attempt to verify the more prominent ones of these theories by analyzing the available data. The primary aim of this project is to uncover the underlying thrust of RBI’s policies when it comes to exchange rates. The initial part of the report looks at establishing visible trends after a rigorous analysis of the data given. Then, the trends are verified against the theoretical framework. Next, as the RBI does not disclose the contents and weights of the currency index it uses; an attempt is made to replicate the index using the inflation data and the exchange rates. Finally, the results of the replicated index are compared with those of the actual index. An attempt has been made to explain discrepancies between the two and to develop a framework consistent with the results.