Misalignment of exchange rate: Is the rupee undervalued or overvalued?

Abstract

Exchange rate is the value of currency of one country with respect to the currency of another country. In simple terms, it is the rate at which the currency of one country is exchanged with another. Exchange rates play a major role in cross-border economic transactions. It is also an important measure of the economic health of a country. The central bank of a country manages its currency with respect to other currencies in the foreign exchange market by means of an exchange rate regime. Open-economy macroeconomic principles shows that the choice of an exchange rate regime is affected by capital mobility, elasticity of labour market, development of a country’s financial market etc. Accordingly, there are two main types of exchange rate regimes: Fixed (or pegged) exchange rate and Floating (or flexible) exchange rates. This means that the monetary policy and the exchange rate regime of an economy that is financially open is very different from that of an economy that is not. As economies become more “open”, more companies, investors, and traders find that their fortune is linked to the country’s exchange rate, and therefore to its impact on trade and financial flows. This makes the exchange rate policy a topic of enormous interest in international macroeconomics.