The Relationship between interest rate and exchange rate in India

The theoretical as well as empirical relationship between the interest rate and exchange rate has been a debatable issue among the economists. According to MundellFleming model, an increase in interest rate is necessary to stabilize the exchange rate depreciation and to curb the inflationary pressure and thereby helps to avoid many adverse economic consequences. The high interest rate policy is considered important for several reasons. Firstly, it provides the information to the market about the authorities’ resolve not to allow the sharp exchange rate movement that the market expects given the state of the economy and thereby reduce the inflationary expectations and prevent the vicious cycle of inflation and exchange rate depreciation. Secondly, it raises the attractiveness of domestic financial assets as a result of which capital inflow takes place and thereby limiting the exchange rate depreciation. Thirdly, it not only reduces the level of domestic aggregate demand but also improves the balance of payment position by reducing the level of imports. But the East Asian currency crisis and the failure of high interest rates policy to stabilize the exchange rate at its desirable level during 1997-1998 have challenged the credibility of raising interest rates to defend the exchange rate. Critics argue that the high interest rates imperil the ability of the domestic firms and banks to pay back the external debt and thereby reduce the probability of repayment. As a result, high interest rates lead to capital outflows and thereby depreciation of the currency.