Why does the rupee depreciate (apart from the changes in the US Dollar due to US policy where we have to fall in line, which is only a recent phenomenon while the depreciation of the rupee is a long-term phenomenon in our country due to continuous budget deficits funded by money creation in whole or in part)?
Such deficit budgeting was adopted under a mistaken understanding of Keynesian deficit budgeting where there were under-utilised resources such as capital. This Keynesian theory is not applicable to a country where there is an absolute shortage of capital and not an under-utilisation of capital due to the lack of effective demand as in the developed countries at a particular time.
Our politicians and some pseudo economists used Keynesian theory to justify deficit financing misinterpreting Keynes.
So our political masters used this pseudo theory to satisfy their desire to spend money. During the colonial rule the domestic money supply was linked to the foreign assets and the money supply increased and decreased with the changes in the external resources. The exchange rate was fixed but subject to market conditions which required devaluations from time to time. Then there was a clamour for the setting up of a Central Bank which could create money on its own initiative without being linked to the External Reserve at a fixed value (which could be changed under compliance with the IMF provisions). This was a disaster since our Central Bank could not function independently. Nothing can function independently in our populist democracy. So our servile Central Bankers funded the budget deficits of the profligate people’s governments after lo and behold we have massive external deficits instead of the more usual price inflation since we are highly import-dependent and imports were unrestricted by UNP Governments.
The problem is not the exchange rate depreciation but the current account deficit in the balance of payments not offset by long-term capital inflows. Long-term capital inflows no longer grow as in the past.
Let us therefore stop budget deficits and ask our Governments to balance the budgets without borrowing abroad to fund such deficits under the pretext of foreign aid. The exchange rate will then become more stable.