In recent weeks, there has been a lot of focus on the appreciation of the rupee against the dollar. In an opinion piece in Financial Express today, I point out that the US dollar has fluctuated considerably in the period after September 2008, and interpret the recent events on the Indian currency market. At first, in the `flight to safety’ into US government bonds that came about after the Lehman shock, the US dollar gained ground. As the global financial system has gained confidence, the reversal of this `flight to safety’ has meant a concomitant decline in the US dollar.

These ups and downs of the US dollar have important implications for our intuition in India about the rupee-dollar rate. If we think the US dollar is roughly fixed, then the pursuit of an inflexible rupee-dollar rate can be interpreted as some kind of `stability’. But if the US dollar itself is a fluctuating yardstick, it is hard to justify efforts at RBI to obtain inflexibility of the rupee-dollar rate. When the dollar declines in value, an attempt at holding on to a rigid rupee-dollar rate is tantamount to forcing a rupee depreciation, and vice versa.

Greater flexibility in the rupee dollar rate will free up monetary policy to pursue the more important goal of stabilising the domestic business cycle. But along the way, for firms to learn to live with greater flexibility of the rupee dollar rate, well functioning currency derivatives markets are required. RBI needs to first step away from the present strategy of banning most of these markets, so as to be able to move forward to greater flexibility of the rupee.

On the macroeconomic arguments about the long-term decline of the US dollar, see Wolfgang Munchau in the Financial Times today.