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IAI Actuarial Core Principles · Business Economics · Balance of payments and exchange rates

Under a floating regime the rupee is initially in equilibrium at ₹80 per dollar. Simultaneously, strong foreign portfolio inflows into Indian equities occur and India's import bill rises sharply (assume both effects are large). Which statement is the most reliable prediction?

The direction of change cannot be determined without knowing the relative size of the two effects. Portfolio inflows raise demand for rupees and appreciate the currency, while a larger import bill raises the supply of rupees and depreciates it, so the net outcome depends on which is bigger.

  1. AThe rupee must appreciate because capital flows always dominate
  2. BThe rupee must depreciate because imports always dominate
  3. CThe rupee's price of a dollar is unchanged, because the two effects are only temporary
  4. DThe direction of change is indeterminate without knowing the relative size of the two effects on rupee demand and supplyCorrect
  5. The rupee will appreciate because the import bill reduces the supply of rupees

Explanation

Portfolio inflows raise demand for rupees and push it up. A bigger import bill raises the supply of rupees (demand for dollars) and pushes it down. These effects work in opposite directions, so the net direction depends on their relative size. The option claiming the import bill reduces rupee supply has the logic reversed.

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