## Monetary Approach to the exchange rate 1. The monetary approach to the exchange rate ==highlights the role of money as a key determinant of the exchange rate. == 2. Excess money supply in the economy relative to what may be necessary for sustainable non-inflationary growth can cause either: 1. higher inflation (if prices are flexible) or 2. a lower interest rate (if the asset market is flexible), both of which can in turn cause the exchange rate to depreciate. 3. ==Exchange rate depreciation, therefore, can be the result of an easy monetary policy stance adopted in the past.== Accordingly, a tighter monetary policy may be warranted to manage a condition of intense exchange market pressure. 4. **The Uncovered interest parity (UIP) puzzle** 1. Uncovered interest parity (UIP) under rational expectations is the hypothesis that there is no foreign exchange risk premium, or that the expected excess returns on foreign bonds is equal to zero. 2. UIP holds that if a country has a higher interest rate relative to the rest of the world, its exchange rate is expected to depreciate. In practice, however, higher interest rates can lead to currency appreciation, and hence the UIP puzzle. 3. The UIP puzzle has several explanations such as imperfect asset substitutability, non-rational expectations, time varying risk premium and the peso problem (that is, when market prices reflect the low possibility of a large change). Moreover, UIP assumes perfect capital mobility, besides domestic and foreign bonds being perfect substitutes. As a result, risk premium is also assumed to be zero. In reality, however, risk premium is both non-zero and time varying, that is, foreign investors in EMEs would expect a risk premium, and their ‘risk on-risk off’ behaviour can make the risk premium time varying, which in turn could be influenced by both domestic and external macro-financial developments, including monetary policy settings. 4. Unconventional monetary policies (UMPs) of advanced economies, and the Fed’s taper talk in May 2013 <span style="background-color: #ecf9ee">altered the risk premiums in both advanced and emerging economies, in turn impacting exchange rate expectations and capital flows. </span> ## Experience of 2013 1. In India, various monetary policy measures were taken in 2013 to reduce exchange market pressures. This [[Measures to stabilise the exchange market#2013|section]] has more details. 2. ==The experience with managing exchange market pressures in 2013-14 underscores the relevance of monetary policy as an instrument of exchange rate stabilisation. 3. Even though in normal times, monetary policy **may not pursue** any exchange rate objective and allow market fundamentals in terms of interest rate differentials and inflation differentials to evolve or condition the path of exchange rate. ## References 1. Reserve Bank of India. (2014). Annual report 2013–14 2.