Rupee appreciation and inflation

C Rangarajan, chairman of the PM's Council of economic advisors, was quoted as saying that rupee appreciation has helped contain the inflation rate- the rate is down to around 5% now.

In his column in Business Standard, Surjit Bhalla contests this. He writes:

The channel of influence for the “strong rupee is good for inflation” crowd is straightforward. Exchange rate affects traded goods, and if the rupee appreciates, prices in rupees go down, and lower inflation is observed. No one can argue against this simple, perhaps too simple, logic. A first test should be the observation of the opposite: when a currency depreciates then inflation should go up. While intuitive, it is not even obvious that an appreciation of the exchange rate will lead to lower inflation (or vice-versa). Consider the fact that until just a few years ago, currency depreciation and lower inflation were the norm for India. A year after the Asian crisis, inflation fell in the East Asian economies, despite a nominal, and real, depreciation of over 30 per cent.

Bhalla is right on the second part: there is no one-to-one correlation between rupee appreciation and the inflation rate. But he is right because the first part of his argument is flawed. The 'simple logic' that he mentions just doesn't hold.

True, rupee appreciation does bring down the prices of imports. But, this only affects the relative price of imports with respect to non-tradeables. To put it differently, imports would become relatively cheaper (so you would expect the inflation rate to go down) but other goods would be relatively costlier ( so you would expect the inflation rate to rise!).

The inflation rate has to do with the overall price level, not with relative prices. And the overall price level, as Milton Friedman pointed out long back, is a function of money supply. Rupee appreciation will not by itself impact on inflation. But it would do so through its impact on money supply.

When the RBI allows the rupee to appreciate, it does not intervene in the currency market. Such intervention tends to cause money supply to rise. By not intervening, the RBI reins in money supply. This reining in impacts on inflation.

So, yes, allowing the rupee to appreciate does impact on inflation. But not on account of "cost-push" factors- that is, cheaper imports. It does so on account of "demand pull" factors- the impact on money supply.