FOREIGN EXCHANGE AND CAPITAL INFLOW

Consider a unified currency area, e.g. the union of Indian states. Whenever some local rate of interest goes up, there is an inflow of money to that region. Thinking about a unified currency area as a fixed exchange rate regime with the exchange rate pegged at unity, the above conclusion suggests that in a fixed exchange rate set-up, capital inflows lead to changes in the stock of domestic money supply

On the other hand, if the exchange rate is fully market determined, there is no need for RBI intervention. The RBI has no reason to either buy up dollars (releasing rupees) or release dollars from its stock (in exchange for rupees). Therefore there is no change in official foreign exchange reserves and no effect on the domestic money supply

In the fixed exchange rate regime, the additional foreign capital that enters India is lodged with the RBI, and the RBI issues additional rupee loans to domestic borrowers against this. Thus domestic money supply in the Indian economy goes up. So we know what happens to the additional dollars in this case: they are hoarded by the RBI. But what happens to these additional dollars when the exchange rate is freely floating? We are told that in this case the money supply hasn’t changed so where have they gone?

If there is no additional demand to hoard dollars (a “stock demand” for foreign exchange), then the additional dollars will have circulated back to the U.S. The inflow of dollars creates an excess supply in the foreign exchange market (matched by an excess demand for rupees). This causes an appreciation of the exchange rate (the rupee becomes stronger), and increases the excess demand for dollars on the trade account. Importers buy up the excess dollars, purchase American goods, and in this manner the dollars return to the U.S.

There is also no change in domestic money supply. The rupees paid by importers to buy dollars are used by foreign investors to lend to domestic borrowers (i.e. buy rupee capital). This meets the excess demand for rupees that arose in the first place when foreign capital tries to move to India.