US Dollar and Indian Rupee conversion rate...

Every time the Indian Rupee (INR) hits a new low against the US Dollar, it creates a lot of buzz. If you compare the inflation rates in both countries and perform a simple calculation, the result closely matches the current exchange rate. I conducted this analysis based on available data but wasn't entirely sure if I was correct, as my knowledge of Economics and Finance is basic, mostly from my MBA, which I completed 20+ years ago. Although I've read a bit about the subject on my own, I needed someone or something to validate my analysis. I ran my findings by ChatGPT and was pleased to discover that the analysis was largely on track, though not entirely complete—something I didn't expect it to be.

Here’s the question I posed to ChatGPT:

"In 2014, one US dollar was equal to 58 Indian Rupees. Over the past 10 years, the average inflation rate in India has been 5.5%, while in the US it has been around 2.1%. The net inflation rate, therefore, is 5.5% - 2.1% = 3.4%. Based on inflation alone, the value of the US dollar, which was 58 rupees in 2014, should today be 58 * (1.034)^10 = 81.03. The current exchange rate is 85, which isn't much higher than 81. Is this analysis correct?"

Response from ChatGPT:

Your analysis is directionally correct, but there are some nuances to consider:

1. Inflation Differential:

   • You've correctly calculated the net inflation as $3.4\mathrm{\%}$ (Indian inflation rate minus U.S. inflation rate) and applied it over 10 years. The formula $58\times (1.034{)^10}^{}$ indeed gives $81.03$, which reflects the expected exchange rate based solely on the inflation differential.

2. Today's Exchange Rate:

   • The actual exchange rate of 85 is reasonably close to the inflation-adjusted estimate of 81.03, suggesting that inflation differentials play a significant role in determining the long-term trend of the exchange rate.

3. Factors Beyond Inflation:

   • Exchange rates are influenced by many other factors besides inflation, such as:
     • Interest Rate Differentials: Higher interest rates in one country attract foreign capital, strengthening the currency.
     • Trade Balance: Persistent trade deficits or surpluses can affect demand for a currency.
     • Capital Flows: Investments, foreign direct investment (FDI), and speculative capital flows also influence exchange rates.
     • Government Policies: Central bank interventions and fiscal policies can have significant impacts.
     • Geopolitical Factors: Political stability, market sentiment, and global events can create deviations from inflation-based predictions.

4. Model Simplifications:

   • Your calculation assumes that the relationship between inflation differential and exchange rate movement is linear and uninterrupted. In reality, short-term fluctuations and market dynamics can cause deviations from this trend.

Conclusion:

Your analysis using inflation differential is a good approximation for the long-term trend, and the proximity of $85$ to $\mathrm{81.03 }$validates this. However, the small difference can likely be attributed to the additional economic and geopolitical factors mentioned above. It's a robust but simplified approach to understanding exchange rate movements.