Real Effective Exchange Rate Indices of the Rupee: A Comparison of the Selected Alternative Series

The indices of Real Effective Exchange Rate (RER) compiled by the RBI end the other researchers assume a static direction and/or commodity-composition of India's exports. These assumptions lose validity as the time-span for which the series is constructed is lengthened. In view of this, it is argued that use of a variable weighting method - based on the exports shares of the previous five years could be adopted to overcome the assumption of a static direction of exports. Moreover, exports of a country have to be globally price-competilive. Hence, the relative inflation rate of country should be measured with respect to the low inflation countries with sizeable share in the global real income. By including countries with very high and chronic inflation rates, the RBI series has underestimated India's relative inflation rateas also the extent of nominal depreciation. Though the extent of underestimation in the real exchange rate on account of this factor is marginal, yet the distortions in the component series can give wrong signals for the policy guidelines. It may lead to complancency for pursuing tight monetary and flscal policies for the containment of inflation at home. Hence, excluding some of these countries is suggested. Lastly. in the economic literaturte these indices are compiled by using the modern definition, wherein the proxies of Wholesale Priceof Index (WPI) (for the rest of the world) and Consumer Price Index (CPI) (for the domestic economy) are used as the proxies for the prices of tradables and non-tradables. respectively. The RBI has not provided any theoretical justifictttion for using these proxies in an exactly opposite manner.