Factors affecting exchange rates. India tends to have much higher inflation than Australia and also much higher interest rates than Australia. Inflation and interest rates are much more volatile in India than in industrialised countries. The value of the Indian rupee is typically more volatile than the currencies of industrialised countries from an Australian perspective; it has typically depreciated from one year to the next, but the degree of depreciation has varied substantially. The bid/ask spread tends to be wider for the rupee than for currencies of industrialised countries.

a. Identify the most obvious economic reason for the persistent depreciation of the rupee.

b. High interest rates are commonly expected to strengthen a country's currency because they can encourage foreign investment in securities in that country, which results in the exchange of other currencies for that currency. Yet, the rupee's value has declined against the Australian dollar over most years even though Indian interest rates are typically much higher than Australian interest rates. Thus, it appears that the high Indian interest rates do not attract substantial Australian investment in Indian securities. Why do you think Australian investors do not try to capitalise on the high interest rates in India?

c. Why do you think the bid/ask spread is higher for rupees than for currencies of industrialised countries? How does this affect an Australian company that does substantial business in India?