If inflation in India is 5% and in US is 3%, would exchange rate of rupee per dollar increase 2%?

Question

I am guessing the answer is not simple and that there is a lot more to exchange rates.

Answer 1

No,

Inflation forces government to push currency in the market (By hiking repo rate) and it may have a little effect in weakening the currency in the world forex market.

But there are other major factors like exports and INR (and USD's)  value wrt other currencies of the world which actually determines the rate between USD and INR.

Answer 2

All other things being equal? Yes. Take a look at the section titled "Nominal and Real Exchange rates" in:

http://en.wikipedia.org/wiki/Exchange_ra...

But all other things are never equal and there are all sorts of reasons for the changes and non-changes in the exchange rates (some of which are described in the Wikipedia page).

For example, China has pegged its currency to that of the U.S. so even though the Chinese inflation rate has been twice as high as that of the U.S. the exchange rate, being pegged, hasn't changed.

Some economists argue that inflation is always the result of too much money, but others recognize that there are different reasons and that they have economic implications.

For example, if the government is printing too much money because it is operating with a deficit, then you'll see inflation  in the "money economy" even if the nothing has changed in the "real economy".

On the other hand, there are changes in the "real economy" that can affect prices as well:

http://en.wikipedia.org/wiki/Inflation

One example of a situation that would both increase the strength of a country and increase inflation would be massive foreign investment.

If everyone suddenly decided that India offered splendid opportunities for investment, then you'd have a massive influx of capital into India. More money would generate "demand-pull" inflation:

http://en.wikipedia.org/wiki/Demand-pull...

But because of the attractiveness of resources in India, foreign investors would still be willing to pay more for rupees to hire people, buy property, etc. This would make the rupee abroad worth more in spite of its inflation within India.