Abstract
This paper examines the empirical relevance of the flexible price monetary model in the Indian context to determine whether US dollar-Indian rupee exchange rate movements are in line with the changes in monetary fundamentals namely relative money supply, relative interest rates and relative output. A sample period of nineteen years (August 1996 to March 2015) was considered for the study and the entire period was divided into two sub periods marked by distinct patterns of exchange rate volatility and variations in the behaviour of macro-economic fundamentals. The study examined whether there exists a long-term relationship between exchange rate and variables of the monetary model besides investigating the predictive ability of the model in determining the exchange rate in the Indian context. The Johansen Juselius test of cointegration was carried out and the variables were found to be linearly cointegrated establishing the long-run relationship between exchange rate and monetary fundamentals rate thereby confirming the suitability of the flexible price monetary model in determining Indian rupee vis-a-vis US dollar. The Granger causality test [21] was conducted to determine the direction of causality between variables and to evaluate the predictive power of the monetary model and the test results exhibited some idiosyncratic patterns among the variables across the two sub periods. For the first sub period, the Granger causality test results show that there is a one-way causality from relative output and relative money supply to exchange rate, while there is no causality from relative interest rate to exchange rates. This result is quite puzzling and calls for further investigation. As the direction of causality is changing within the sample, the study suggests that the monetary model standalone cannot be effectively used for predicting exchange rate in the Indian context. A more comprehensive model with more macro-economic variables such as trade balance and capital flows may be combined with the existing variables for effective forecasting of exchange rate in India.
Highlights
In an increasingly globalised world, with the growing significance of international trade, the exchange rate has become an important variable impacting the decisions of exporters, importers, bankers, financial institutions and policymakers alike across both the developed and developing world
The empirical relevance of the flexible price monetary model has been studied for India, to determine whether US dollar-Indian rupee exchange rate movements are in line with the changes in monetary fundamentals
Flexible price monetary variables namely relative money supply, relative interest rates and relative output were considered in the study
Summary
In an increasingly globalised world, with the growing significance of international trade, the exchange rate has become an important variable impacting the decisions of exporters, importers, bankers, financial institutions and policymakers alike across both the developed and developing world. The liberalisation and development of foreign exchange and assets markets, have led to the consideration of important variables such as capital flows, volatility in capital flows and forward premium along with central bank intervention in determining exchange rates. The micro level dynamics in foreign exchange markets has gained prominence due to rise in the trading volumes in these markets and the subsequent evolvement of the microstructure theory in determining exchange rates (Evans and Lyons, [1] [2]). The study focuses on studying the validity of the flexible price monetary model during a managed float exchange rate regime to answer the following two main research questions
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