MONETARY, REAL SHOCKS AND EXCHANGE RATE VARIATIONS IN INDIA

Abstract

(ProQuest: ... denotes formulae omitted.)1. INTRODUCTIONVariability of major world currencies in the post Britton Woods exchange rate era drew considerable attention to the economists, monetary authorities and market participants. Economists proceeded to provide theoretical explanations for this phenomenon. Consequently, international economics, over the last four decades, saw the growth of a plethora of economic theories on exchange rate. A number of fundamentals have been identified. A large number of empirical research studies have examined if the nominal and the real exchange rate variations are due to the real or nominal, the anticipated or unanticipated shocks in countries concerned.India has been experiencing, since the early phase of 1970's, a spell of depreciation of rupee against major currencies like the U.S. dollar. The rate of depreciation, however, displayed variation over the period. Such depreciation became spectacular since the recent past when India has been initiated into the market based exchange rate regime. The exchange rate regime that India has followed since 1993 is virtually the market-based system. The phenomenon of excess variability and continuous depreciation (with some occasional breaks) of exchange rate, particularly in the market-based exchange rate regime, constitutes an issue of interest to the researchers and monetary authority of India. This is because the exchange rate is a key instrument to the monetary policy particularly in such an emerging open economy having growing global integration. Movements of exchange rate influence portfolio investment, volume of trade, cost of debt payments and even price level in India.It has been found that macroeconomic fundamentals, sharply deteriorating merchandise trade balance, and large and growing current account deficit, speculation and central bank intervention, volatility in capital flows and forward premium are some of the important factors responsible for large depreciation and increased volatility of the Indian rupee (a more detail discussion is in Section 3: a review of related literature). The present study examines whether the variations of the Indian rupee against the US dollar that have been observed in the market-based exchange rate regime are related to the unanticipated shocks generated through money supply process and output production of India. This paper also presents a theoretical relation that variation in exchange rates is related to an unanticipated shock generated through the money supply process and output production of home country. This theoretical relation has been used as the base of the empirical analysis.The remaining part of the paper is structured as follows: Section 2 presents theoretical exposition. A review of related literature is presented in Section 3. Section 4 deals with variables, data and methodological issues. Analysis and discussion of the results are presented in Section 5 and Section 6 concludes the article.2. THEORETICAL EXPOSITIONDornbusch (1976) explained how exchange rate makes a dynamic adjustment to an unanticipated monetary shock. An unanticipated increase in the domestic money supply leads a rise in the exchange rate from its initial position. Domestic currency overshoots from the long run Purchasing Power Parity line. In short, monetary expansion leads to a depreciation of the domestic currency. Following Dornbusch, monetary approach to exchange rate determination (MAER) postulates that exchange rate is negatively related to domestic money growth. According to MAER (given sufficient capital mobility and sticky price level) the asset market bears the entire (unanticipated) shock transmitted through the monetary channel. More specifically, an unanticipated increase in domestic money supply leads to fall interest rate and, as result, opportunity cost of holding money falls. Investors, therefore, sell domestic bonds and money balances and purchase foreign bonds. …