Abstract
The current study attempts to examine the importance of the Flexible Price Monetary (FPM) Model in explaining the INR/USD exchange rate movement with macro variables such as relative money stock, relative rates of interest and relative output for the period from April 1995 till December 2016. Prior to estimating the empirical model, an array of non-stationarity tests was employed to identify the time series characteristics of the data. Since all the data series were confirmed to be integrated of order one, the multivariate cointegration methodology was used to verify long-run validity of the model. The empirical results garner support for the FPM model in determining INR/USD exchange rate in the long run. The test on direction of causality confirmed existence of causality from FPM variables to exchange rate. The empirical model was estimated in the Vector Auto regression (VAR) framework and variance decomposition analysis was used to examine fluctuation in INR/USD exchange rate caused by the shocks in FPM model variables. It was found that, the monetary model variables explain the exchange rate patterns over a longer period of time but was found not very effective in the short run and hence cannot be considered as a useful framework in explaining the variations in INR/USD exchange rate.
Highlights
Over the last few decades, the complex behavior of foreign exchange rates and its determination has garnered significant interest both among policy makers and in academia
The empirical model was estimated in the Vector Auto regression (VAR) framework and variance decomposition analysis was used to examine fluctuation in INR/USD exchange rate caused by the shocks in Flexible Price Monetary (FPM) model variables
In order to examine the fluctuation in INR/USD exchange rate caused by the shocks in FPM model variables, variance decomposition analysis was used
Summary
Over the last few decades, the complex behavior of foreign exchange rates and its determination has garnered significant interest both among policy makers and in academia. Most of the empirical literature in the field of international finance is highly biased towards the study of exchange rate behavior of major currencies of advanced economies such as USD, Yen and pound sterling while very little attention has been paid to currencies of emerging economies. Against this backdrop the present article attempts to bridge this gap by investigating the importance of the FPM model in determining the INR/USD exchange rate over a longer time frame.
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