Factors Determining the Exchange Rate Movement under a Partial Capital Mobility Regime

Abstract

The study examines the rupee–US dollar exchange rate (Rs/$) behaviour in the presence of increasing and ample capital inflows in the post-reform period in India. Using monthly data (1994:4 to 2007:8) the study estimates a basic exchange rate model in a time series framework in order to assess the relative significance of capital inflows in the presence of interest rate, inflation rate and growth rate differentials and other factors (forward exchange rate/expected exchange rate) in influencing the rupee–dollar exchange rate behaviour. It finds the dominance of foreign institutional investments affecting the rupee–dollar exchange rate and, to a certain extent, it is seen that the influence of the growth rate differential affects the exchange rate behaviour in India.

Keywords:

• Exchange rate
• capital mobility
• interest rate
• inflation
• block Granger causality

JEL Classifications:

• C3
• E52
• E62
• F33
• F4
• H3

Acknowledgements

The author acknowledges the valuable suggestions received from the panellists and the participants of the National Conference on ‘Forecasting Financial Markets in India’ held at IIT, Kharagpur on 29–31 December 2008.

Notes

¹The interest parity condition explains the relationship between interest rates and exchange rates. Under perfect capital mobility, interest rate differences must be offset by expectations of exchange rate movements if the investors are risk averse and endowed with rational expectations. The domestic interest rate can exceed the foreign interest rate only if the domestic currency is expected to depreciate. This is known as uncovered interest parity.

²In estimating the long-run parameters of the interest rate equations through Dynamic Ordinary Least Square (DOLS), it basically involves regressing any I(1) variables on - other I(1) variables, any I(0) variables to be incorporated and leads and lags of the first differences of any I(1)variables in the model.