Management of exchange rates: India's experience

Abstract

In today's world or internationalized markets, managing exchange rate is as important, if not more, as managing the domestic money supply and price level. This is true for both the developed as well as the developing economies. However, in the case of developing economies, the need for effective exchange rate management becomes more pressing as they have to constantly adjust to the external shocks of frequent currency realignments arising out or changes in the major currencies o the world. Owing to high degree of dependence on the developed countries, any adjustments in the rates of major currencies of the world have direct effects on trade, capital flown, and the price level or developing countries. The objectives of this study (behavior of the exchange rate of Indian rupee since the beginning or the 'Basket pegging' in September, 1975) are tour told: (a) To examine the theory behind the exchange rate determination in the Indian context. This is attempted through testing the existing alternative models or exchange rate determination using Indian data. (b) To unearth the composition of the basket used by the Reserve Bank of India to regulate the rupee exchange rate. (c) To evaluate alternative exchange rate arrangements. (d) To examine the developments in India's exchange rate policy since 1975 in relation to its overall macroeconomic policy. The issue concerning the impact of devaluation on balance of trade is also discussed in the study. The study has been conducted in a partial equilibrium framework. Single equation models were formulated and estimated using Ordinary Least Squares (OLS) and Restricted Least Squares (RLS) methods. Sensitivity analyses/simulations were carried out to further validate the findings and derive implications for India's exchange rate policy. The main findings of the study are: 1) The short-run exchange rate or rupee deviates from its long run equilibrium rate (purchasing power parity ii) The observed persistence of exchange rate movements is not fully explained by any of the models estimated. Though there are controls operating in India on inflow and outflow or foreign capital, the interest rate differential enters as a significant explanatory variable in almost all versions of the monetary model. iii) A five currency basket consisting of US dollar, Japanese yen pound sterling French franc and Deutsche mark explains more than 95 per cent variation in the rupee rate under the present system. Iv) The exchange rate policy in the Indian context has been fallout of overall economic policy. The focus has been mainly on the 'stability' of exchange rate, particularly since 1975. v) The estimated elasticity’s of demand for India's exports and imports do not offer any conclusive evidence for or against the utility of devaluation as policy stance to overcome balance of payments difficulties.