Bank Rate and Interest Yield Differentials as Determinants of Foreign Exchange Rate in India

Considering that foreign exchange rate is the price of domestic currency in terms of a foreign country’s currency, it can be established that the market price of domestic currency would depend largely on the demand-side and supply-side factors influencing the foreign exchange market of a country. This is especially true in the case of an economy where either free-float or managed-float exists. The present research tests the validity of this notion in part, by considering the supply-side factors influencing the foreign exchange market of India, against the dollar. These factors include various types of interest rates and interest rate differentials between India and the US, money supply and foreign exchange reserves of India. Considering the impact of money supply, the role of monetary policy through the management of bank rate policy of the Reserve Bank of India (RBI) can also be influential. Application of OLS method on a monthly time series from April 1996 to January 2006, indicates that bank rate of the RBI, the short-term and long-term domestic interest differentials and interest yield differentials, and the growth rate of foreign exchange reserves determine the rupee-dollar exchange rate to a significant extent.