Exchange rate determination in India endogenising foreign capital flaws and some entities of monetary sector

The exchange rate in India had not been fully floating until the financial year 1992-1993. Even after this the exchange rate market has required intervention on many occasions by the Reserve Bank of India that sold US dollars in the spot and forward markets. Based on the theoretical foundations, alternative single equation models have been used to describe the behaviour of the nominal bilateral exchange rate between India and U.S.A over the time period 1971-72 to 1996-97. A simultaneous equation model, endogenising foreign capital flows and some entities of the monetary sector, has been specified and estimated by the 2 SLS method. The Regression results seem to be quite satisfactory in terms of all the econometric properties and expected signs of coefficients of the variables. Prices, interest rates, and money supply in the home and foreign country are found important variables to explain the behaviour of the bilateral exchange rate. Other significant variables found are balance of payments items such as current and capital account balances and foreign exchange reserves. Dummy variables representing the exchange rate policies in India since 1991-92 are also found significant. Although the exchange rate time series is found stationary of order one, but the detrended variable and the first order difference of the exchange rate variable does not provide better estimates. Thus, the 2SLS results are based on the actual values of the exchange rate. The results based on the 2SLS method of estimation show that the endogenous variables considered are highly correlated with each other. The exchange rate is found to be determined by the domestic price index with a positive coefficient and the wholesale price index in the U.S.A. with a negative coefficient. The results show that the model can be used for forecasting the exchange rate in the short run. The reduced form and the impact multipliers for the model have also been obtained.