Exchange rate interest rate linkages in India: an empirical investigation

Purpose The purpose of the paper is to examine the linkages between exchange rate and interest rate in India using quarterly data from Q1 of 1996 to Q4 of 2014. Design/methodology/approach Stationarity properties of data are checked using the Augmented Dickey–Fuller (ADF), Dickey–Fuller test with GLS de-trending (DF-GLS) and Kwiatkowski-Phillips-Schmidt-Shin (KPSS) tests and Perron’s unit root test with structural breaks. Johansen Juselius and Gregory Hansen tests are applied to assess cointegration, and block exogeneity test is used to detect causality among variables. Findings The study finds long-run relationship among interest rate, rupee–dollar exchange rate, capital flows, intervention, inflation differential, money supply differentials, output differentials and trade-balance differentials. However, the interest rate does not explain movements in the exchange rate, directly and indirectly, via capital flows. Intervention by the Central Banks to stabilize exchange rate does not have implications for movements in interest rate. Research limitations/implications The study finds capital flows to be insensitive with respect to interest rates and hence thwarts International Monetary Fund ’s (IMF) claim of using interest rates as a tool to stabilize exchange rate. The much-debated conflict between exchange-rate stabilization and control over interest rates also does not hold up to the empirical reality of India. Originality/value The study augments the existing literature by taking into account the problem of structural break in the relationship between interest rate and exchange rate. Three measures of interest rate are used to assess the robustness of results adding to their credibility compared to previous studies.