Forecasting the Rupee-Dollar Exchange Rate Using the Monetary Model

We use the monetary model of exchange rate determination to generate in-sample and out-of-sample forecasts of the Rupee-Dollar exchange rate. The assumptions of flexible prices and maintenance of Purchasing Power Parity implies that the domestic price level and the exchange rate are endogenously determined given the money supply policy. We undertake simultaneous equation estimation with the nominal exchange rate and the consumer price index as the endogenous variables using the two-stage least squares procedure. The estimated parameters were then used to generate in-sample and out-of-sample forecasts and compared with actual values