TITLE:
Does Existence of Long-Run Relationship Ensure Predictability of Exchange Rate? Empirical Analysis of Indian Rupee Vis-à-Vis US Dollar under Monetary Model Framework
AUTHORS:
Vaishali Padake, Bhargavi Karamcheti, T. Geetha
KEYWORDS:
Exchange Rate, Monetary Model, Cointegration, Granger Causality, Indian Rupee
JOURNAL NAME:
Theoretical Economics Letters,
Vol.6 No.3,
June
17,
2016
ABSTRACT: This paper examines the empirical relevance of the flexible price monetary
model in the Indian context to determine whether US dollar-Indian rupee exchange
rate movements are in line with the changes in monetary fundamentals namely relative
money supply, relative interest rates and relative output. A sample period of nineteen
years (August 1996 to March 2015) was considered for the study and the entire period
was divided into two sub periods marked by distinct patterns of exchange rate volatility
and variations in the behaviour of macro-economic fundamentals. The study examined
whether there exists a long-term relationship between exchange rate and variables
of the monetary model besides investigating the predictive ability of the model
in determining the exchange rate in the Indian context. The Johansen Juselius test
of cointegration was carried out and the variables were found to be linearly cointegrated
establishing the long-run relationship between exchange rate and monetary fundamentals
rate thereby confirming the suitability of the flexible price monetary model in
determining Indian rupee vis-à-vis US dollar. The Granger causality test [21] was
conducted to determine the direction of causality between variables and to evaluate
the predictive power of the monetary model and the test results exhibited some idiosyncratic
patterns among the variables across the two sub periods. For the first sub period,
the Granger causality test results show that there is a one-way causality from relative
output and relative money supply to exchange rate, while there is no causality from
relative interest rate to exchange rates. This result is quite puzzling and calls
for further investigation. As the direction of causality is changing within the
sample, the study suggests that the monetary model standalone cannot be effectively
used for predicting exchange rate in the Indian context. A more comprehensive model
with more macro-economic variables such as trade balance and capital flows may be
combined with the existing variables for effective forecasting of exchange rate
in India.