The Role of Interest Rate in Exchange Rate Management in India

PRADYUMNA DASH **

L. M. BHOLE *

Abstract

While the Mundell-Fleming model predicts that a change in interest rate is

necessary to stabilize exchange rate, the empirical validation of the effectiveness of

such policy stance has not been very strong in economic literature. This Paper

presents the empirical estimates of the relationship between interest rate and exchange

rate in India during January 1991 to December 2005 (Entire Reform period), January

1991 to March 1997 (“High” Interest Rate period), and April 1997 to December 2005

(Low or “Soft” Interest Rate period) by using Co-integration Technique based on

Vector Autoregressive Error Correction Model, and the Impulse Response Function

Analysis. The regression results show that an increase (decrease) in interest rate was

associated with an appreciation (depreciation) of exchange rate in India during

January 1991 to March 1997, but not in other two periods mentioned above. Thus,

interest rate has not been found to be consistently or uniformly effective in stabilizing

exchange rate in India in all the years. The empirical results in this Paper raise doubts

about the effectiveness of interest rate as a potential instrument to stabilize exchange

rate if capital is freely mobile.

**Pradyumna Dash is Faculty of Economics, ICFAI Business School, Mumbai Email: pradyumna.dash@gmail.com* L. M. Bhole is Professor of Economics, Department of Humanities and Social Sciences, Indian Institute of Technology, Mumbai. Email: bhole@hss.iitb.ac.in. website:www.hss.iitb.ac.in/faculty/bhole

The Role of Interest Rate in Exchange Rate Management in India

PRADYUMNA DASH **

L. M. BHOLE *

As a part of the acceptance of the policy of Structural Adjustment Programme

(SAP) and Stabilization Programme (SP), India has adopted a “Managed Floating” or

“Managed Flexible” exchange rate system since March 1993. In the aftermath of the

adoption of such a policy, the external value of the rupee has substantially depreciated

in terms of major currencies, and the rupee exchange rate has now become far more

volatile than in the past (See Table 1 and Figure1). As it has been argued, “capital

movements have rendered exchange rates significantly more volatile than before”

(Mohan, 2004, p. 95).

As it is natural, the exchange rate management has become one of the major

tasks of the monetary authorities under the “managed float” system of exchange rate.

The objective of exchange rate management or exchange rate policy has been to

maintain the stability of exchange rate, or to target orderly movements in exchange

rate changes, or to avoid excessive volatility or sharp changes in the behavior of

exchange rate. The exchange rate policy in India does not allow the rupee to

appreciate freely in line with market trends, or to depreciate significantly, nor does it

Table 1: Variability of Exchange Rates in India

Exchange Rates

Year

US Dollar

Pound Sterling

DeutschMark

JapaneseYen

NEER(Trade Based Weights)

NEER(Export Based Weights)

1992-1997 2.02 4.15 2.05 3.65 2.50 2.391997-2005 3.44 6.80 11.85 4.20 1.58 1.601991-2005 6.54 11.58 14.15 5.56 3.36 3.39

Note: Variability has been measured by standard deviation.

**Pradyumna Dash is Faculty of Economics, ICFAI Business School, Mumbai Email: pradyumna.dash@gmail.com* L. M. Bhole is Professor of Economics, Department of Humanities and Social Sciences, Indian Institute of Technology, Mumbai. Email: bhole@hss.iitb.ac.in. www.hss.iitb.ac.in/faculty/bhole.

1

Figure 1: Exchange Rate of the Indian Rupee Vis-à-vis Some Major Foreign Currencies

Panel A: US Dollar

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e Rate (INR/100

Yen

)

Source: Reserve Bank of India, Handbook of Statistics on the Indian Economy, 2004-05.

target its “calculated volatility”. In the words of the former Governor of the RBI, “the RBI

does not have a fixed “target” for the exchange rate which it tries to defend or pursue over

time; the RBI is prepared to intervene in the market to dampen excessive volatility as and

when necessary…….”(Jalan, 2003, pp.16).

2

Apart from direct market intervention in the form of buying and selling of

foreign currencies by the RBI, the authorities have to use other techniques of

monetary policy in their efforts to contain wide swings in the exchange rate. Given

the RBI’s preference for indirect or market-oriented techniques of monetary policy as

a part of financial sector reforms, the use of interest rates as an instrument to achieve

certain objectives, including the stability of exchange rate, has assumed great

importance. The RBI has already been using interest rate policy to contain the

volatility of the exchange rate in India. For example, as it has been stated, “the

Reserve Bank responded promptly through measures like the bank rate, repo

rate…..to curb destabilizing speculative activities during these episodes of volatility

while allowing an orderly correction in the value of the rupee” (RBI, 2002-03, p.204).

The use of interest rates policy effectively to dampen excessive volatility of the Indian

exchange rate requires systematic knowledge about the precise nature of relationship

between the interest rate and exchange rate, or the extent of impact of changes in the

rate of interest on the behavior of the exchange rate.

The objective of this paper is, therefore, to try to find out empirically whether

and how far the exchange rate is determined by the interest rate in India by using the

advance econometric techniques. Apart from a study by Pattanaik and Mitra (2001),

there is hardly any other major study on this theme in India. The present study

therefore assumes greater relevance and importance. It improves on the study just

mentioned by taking a much longer period for analysis, by improving the model

specification, and by conducting the period analysis. The paper estimates the

relationship between the rate of interest and exchange rate for 3 periods: (i) January

1991 to December 2005 (the entire reform period.). (ii) January 1991 to March 1997

(high interest rates period). (iii) April 1997 to December 2005 (low or “Soft” interest

rates period).

The paper is structured as follows: Section I presents a brief review of

literature on interest rate and exchange rate relationship. The methodology and model

used in this Paper is discussed in Section II. Section III discusses the empirical

findings. The conclusions are presented in Section IV.

3

Section IA Brief Review of Literature

A variety of patterns of interrelationships between the exchange rate and

interest rate has been visualized in economic literature. For example, the uncovered

interest parity theory implies that domestic interest rate is the sum of world interest

rate and expected depreciation of home currency. In other words, the interest rate

differential between domestic country and the rest of the world is equal to the

expected change in the domestic exchange rate. Assuming the world interest rate (i*)

to be exogenously determined, the relationship between domestic interest rate and

exchange rate depends on how expected exchange rate responds to changes in interest

rates. For example, in Dornbusch’s over shooting model (1976), expected exchange

rate appreciates more than the spot rate that prevails before raising interest rates to

equalize the returns on domestic assets and foreign assets. Therefore, there is a

negative relationship between interest rate and exchange rate. i.e., a high interest rate

policy is associated with exchange rate appreciation.

According to Sargent and Wallace (1981) a high interest rate policy may lead

to a reduction in demand for money and increase in price level because an increase in

interest rate implies an increase in government debt, which, in turn, would be financed

by seinorage. As a result there will be exchange rate depreciation. Similarly, an

increase in interest rate may adversely affect the future export performance which

would reduce foreign exchange reserves and thereby, lead to depreciation of currency

(Furman and Stiglitz, 1998). They have further argued that there are two important

channels through which exchange rates are likely to be affected by the increase in

interest rates namely, the risk of default and risk premium. The high interest rate

policy may decrease the probability of repayment and increase the risk premium on

domestic assets. Therefore, an increase in interest rate may lead to exchange rate

depreciation via increase in capital outflow.

Another view in this context has been that in the atmosphere of political

stability and perfect information, a temporary increase in interest rate can lead to

exchange rate stability because it will induce investors to believe that there will be

exchange rate appreciation (Drazen, 2001). According to Bensaid and Jeanne (1997),

over a period of time, the cost of an interest rate defense of the currency may get

4

reflected in financial fragility of banks and financial institutions, deteriotion of the

fiscal position of the government, reduction in the share of export in national income,

all of which may lead to the depreciation of currency.

The nature of relationship between the rate of interest and exchange rate has

been studied by some researchers abroad empirically also. For example, Goldfajn and

Baig (1998) have studied the linkage between real interest rate and real exchange rate

for the Asian countries during July 1997 to July 1998 by using Vector Autoregression

(VAR) based on the impulse response function of the daily interest rates and

exchange rates. They were not able to arrive at any strong conclusion regarding the

relationship between interest rate and exchange rate. Goldfajn and Gupta (1999) have

examined 80 currency crisis episodes between 1980 and 1998. By using fixed effect

panel regression, they have concluded that an increase in interest rate is associated

with an appreciation of nominal exchange rate. Kraay (1998) has examined whether

an interest rate policy can be used to defend the speculative attack on currency by

using monthly data for 75 developed and developing countries over the period 1960-

99 and found that the high interest rates policy is not effective in defending the

currencies against speculative attacks. Furman and Stiglitz (1998) have examined the

effect of an increase in interest rate on the exchange rate for 9 developing countries

during 1992-98. They found that the high interest rate was associated with a

subsequent depreciation of nominal exchange rate but the effect was more

pronounced in low inflation country than in high inflation country.

The spot exchange rate not only depends on monetary variables but also other

factors (non-monetary variables). Some studies have attempted to control the

influence of factors other than domestic monetary policy so that the effect of

monetary policy on exchange rate can be isolated. Basurto and Ghosh (2000) have

used this procedure for Indonesia, Republic of Korea, Thailand, and Mexico during

1990s. They found that the tight monetary policy was associated with an appreciation

of exchange rate.

Gould and Kamin (2000) examined the interest rate and exchange rate

relationship by studying the effect of interest rate, risk premium, and default

probabilities on the exchange rates for Indonesia, South Korea, Malaysia, Philippines,

5

Thailand, and Mexico. They found that the exchange rates in these countries were not

influenced by interest rates. In India a study by Pattanaik and Mitra (2001) found that

one standard deviation shock to the call rate leads to rupee appreciation by about 8

paise in the second month, but subsequently the exchange rate depreciates more than

offsetting the initial impact of the hike in interest rates.

Section II

The Model And MethodologyBefore we present the model, and methodology used by us for econometric

estimation of the extent of influence of interest rate on the exchange rate, let us form a

preliminary view of this relationship with the help of graphical analysis. Figures 2

and 3 present the relative behavior of interest rate and exchange rate, respectively by

using monthly data for the 15 year period of 1991-2005. While Figures 2 and 3

present the relative behaviour of interest rates (call money rate and 91-day Treasury

Bills rate, respectively) and rupee-dollar exchange rate, Figure 4 presents the said

exchange rate and the interest rate differential (measured as 91-day Treasury Bills

Rate in India minus 3-month Treasury Bills Rate in U.S.A).

Figure 2:

Nominal Exchange Rate and Call Money Rate in India, January 1991 to December 2005

20

25

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91Ju

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ange

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e

-416111621263136

Cal

l Mon

ey R

ate

Exchange Rate ($) Call Money Rate

Impact of Asian and Russian Crises and Economic Sanctions

Impact of Mexican Crisis

Source: Same as in Figure 1.

Figure 3:

6

Nominal Exchange Rate and 91-day Treasury Bills Rate in India, January 1991 to December 2005

20253035404550

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ay T

reas

ury

Bills

Rat

e (%

)

Exchange Rate (INR/ 1 US Dollar)91-day Treasury Bills Rate

Source: Same as in Figure 1.

Figure 4:

Interest Rate Differential and Exchange Rate in India, January 1991 to December 2005

20

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($)

-2-1012345678

Inte

rest

Rat

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iffer

entia

ls

(%)

Exchange Rate Interest Rate Differential

Note: Interest rate differential is equal to 91-day Treasury bills rate in India minus 3-month Treasury bills rate in US.Source: Same as in Figure 1.

7

It can be observed from these figures that, on the whole, over the entire period

under study, while the Indian exchange rate has increased (i.e. rupee has depreciated),

the interest rates have first increased and then declined. The year-wise analysis would

reveal that increases in interest rates have been associated with increases in exchange

rate i.e. interest rate and exchange rate have been positively related in many periods

such as January 1991 to February 1993, and so on. On the other hand, they have been

negatively related in many other periods. It may be carefully noted here that the

exchange rate is defined as so many units of rupee per unit of foreign currency, say

the dollar. Therefore, an increase in exchange rate represents a depreciation of the

rupee, and when accompanied by an increase in interest rate, the exchange rate and

interest rate can be said to be positively related. In other words, if it is found that

interest rate and exchange rate are positively related, it means that increases

(decreases) in interest rates have led to depreciation (appreciation) of the rupee.

Let us now turn to the further analysis of the interest rate-exchange rate

relationship with the help of co-integration technique.

On the basis of a study of theoretical and empirical literature on the

relationship between interest rate and exchange, we hypothesize that the exchange

rate is a function of interest rate, money supply, gross domestic product, inflation rate

differential, and net intervention. The rationale behind this hypothesis is as follows:

The impact of changes in domestic interest rate on exchange rate could be

either positive (i.e., depreciation) or negative (i.e. appreciation). Other things

remaining constant, a higher domestic nominal interest rate reduces demand for real

balances. Given the quantity of money, the reduced demand for real money balances

leads to a rise in price level. A rise in domestic price level causes exchange rate to

depreciate to maintain purchasing power parity. The same effect of interest rate may

occur through another channel. An increase in domestic interest rates may imperil the

ability of the domestic firms and banks to pay back the external debt. As a result, risk

of default increases which causes capital outflows and the depreciation of the

currency. According to another view, higher nominal interest rates strengthen the

value of domestic currency because they induce capital inflows reflected in a rising

8

capital account surplus that requires a domestic currency appreciation to assure

external balance.

An increase in money supply at home, ceteris paribus, can be expected to lead

to exchange rate depreciation because a higher money supply causes an increase in

price level and in order to maintain purchasing power parity, the exchange rate has to

depreciate.

The impact of changes in domestic output on exchange rate could be either

positive (i.e., depreciation) or negative (i.e. appreciation). The domestic output may

have negative effect on exchange rate via transaction demand for money. Other things

remaining constant, an increase in domestic output increases the transaction demand

for money, which, in turn, leads to a decline in price level, and, therefore, to an

exchange rate appreciation to maintain purchasing power parity. According to another

view, other things being equal, a rise in home income raises import spending and

hence worsens the current account results in the depreciation of exchange rate to

assure external balance.

The exchange rate and the inflation rate differential between the home country

and the rest of the world are expected to be positively related. An increase in domestic

inflation as compared to world inflation may increase the domestic demand for

foreign commodities and reduce the foreign demand for domestic commodities,

which, in turn, would lead to the depreciation of domestic currency.

What could be the effect of net intervention, i.e., the difference between the

purchases and sales of foreign currency assets by the monetary authorities on the

exchange rate? Intervention is of two types: sterilized and nonsterilized intervention.

Nonsterilized intervention increases domestic money supply and depreciates the

exchange rate. On the other hand, sterilized intervention can have either positive or

negative impact on the exchange rate. According to former channel, a sterilized

intervention may induce agents in the economy to anticipate that the monetary

authorities are committed to lowering the value of domestic currency and may

depreciate the exchange rate. According to latter channel, a sterilized intervention

9

increases the amount of domestic bonds. Given the domestic interest rate, it attracts

more capital inflow and appreciates the exchange rate.

Thus, the relationship between exchange rate and interest rate can be studied

with the help of the following exchange rate function:

ERt=C+1IRDIFFt+ 2M1+ 3GDP+4INFDIFFt+5INTERt+Ut ………(6.1)

Where ER= Exchange Rate, IRDIFF=Interest Rate Differential between

domestic and foreign countries, M1=Money Supply, GDP=Gross Domestic Product,

INFDIFF=Inflation Differential between domestic and foreign countries, INTER=Net

intervention by the Central Bank, C=constant, and t is time period.

The regression coefficients in the above equation are expected to have the

following signs:

1 or 0, 20, 3 or 0, 4 0, 5 0

We have estimated this equation by using Co-integration, and Impulse

Response Techniques (Enders, 1995; Hamilton, 1994). All variables are expressed in

the level form. The required data for the purpose of estimation have been obtained

from the various publications of Reserve Bank of India and the International

Monetary Fund. The study uses monthly data from January 1991 to December 2005.

The exchange rate is measured as the units of Indian rupee vis-à-vis US dollar.

Interest rate differential is measured as the difference between domestic 91-day

Treasury Bill Rate and US 3-months Treasury Bill Rate. Money supply is measured as

domestic narrow money supply. General Index of Industrial Production has been used

as proxy for Gross Domestic Product because the monthly data for the latter variable

are not available. Inflation differential is measured as the difference between domestic

inflation rate (measured in terms of Wholesale Price Index (1980-81=100)), and US

inflation rate (measured in terms of Producer Price Index (1980-81=100). Net

intervention is represented by the monthly net purchases of foreign currency by the

RBI in terms millions of US dollars.

10

The assumptions of the classical linear regression model require that both the

dependent and independent variables are stationary. In the presence of nonstationary

variables, there might be what Granger and Newbold (1974) call a spurious

regression. A spurious regression has a high R2, significant t-statistics, but the results

are without any economic meaning. Therefore, the first econometric step we have

taken is to test the null hypothesis that the series are random walk or non-stationary

by using Augmented Dickey-Fuller (1979, 1981) tests. To test if a series contains a

unit root, the following three equations are considered.

Yt=+t+Yt-1+ +t (1)

Yt=+Yt-1+ +t (2)

Yt=Yt-1+ +t (3)

The first equation includes both an intercept and a deterministic trend. The

second equation excludes the deterministic trend, whereas the third equation excludes

both the drift and the deterministic terms. In each case the null hypothesis is that =0,

that is, there is a unit root. Comparing the resulting t-statistics with the appropriated

value reported in the Dickey-Fuller tables allows to determine whether to accept or

reject the null hypothesis =0. The critical values are denoted by ττ τμ τ for equations

1, 2, and 3, respectively.

Since the true data generating process is not known, we have followed a

sequential procedure suggested by Doldado, Jenkinson, and Sosvila-Rivero (1990) to

test for a unit root. Such a procedure is important because if we inappropriately omit

the intercept or time trend, the power of the test can go to zero. On the other hand,

extra regressors increase the absolute value of the critical values so that we may fail to

reject the null of a unit root.

If the variables were found to be non-stationary, we have tested the possibility

of one or more co-integrating relationships using the Johansen and Juselius (1990,

1992) methodology in the form of two test statistics namely, the trace test and the

maximal eigen value during the above-mentioned three time periods. The impact of

stationary exogenous variables on exchange rate has been studied with the help of

11

error correction model (ECM) (Sargan, 1984; Engle and Granger, 1987). The

interrelationship between exchange rate and interest rate differential has been

captured by the Impulse Response Function Analysis which traces the response of

exchange rate to one standard deviation change in interest rate. When the off-diagonal

elements of the correlation coefficient matrix of the error terms are found to be greater

than 0.2, Cholesky Decomposition has been followed in the ordering of the variables

to make the errors contemporaneously uncorrelated (Sims, 1980; Enders, 1995).

Section-IIIEmpirical Results

Table 2 presents the ADF unit root test results for all variables. The variables

like money supply, inflation rate differential, industrial production, exchange rate,

interest rate differential are found to be non-stationary, whereas the net intervention is

found to be stationary in level form.

Table 2: Unit Root Test Statistic

VariablesNull: γ =o in equation3

ττ

Null :γ=0, =0,in equation 3

3

Null: γ=0 inequation 2

τμ

Null: γ=0,α=0In equation 2

1

Null: γ=0 in equation 1

τ

Results*

M1 (4) 1.84 13.30 Yes**INFDIFF (2) -2.65 3.72 -2.20 2.45 -1.67 Yes**

GIIP (4) -2.61 4.56 1.10 8.84 Yes**ER (2) 2.07 5.28 -3.11 8.42 Yes*

INTDIFF (1) 2.76 4.67 -2.46 4.16 -1.05 Yes**INTER (0) -7.90 No*CV at 5% -3.43 6.34 -2.88 4.63 -1.95CV at 1% -3.99 8.27 -3.46 6.52 -2.48

Note: (1) CV denotes critical values. (2)* and ** indicate significance at 1 % and 5% level respectively. (3) Numbers in brackets indicate lag length.

The optimal lag length or order of the VAR was found to be 2 by the Akaike

Information Criterion (AIC), Schwarz Bayesian Criterion (SBC) for the entire reform

period and for the high interest rates period but the optimal lag length was found to be

one for the low interest rates period. It has been found that the data shows the

existence of linear trend. This implies that the underlying VAR model does not

contain deterministic trend but contains unrestricted intercept. The maximal eigen

value and the trace statistics strongly rejected the null hypothesis that there is no co-

integrating relationship between the variables (i.e., r=0), and they showed that there is

12

one co-integrating relationship between the variables (i.e., r=1) for the entire reform

period, high interest rates period, and low interest rates period ( See Tables 3 and 4).

The model selection criteria like AIC and SBC also suggested the existence of one co-

integrating relationship between the variables (results have not been reported here).

The normalized co-integrating vectors for the exchange rate have been presented in

Table 5.

Table 3: Cointegration LR Test Based on Maximal Eigen value of the Stochastic Matrix for Nominal Interest Rates

H0: H1: StatisticsCritical Values

Results95% 90%Exchange Rate=f (Money Supply, Inflation Rate Differential, GIIP, Interest Rate Differential) Order of VAR=2 Time Period: January 1991 to December 2005r = 0 r = 1 44.61 33.64 31.02 Reject Null Hypothesisr 1 r = 2 22.06 27.42 24.99 Accept Null Hypothesisr 2 r = 3 17.09 21.12 19.02 Accept Null Hypothesisr 3 r = 4 8.77 14.88 12.98 Accept Null Hypothesisr 4 r = 5 1.38 8.07 6.50 Accept Null HypothesisExchange Rate=f (Money Supply, Inflation Rate Differential, GIIP, Interest Rate Differential) Order of VAR=2 Time Period: January 1991 to March 1997r = 0 r = 1 39.90 33.64 31.02 Reject Null Hypothesisr 1 r = 2 17.59 27.42 24.99 Accept Null Hypothesisr 2 r = 3 6.05 21.12 19.02 Accept Null Hypothesisr 3 r = 4 3.90 14.88 12.98 Accept Null Hypothesisr 4 r = 5 1.08 8.07 6.50 Accept Null HypothesisExchange Rate=f (Money Supply, Inflation Rate Differential, GIIP, Interest Rate Differential, Net Intervention) Order of VAR=1 Time Period: April 1997 to December 2005r = 0 r = 1 62.26 33.64 31.02 Reject Null Hypothesisr 1 r = 2 25.54 27.42 24.99 Accept Null Hypothesisr 2 r = 3 6.65 21.12 19.02 Accept Null Hypothesisr 3 r = 4 5.72 14.88 12.98 Accept Null Hypothesisr 4 r = 5 0.89 8.07 6.50 Accept Null HypothesisNote: r is the order of cointegration.

As expected, the coefficient of money supply has positive sign in both high

interest rate and low interest rate periods but has negative sign in the entire reform

period. Similarly, inflation rate differential has influenced positively exchange rate in

the whole period and low interest rate period. This implies that the pass-through effect

of inflation rate differential to exchange rate. The coefficient of industrial production

has positive sign in all equations except the low interest rate period. Since the

coefficient of interest rate differential has positive sign in the whole period and in the

low interest rate period, it implies that an increase in interest rate differential has

caused depreciation of exchange rate in India in the just mentioned time periods. But

an increase in interest rate differential resulted in appreciation of exchange rate in the

Table 4: Cointegration LR Test Based on Trace Statistics of the Stochastic Matrix for Nominal Interest Rates

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H0: H1: StatisticsCritical Values

Results95% 90%Exchange Rate=f (M1, Inflation Differential, GIIP, Interest Rate Differential) Order of VAR=2 Time Period: January 1991 to December 2005r = 0 r 1 93.93 70.49 66.23 Reject Null Hypothesisr 1 r 2 49.31 48.88 45.70 Reject Null Hypothesisr 2 r 3 27.25 31.54 28.78 Accept Null Hypothesisr 3 r 4 10.15 17.86 15.75 Accept Null Hypothesisr 4 r =5 1.38 8.07 6.50 Accept Null HypothesisExchange Rate=f (M1, Inflation Differential, GIIP, Interest Rate Differential) Order of VAR=2 Time Period: January 1991 to March 1997r = 0 r 1 68.53 70.49 66.23 Reject Null Hypothesisr 1 r 2 28.63 48.88 45.70 Accept Null Hypothesisr 2 r 3 11.03 31.54 28.78 Accept Null Hypothesisr 3 r 4 4.98 17.86 15.75 Accept Null Hypothesisr 4 r = 5 1.08 8.07 6.50 Accept Null HypothesisExchange Rate=f (M1, Inflation Differential, GIIP, Interest Rate Differential, Net Intervention) Order of VAR=1 Time Period: April 1997 to December 2005r = 0 r 1 101.05 70.49 66.23 Reject Null Hypothesisr 1 r 2 38.78 48.88 45.70 Accept Null Hypothesisr 2 r 3 13.24 31.54 28.78 Accept Null Hypothesisr 3 r 4 6.58 17.86 15.75 Accept Null Hypothesisr 4 r = 5 0.85 8.07 6.50 Accept Null HypothesisNote: same as in Table 4.6.

Table 5: Co-integrating Coefficients of Exchange RateVariables January 1991 to

December 2005January 1991 to March 1997

April 1997 to December 2005

Money Supply (M1) 0.00017 (0.00003)

0.00025 (0.00006)

0.00075 (0.00072)

Inflation Rate Differential

0.9185 (0.3435)

0.7577 (0. 2603)

1.2915 (1.4553)

GIIP 1.0871 (0.1827)

0.8454 (0.2701)

4.3951 (4.1307)

Interest Rate Differential

1.0076 (0.4571)

- 0.0421 (0.2816)

1.5676 (2.0461)

Net Intervention**

0.00014(0.00002)

Note: (a) Figures in brackets are standard errors. (b)** Coefficients have been obtained from the error correction model.

high interest rate period, as the coefficient of interest rate differential has negative

sign. The same result has also been obtained by some other studies (Pattnaik and

Mitra, 2001). The coefficient of stationary exogenous variable like net intervention

has been obtained from the error correction model. The effect of net market

intervention on exchange rate was found to be negative.

Figure 5: Impulse Response of Exchange Rate due to One Standard Deviation

Change in Interest Rate Differential

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Panel a:

Pane b:

Panel c:

The dynamic interaction between the variables can be captured by the Impulse

Response Function Analysis which traces the response of a given variable to one

standard deviation change in any other variable. Here, the impulse responses of

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exchange rate to interest rate differential have been studied in three time periods (See

Figures 5, panel a, b, and c). In order to draw useful structural information, some sort

of restrictions that are consistent with economic theory should be imposed on the

error correction model. Following Cholesky type of identifying restrictions, the order

of the variables chosen here is money supply, inflation rate differential, industrial

production, exchange rate, and interest rate differential. If money supply increases,

the aggregate demand increases, which, in turn, increases the price level and industrial

production, which again, causes depreciation of exchange rate and the RBI increases

interest rate to stabilise exchange rate.

It is found that one standard deviation change (around 0.60 percentage

increase) in interest rate differential caused exchange rate depreciation by 3.5 paise in

the whole time period (Figure 5, panel a). On the other hand, a 0.74 percentage

increase in interest rate differential resulted in exchange rate appreciation by 1.5 paise

in the fourth month and later on depreciated a little but the overall impact was net

appreciation by 0.87 paise (Figure 5, panel b). But the exchange was found to be

depreciated by 0.041 paise due to change (around 0.43 percentage increase) in interest

rate differential in the low interest rate differential (Figure 5, panel c).

Section IVSummary and Conclusions

The monetary authorities in India have taken several steps to liberalize capital

account transactions and to make exchange rate more flexible to maximize gains from

foreign capital. But free capital mobility very often causes many adverse economic

consequences like sharp exchange rate depreciation, or sudden fall in foreign

exchange reserve, or both. The external value of the rupee has become volatile as the

Indian economy has been opened up progressively. Apart from direct intervention, the

Reserve Bank of India has been using interest rate policy to reduce volatility of the

Indian rupee.

In this context, the present Paper has attempted to find out empirically the role

of interest rate in determining the exchange rate in India by using cointegration

technique based on vector autoregression model during January 1991 to December

2005, January 1991 to March 1997 (high interest rate phase), and April 1997 to

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December 2005 (low interest rate phase). The results show that the industrial

production, money supply, interest rate differential, and inflation rate were positively

related with the exchange rate during 1991-2005 and 1997-2005, while they were

negatively related with the exchange rate during 1991-1997. The impulse response

technique shows that the over all exchange rate appreciation was 0.87 paise due to

one standard deviation change (around 0.74 percentage increase) in interest rate

differential during 1991-97, whereas the exchange rate was found have depreciated by

0.041 paise due to one standard deviation change (around 0.43 percentage increase) in

interest rate differential during 1997-2005. These results imply that the impact of

interest rate changes on the exchange rate is not uniform or consistent in all the

periods, and, therefore, there are limitations on the effective use of interest rate as a

monetary policy instrument for stabilizing the external value of rupee. It also means

that the further liberalization of the capital account transactions in India may not be

advisable at least in the near future.

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