REAL EFFECTIVE EXCHANGE RATE OF INDIA: PATTERNS AND DETERMINANTS

Abstract

In this paper, author endeavors to establish the patterns and trends of Real Effective Exchange Rate of India during 1970-2015 and tries to show the determinants of REER e.g., growth rate, current account deficit as percent of GDP, percent of openness, foreign direct investment inflows, and foreign exchange reserves excluding gold. The author used semi-log, double log linear and exponential model, autoregression, ARIMA, GARCH models for trends and volatility. Bai and Perron (2003) model was applied to show structural breaks and Hodrick and Prescott (1997 ) model was applied for smoothness of cyclical trend. Johansen (1988, 1991, 1996) models were used to fit co-integration test and vector error corrections. Residual tests were done to verify autocorrelations, normality and impulse response functions were found to show stability and convergence.       

The paper concludes that REER has been declining at the rate 0.4085 percent per year which is insignificant at 5% level during 1970-2015 but it is exponentially declining at the rate of 0.2028 percent which is significant. AR(1) of REER is convergent, stationary and significant but AR(2) is convergent, non-stationary and insignificant. Even ARIMA(1,1,1) is non-stationary because AR(1) is stationary but MA(1) is non-stationary. GARCH(1,1) showed insignificant. Thus the series REER is highly volatile. This series contains five significant structural breaks in 1976, 1986, 1992, (downward) 2004 and 2010 (upward). Its pattern is cyclical which was turned to smooth cycle. Trace statistic showed three cointegrating vectors and Max-Eigen Statistic showed two cointegrating vectors that verify cointegration in the order one. Vector Error Correction model is stable because all roots lie in the unit root circle but it is non-stationary because impulse response functions are diverging and error corrections are significant  only in degree of openness and FDI inflows in relating REER during 1970-2015 with one period lag. Residuals test of VECM confirmed non normality and autocorrelations.

Only sound fiscal and monetary policy can control upward movement of REER so that significant relationships can be achieved with those selected determinants that would spur the growth of international trade.