Relationship between exchange rates and inflation rates and other macroeconomic factors: An empirical analysis

Abstract

The exchange rate along with factors like interest rate and inflation rate are key indicators of the health of an economy. The exchange rate is defined as “the rate at which one currency may be converted into another”1 . In an open economy, the role of exchange rates is significant in the level of trade, which is very critical for the functioning of a free market economy. Exchange rate also have implications on price stability and growth. For example, as exchange rate affects prices influence prices for international trade and say the rupee depreciates against US dollars, the prices of India’s imports go up. As import prices go up, the inflation can rise directly (price of oil) as well indirectly (price of imported raw materials and imported goods). Exchange rates are also important on smaller scales as they affect the returns on an investor’s portfolio. Thus, exchange rates are very important for policy makers, firms as well as investors and hence they are closely monitored and analysed. Despite their importance, however, there no clear understanding of what the factors determining the exchange rate are. The work on exchange rates by Meefe and Rogoff2 in 1983 suggested that the theoretical exchange rate models aren’t very effective in predicting exchange rates. Their contention was that predictor models with macroeconomic variables like interest rates, inflation rates, output gap, etc were able to predict the movements in exchange rates “no better than a random walk model” 2 . Some models were found to perform better than random walk models for a few time horizons and sample periods, but no model was found to be broadly consistent. This was the motivation behind this study. In this study, we empirically explore the relationship between exchange rate behaviour, levels and volatility, and macroeconomic variables like interest rates, inflation rates as well as the intervention by central bank in the foreign exchange market, net inflow from Foreign Institutional Investors. We also try to explore the effects of expected inflation on exchange rates. A similar study was carried out by Behera et al. in their paper “Relationship between exchange rate volatility and central bank intervention: An empirical analysis for India”3 . The paper investigates “the effect of RBI intervention and exchange rate behaviour in the Indian foreign exchange market for the period from June 1995 to December 2005” 3 . Their study suggested that the intervention by the central bank has the effect of reducing the fluctuations in the exchange rate rather than influencing the direction in which Indian rupee moves against US Dollar. We began our study by trying to reproduce the results of Behera et al. and critiquing their findings. Further, we tried to incorporate the factors that we found were missing in their analysis.