Exchange rate management: An analysis of decision making in a dynamic environment

Abstract

It is well known that the factors like interest rate differential, GDP growth, inflation differential, current account deficit, foreign exchange reserves and global shocks affect the exchange rate in the economy. It is also felt that the exchange rate in turn affects some of these variables. In our present study, we have analyzed whether this hypothesis is validated for the Indian Economy between the period 1999-00 to 2008-09 by considering the exchange rate between the US Dollar and the Indian Rupee. In our model, Current Account deficit does not emerge as a significant variable. We have used the model to propose the likely policy actions that can be taken at the economy as well as firm level based on a forecast of an appreciating rupee. We have also studied the pros and cons under the different exchange rate regimes and derived the lessons for exchange rate management that can be taken out of it. Finally, we have explained under what conditions could the economy may be susceptible to a speculative attack and proposed means to tackle the same.