Understanding Exchange Rate Expectations in India

Abstract:     
Generally it is believed that the central monetary authority can, and should, exercise control over the exchange rate only in case of fixed/pegged exchange rate regime. However, such a regulation is essential even in an economy that has adopted floating exchange rate policy. This is because no economy can stay immune to the extreme external shocks that affect the domestic economic stability through exchange rate channel. These shocks may be due to changes in the trade balance and relative terms of trade, purchasing power of the two currencies, capital movements, and differences in the general price levels of the two economies under consideration. Especially, when the economy is open to capital movements, the expectations regarding forward exchange rate play an important role in deciding the capital flows as well as the actual exchange rates in future. And, if unguarded, the fluctuations in the exchange rate can cause deep financial crisis in any economy regardless of its size and dependence on the external sector. This paper makes an attempt to define such a relation between the capital movements and the forward exchange rate through the Covered Interest Parity (CIP) model. Monthly data from April 1996 to May 2008, relating to Indian and the US economies, are used for establishing this hypothesis. A comparative analysis of the CIP model with the Uncovered Interest Parity (UIP) model indicates that the former is more efficient in projecting the forward exchange rate movements with greater accuracy. The ability to forecast the future exchange rate based on the same model is an added advantage of adopting the CIP for monitoring the exchange rate and capital movements in India.

Accepted Paper Series