The INR/USD Exchange Rate Determination: An Empirical Investigation of the Flexible Price Monetary Model in a Vector Auto Regression Framework

Abstract

The current study attempts to examine the importance of the Flexible Price Monetary (FPM) Model in explaining the INR/USD exchange rate movement with macro variables such as relative money stock, relative rates of interest and relative output for the period from April 1995 till December 2016. Prior to estimating the empirical model, an array of non-stationarity tests was employed to identify the time series characteristics of the data. Since all the data series were confirmed to be integrated of order one, the multivariate cointegration methodology was used to verify long-run validity of the model. The empirical results garner support for the FPM model in determining INR/USD exchange rate in the long run. The test on direction of causality confirmed existence of causality from FPM variables to exchange rate. The empirical model was estimated in the Vector Auto regression (VAR) framework and variance decomposition analysis was used to examine fluctuation in INR/USD exchange rate caused by the shocks in FPM model variables. It was found that, the monetary model variables explain the exchange rate patterns over a longer period of time but was found not very effective in the short run and hence cannot be considered as a useful framework in explaining the variations in INR/USD exchange rate.