Does Existence of Long-Run Relationship Ensure Predictability of Exchange Rate? Empirical Analysis of Indian Rupee Vis-à-Vis US Dollar under Monetary Model Framework

Abstract

This paper examines the empirical relevance of the flexible price monetary model in the Indian context to determine whether US dollar-Indian rupee exchange rate movements are in line with the changes in monetary fundamentals namely relative money supply, relative interest rates and relative output. A sample period of nineteen years (August 1996 to March 2015) was considered for the study and the entire period was divided into two sub periods marked by distinct patterns of exchange rate volatility and variations in the behaviour of macro-economic fundamentals. The study examined whether there exists a long-term relationship between exchange rate and variables of the monetary model besides investigating the predictive ability of the model in determining the exchange rate in the Indian context. The Johansen Juselius test of cointegration was carried out and the variables were found to be linearly cointegrated establishing the long-run relationship between exchange rate and monetary fundamentals rate thereby confirming the suitability of the flexible price monetary model in determining Indian rupee vis-à-vis US dollar. The Granger causality test [21] was conducted to determine the direction of causality between variables and to evaluate the predictive power of the monetary model and the test results exhibited some idiosyncratic patterns among the variables across the two sub periods. For the first sub period, the Granger causality test results show that there is a one-way causality from relative output and relative money supply to exchange rate, while there is no causality from relative interest rate to exchange rates. This result is quite puzzling and calls for further investigation. As the direction of causality is changing within the sample, the study suggests that the monetary model standalone cannot be effectively used for predicting exchange rate in the Indian context. A more comprehensive model with more macro-economic variables such as trade balance and capital flows may be combined with the existing variables for effective forecasting of exchange rate in India.