Macroeconomic Fundamentals and Exchange Rate Volatility during the Floating Exchange Rate Regime in India

Exchange rate stability is one of the pre-conditions for macroeconomic stability. So choice of exchange rate regime is the core of the successful macro-management. India has opted market-determined exchange rate system since 1993. Exchange rate volatility arises due to macro-economic fundamentals like growth, trade, price level, interest rate, foreign exchange reserve etc. and short-term speculation. We have estimated the relationship between exchange rate and the fundamental macro-variables using the Vector Error Correction Model (VECM) with monthly data for the period April, 1993 to March, 2012. It is found that export, interest rate, foreign exchange reserve and economic growth have appreciating effect where as import and inflation have depreciating effect on exchange rate. All the variables under the study other than interest rate and the foreign exchange reserve have played significant role in exchange rate stabilization during the floating exchange rate regime. In the short-run, exchange rate is negatively influenced by its own lags and interest rate as well as foreign exchange reserve. But it is positively affected by country’s import. Generalized variance decompositions indicate that interest rate, economic growth and inflation have stronger impact on exchange rate.