The use of the ARDL approach in estimating virtual exchange rates in India

This paper applies the autoregressive distributed lag approach to cointegration analysis in estimating the ʹvirtual exchange rateʹ (VER) in India. The VER would have prevailed if the unconstrained import demand were equal to the constraint imposed due to foreign exchange rationing and the VER is used to approximate the ʹpriceʹ of rationed foreign exchange reserves. We highlight the shortcomings of the existing literature in approximating equilibrium exchange rates in a less developed country such as India and propose the VER approach for equilibrium rates, which uses information from an estimated structural model. In this relationship, black market real exchange rate (EU) is a dependent variable and real official exchange rates (EO), the ratio of the foreign (r*) to the domestic (r) interest rate (I), and official forex reserves (Q) are explanatory variables. In our estimation, the VERs are higher than EO by about 10% in the short-run and 16% in the long-run.