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2017 | OriginalPaper | Chapter

8. Capital Flows and Exchange Rates: The Indian Experience

Authors : Pami Dua, Partha Sen

Published in: Perspectives on Economic Development and Policy in India

Publisher: Springer Singapore

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Abstract

This paper examines the relationship between real exchange rate and the level as well as volatility of capital flows for the Indian economy for the period 1993Q2 to 2010Q4. Other variables include fiscal policy, monetary policy and external balance indicators. Estimation results indicate that the variables are co-integrated and each Granger-causes the real exchange rate. The generalized variance decompositions show that determinants of the real exchange rate, in descending order of importance include net capital inflows and their volatility (jointly), government expenditure, money supply and the current account surplus. An analysis on similar lines is also performed for the foreign exchange reserves held by the Reserve Bank of India.

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previous chapter Estimation of Calorie Norms and Measurement of Food Intakes: Some Implications for the Magnitudes of the Prevalence of Undernutrition in India

next chapter Determinants of Import Intensity of India’s Manufactured Exports Under the New Policy Regime

Earlier works include Krishnamurty and Pandit (1997).

All developing countries include 128 developing countries from Europe and Central Asia (23), Latin America and the Caribbean (27), Middle East and North Africa (9), Sub-Saharan Africa (45), East Asia and Pacific (16) and South Asia (8).

That is how the data is reported in India.

In an open economy the real values are obtained by deflating nominal variables by a price index Q that is a weighted average of the price of the domestic good (P) and the domestic currency price of the imported good (P*/E). The weights of the two goods are a and 1 − a respectively.

Demand for government bonds J(.) depends negatively on Y since we assume assets are gross substitutes. An increase in Y increases transactions demand for money, and given wealth, people reduce holdings of both bonds (domestic and foreign).

A semi-reduced form is a term used for this expression because to obtain this we have solved the system of differential equations. The expression for the real exchange rate depends on the state variables B/Q and F (endogenous over time) and the current and expected future exogenous variables.

Alternative measures of all the variables were also tried. For instance, to capture capital inflows foreign exchange reserves were employed. Volatility was measured by the three-period and four-period moving average coefficient of variation. Alternative monetary policy measures included M3, M1 and domestic credit. Fiscal policy measures included a measure of fiscal stance as described by Joshi and Little (1998) as well as fiscal deficit. Various measures of interest rate differential we have tried—three-month and one-year differential between the Treasury bill rate and LIBOR, difference between commercial paper rate and three-month LIBOR, three-month LIBOR and one-year LIBOR. The variables selected and reported gave the most satisfactory results.

Increased government expenditure directed towards the domestic good, creates excess demand for the latter. A real appreciation is a rise in the price of the domestic good in terms of the imported good. This result also comes out of an alternative definition of the real exchange rate where it the relative price of the non-traded good (the Salter-Swan Model). There if the government expenditure is directed towards the non-traded, the real exchange rate (now defined as its price in terms of the traded good) must appreciate.

The theoretical effect along the dynamic path of the economy of an increase in money supply (with sticky prices and an increase in real balances) and the real exchange rate is ambiguous. On the one hand, an increase in money supply through portfolio balance would cause an excess demand for foreign assets. This is achieved, inter alia, through a depreciation of the currency. On the other hand, an increase in capital inflows would tend to appreciate the currency, lower the transactions demand for money and lead to lower real balances (see Buiter and Miller 1981).

Note that the generalized forecast error variance decompositions add to more than 100%. The magnitude of the sum depends on the strength of the covariance between the different errors.

Real foreign exchange acquisitions are denoted by forexacq.

This statement is not quite accurate because stocks and flows have different time dimensions.

For instance, see Kletzer and Kohli (2000) who estimate a fully flexible exchange rate monetary model after discussing at length the RBI’s intervention!

Buiter, W. H., & Miller, M. H. (1981). Real exchange rate overshooting and the output cost of bringing down inflation. The Warwick Economics Research Paper Series (TWERPS) 204. University of Warwick, Department of Economics.

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Joshi, V., & Little, I. M. D. (1998). India: Macroeconomics and political economy, 1964–1991 (pp. 231–234). Oxford: Oxford University Press.

Kletzer, K., & Kohli, R. (2000). Exchange rate dynamics with financial repression: A test of exchange rates models for India. Indian Council for Research in International Economic Relations, Working Paper No. 52.

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Krishnamurty, K., & Pandit, V. (1997). Exchange rate, tariff and trade flows: Alternative policy scenarios for India. Journal of Asian Economics, 8, 425–454.CrossRef

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Sims, C. (1981). An autoregressive index model for the US 1948–1975. In J. Kamenta & J. B. Ramsey (Eds.), Large scale macro-econometric models. The Netherlands: North-Holland.

Title: Capital Flows and Exchange Rates: The Indian Experience
Authors: Pami Dua
Partha Sen
Publisher: Springer Singapore
Book: Perspectives on Economic Development and Policy in India
Print ISBN: 978-981-10-3149-6

Electronic ISBN: 978-981-10-3150-2

Copyright Year: 2017
DOI: https://doi.org/10.1007/978-981-10-3150-2_8

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