r

Sukumar Nandi
Indian Institute of Management Lucknow
 Exchange Rate Regime in India

• Fixed Exchange rate regime : 1954 – 1966  $ 1 = Rs. 4.76

• 1966 – 1971  $ 1 = Rs. 7.50

• Post Bretton Woods Era : !973 0nwards  Flexible exchange rate

regime, and rupee was
linked with a basket of
currencies

• Rigid system of exchange control….

• Foreign Exchange Regulation Act, 1973

• Effects:: a) Hawala Transactions [ arbitrage on gold prices – India

and Middle East ]
• b) Black market exchange rate

04/02/08 Real Exchange Rate Targeting __ S Nandi 2

 Continued…

• A near stagnant exports and increasing imports made the capital

account balancing item depending on external loans, that was not very
reassuring  the result had been a precarious position of
international reserves

• GOI tried to manage this situation with tight control on the use of
foreign exchange
• The license permit raj in domestic markets had its spill over in external
sector with results of --- (i) huge black market of foreign
exchange , and
• (ii) capital flight

• The paradigm change from 1990 brought fundamental change in the

exchange rate regime in India

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 INR Movement

Exchange Rate

Index (1993-94=100)
Rupees per US dollar

50 115
45 105
40 95
35 85
30 75
Apr-93

Apr-94

Apr-95

Apr-98

Apr-99

Apr-01

Apr-04
Apr-96

Apr-97

Apr-00

Apr-02

Apr-03

Apr-05
Rupees per US dollar REER NEER

04/02/08 Real Exchange Rate Targeting __ S Nandi 4

 Official and Black Market Exchange Rates of Indian Rupee
1954 – 1990 [ The black market premium being linked to gold prices
difference/ hawala premium]

Rs/ USD

35

25
Black market Rate

15
Official Rate
5
1954 1966 1971 1990

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 INR Movement in 2007

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 Issue
• Every country while seeking equilibrium in open economy situation
faces the impossible trinity: Independence of monetary policy, fixed
exchange rate policy and free capital mobility. A country can have any
of the two at a time, and the third is to be sacrificed… this is the
choice.
• Given the fact that international capital mobility is now facts of life, a
country’s choice is now restricted to either fixed exchange rate regime
or monetary policy independence. Since the latter is very important, a
country is to adapt a flexible exchange rate regime. In that attempt a
country may monitor the movement of real exchange rate and use the
latter as a target.

04/02/08 Real Exchange Rate Targeting __ S Nandi 7

 Model

• There are different models for the determination of equilibrium real

exchange rate( RER) in an economy. RER depends on the
macroeconomic fundamentals of an open economy apart from policies
of the government.
• Here we will follow the model as developed by Edwards in his JDE ( 1988)
paper
• [ The choice is influenced by the fact that this approach takes into account the whole
mapping of macroeconomic fundamentals of the economy along with government policies
in an equilibrium setting]
• Let us consider a small open economy with a dual exchange rate
regime ___ a fixed exchange rate for goods and a flexible exchange
rate for assets.
• There are three goods ___ exports, imports and non-traded goods.
The non-traded goods are produced and consumed domestically.
Exports are produced in the country and consumed abroad (importing
countries). Imports are produced abroad and consumed in the
country. Therefore, domestic consumers and producers are concerned
with the relative prices of imports and exports.

04/02/08 Real Exchange Rate Targeting __ S Nandi 8

 Real Exchange Rate

• Since exchange rate is the link between the price levels of two
countries, it is the real value of money that determines the
competitiveness of a country’s exports. This leads us to the concept
of real exchange rate( RER).
• Real exchange rate is defined as the nominal exchange rate
multiplied by the ratio of the price of traded commodities to the price
of non-traded commodities, or
• s= E * ( CPI T / CPI NT ) ......
( 1)

• Since prices of traded commodities are related to the world prices

only, the wholesale price index of the United States of America ( WPI*)
is taken as a proxy. Again, the prices of non-traded commodities is
approximated by the domestic consumer price index or CPI. So the
equation of RER is

• s= E* ( WPI* / CPI) ………

(2)
04/02/08 Real Exchange Rate Targeting __ S Nandi 9
 RER
• Thus the relative price of import is

• Wm = Pm / Pn ,

• And the relative price of exports similarly will be

• Wx = Px / Pn

• Here Px , Pm and Pn are respectively domestic prices of exports

(X), imports (M) and non-traded goods (N). The price of imports
includes tariffs that make the domestic price of the imported
goods.
• Suppose Wm* is the relative price of imports domestically that
excludes tariff.
• Real exchange rate ( RER and denoted by s) as defined in the
beginning is a weighted average of the two relative prices, i.e.,

• s= a Wm* + ( 1 – a ) Wx ……
……… ( 3)

04/02/08 Real
• where a is a positive Exchange( Rate
fraction 0<Targeting
a < 1) __ S Nandi
, and Wi ’s are relative10
prices as defined above.
 RER
• The real exchange rate can also be rewritten in terms of
the world prices of exports and imports ( denoted by
asterix * ), the domestic price of non-traded goods and the
nominal exchange rate E, or,

• s= [ b Pm* + ( 1 – b ) Px* ] E / Pn
……….. (4)

• The world prices of exports and imports are

exogenously given. Exports are assumed to be the
numeraire, so RER is affected by the ratio of the price of
imports to that of exports, and this is the inverse of the
terms of trade. Again RER is also influenced by the price of
non-traded goods and these are determined in the market
of non-traded goods .
04/02/08 Real Exchange Rate Targeting __ S Nandi 11
 Non-Traded goods

• In a country demand for non-traded goods is determined by assets of

people, government consumption of non-traded goods, and the
relative price of imports, the latter is the ratio of the domestic price of
imports to the price of non-traded goods
• The price of non-traded goods is thus a function of real
assets A, world import price Pm* that does not include
tariffs, rates of tariffs tr, and government consumption of
non-traded goods GC. Thus the function of the price of
non-traded goods is

• Pn = f ( A, Pm* , tr, GC )
……….. ( 5)
• + + + +

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 Continued…

• Thus in Edward model RER in equilibrium is determined by

some macroeconomic fundamentals of the economy like
tariffs, terms of trade, composition of government
consumption, capital flows and technical progress, or,

RER ( s*) = f ( tariff rate, terms of trade, government

consumption of non-traded goods,
official capital flows, technical progress )

……………. ( 6)

Edwards also considers the effects of government policies at

different levels that cause deviations of RER from its equilibrium
level.
The policies considered are monetary policy, fiscal policy and
exchange rate policy
04/02/08 Real Exchange Rate Targeting __ S Nandi 13
 Continued…

• s(t)= a0 + a1 tr + a2 tot + a3 GCON + a4 cflows + a5 tech

+ a6 fp + a7 mp + a8 ep
•
…………… (7)
• Where the macro fundamentals that determine the
equilibrium RER like tariff rate, terms of trade, government
consumption of non-traded goods, official capital flows and
technical progress are denoted by tr, tot, GCON, cflows
and tech respectively apart from three policies fp, mp and
ep as defined above.
• The proxies for the policy variables are constructed following the
recommendations of Edwards ( 1988b).

• Fiscal policy is approximated by the ratio of fiscal deficits to high

power money with a lag as developing countries often use a policy of
seigniorage,
04/02/08 which isReal
money creation
Exchange to finance
Rate Targeting budget deficit
__ S Nandi . 14
 Continued…

• Monetary policy is approximated by the growth of domestic credit. The latter

includes claims on the central government, state government, local
institutions and non-monetary financial institutions.
• Again exchange rate policy is approximated by the changes in the nominal
exchange rate, that may result through direct intervention by the
government in foreign exchange market ( fixed rate regime ) , or indirect
intervention when apex bank intervenes in floating rate system.

• We now have the equation of estimation after incorporating the

proxy variables as follows:

• s(t)= a0 + a1open + a2 tot + a3 GCON + a4 cflows + a5

GW + a6 fp + a7 mp + a8 ep + u
•
…………. (8)

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 Description of the Variables with proxy

Table1: Descriptionof Variable

Variable Description Proxy if any

s(t) Real exchange rate

open Degree of openness ratio of total trade to GDP

tot Terms of trade ratio of US WPI to CPI of India

GCON Government consumption of ratio of government consumption

nontraded goods to GDP

cflows Official capital flows ratio of capital flows to GDP

GW Rate of growth log difference of GDP

fp fiscal policy Ratio of fiscal deficit to high

power money

mp monetary policy log difference of domestic credit

ep Exchange rate policy log difference of nominal

exchange rate

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 Data

• The period of the study is 1990 – 2006 as the liberalization of the

economy in 1990 led to a much flexible policy in the exchange rate.
The apex bank became serious about the stability of the real
exchange rate.

• The annual data are collected from International Finance Statistics,

Year Book_ different issues

• Since the variables show the existence of unit root of order one, first
differences of the variables have been used so that they become
stationary.

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 Estimation

• Table 2: Estimation_ Dependent variable: Real Exchange Rate

• s(t) = - 0.7517 – 7.353 tot + 14.43 GCON + 6.35 cflow – 23.34 GW +

20.489 open
• ( - 1.425) (-1.044) ( 0.227) ( 2.77) (-2.027)
( 1.028)

– 65.87 fp – 1.79 mp + 10.657 ep + e

– ( -1.536) ( -0.28) ( 5.365)

– R-squared 0.9079 D-W statistic

1.6145
– Adjusted R-square 0.8028 F-statistic 8.634
– n= 16
– Sample:: 1991 2006

– Value in parentheses
04/02/08 Realare respective
Exchange t- statistic
Rate Targeting of the coefficients
__ S Nandi 18
 Nominal, Exact and Real exchange rates of rupee: 1980 –
1993

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 Real Exchange rate and its predicted value from
the model

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 RER and predicted value from model without the policy variables

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 REER of Japan, USA and Euro area

Real Effective Exchange Rate for Industrial Economies

150 (1997 January - June = 100)

140
Japan
130

120
USA
110

100

90 Euro Area

80
1990M1 1992M1 1994M1 1996M1 1998M1 2000M1 2002M1 2004M1 2006M1
Euro Japan United States

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 REER of Some Countries [ REER is the weighted average of RER of
countries and weights are the percentage of trade with the partner countries]

Real Effective Exchange Rate for Some Countries

180 Index Number (1990 = 100)

160 ECA

140

120 Latin America

China
100
East Asia
80
India
60
1990M1 1992M1 1994M1 1996M1 1998M1 2000M1 2002M1 2004M1 2006M1
LAC EA7 China India ECA

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 Ratio of Exchange rate and Interest Rate Volatility
[ data: Int. Fin. Statistics]

South East Asian Countries

60

50 India

40

30

S. Korea
20

10

0
China
Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06

Hong Kong Korea Malaysia Singapore Thailand China India

04/02/08 Real Exchange Rate Targeting __ S Nandi 24

 References

• Edwards, S. , Exchange Rate Misalignment in Developing countries,

( 1988a), Baltimore: Johns Hopkins University Press.

• Edwards, S (1988b) Real and monetary Determination of Real Exchange

Rate Behavior. Journal of Development Economics, 29, 311-341.

• Devereux, M B, Real Exchange Rates and Macroeconomics: Evidence and

Theory, Canadian Journal of Economics, 30, 1997, 773- 808

• Isard, P., Exchange Rate Economics, NY, Camb. Univ. Press, 1995.

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