Exchange rate policy modeling and forecasting the exchange rate: Indian rupee vis‐à‐vis the U.S. dollar

• Author: Babu Rao Gona,Manamani Sahoo
• DOI: http://doi.org/10.1002/pa.2073
• Date: 01 August 2020
• Published date: 01 August 2020

ACADEMIC PAPER

Exchange rate policy modeling and forecasting the

exchange rate: Indian rupee vis-à-vis the U.S. dollar

Babu Rao Gona

1

| Manamani Sahoo

2

1

Department of Economics, Dr. Abdul Haq

Urdu University, Kurnool, India

2

Department of Economics, Utkal University,

Odissa, India

Correspondence

Babu Rao Gona, Department of Economics,

Dr. Abdul Haq Urdu University, Kurnool

518002, India.

Email: baburaopcu@gmail.com

The exchange rate is a very important key financial variable that affects decisions

made by the foreign exchange investors, exporters, importers, bankers, businesses,

financial institutions, policymakers, and tourists in the developed as well as the devel-

oping world. Exchange rate fluctuations affect the value of international investment

portfolios, competitiveness of exports and imports, value of international reserves,

currency value of debt payments, and the cost of tourists. Movements in exchange

rates thus have very important implications for any country's economy's business

cycle, trade, and capital flows and are therefore crucial for understanding financial

developments and changes in economic policy. The study will be looking at the vari-

ous aspects of country's economic policy with respect to the exchange rate and

modeling and forecasting the exchange rate. The study will be analyzing India's

exchange rate story and will be discussing the structure of the foreign exchange mar-

ket in India in terms of participants, instruments, and trading platform as also a turn-

over in the Indian foreign exchange market and forward premia. The study will be

attempting to develop a model for the rupee–dollar exchange rate taking into

account variables from monetary and microstructure models as well as other vari-

ables including intervention by the central bank. The main focus will be on the

exchange rate of the Indian rupee vis-à-vis the U.S. dollar, that is, the Re/$ rate. The

data will be covering from January 1990 through April 2013. This study will be exam-

ining the forecasting performance of the monetary model and various extensions of

it in the vector autoregressive and Bayesian vector autoregressive framework.

1|INTRODUCTION

The exchange rate is a key financial variable that affects the decisions

made by foreign exchange investors, exporters, importers, bankers,

businesses, financial institutions, policymakers, and tourists in the

developed as well as the developing world. Exchange rate fluctuations

affect the value of international investment portfolios, competitive-

ness of exports and imports, value of international reserves, currency

value of debt payments, and the cost to tourists in terms of the value

of their currency. Movements in exchange rates thus have more

important implications for the economy's business cycle, trade, and

capital flows and are therefore crucial for understanding financial

developments and changes in economic policy. Timely forecasts of

exchange rates can therefore provide valuable information to

decision-makers and participants in the spheres of international

finance, trade, and policymaking. Nevertheless, the empirical literature

is skeptical about the possibility of accurately predicting exchange

rates.

In the international finance literature, various theoretical models

are available to analyze the exchange rate behavior. Although

exchange rate models existed prior to 1970s (Mundell, 1962; Nurkse,

1944), most of them were based on the fixed price assumption. With

the advent of the floating exchange rate regime among major industri-

alized countries in the early 1970s, a major advance was made with

the development of the monetary approach to the exchange rate

determination. The dominant model was the flexible price monetary

Received: 16 November 2019 Accepted: 15 December 2019

DOI: 10.1002/pa.2073

J Public Affairs. 2020;20:e2073. wileyonlinelibrary.com/journal/pa © 2020 John Wiley & Sons, Ltd 1of9

https://doi.org/10.1002/pa.2073