Interaction of real effective exchange rate with economic growth via openness of the economy: Empirical evidence from India

• Published date: 01 May 2020
• DOI: http://doi.org/10.1002/pa.2042
• Author: Nihar Ranjan Jena,Narayan Sethi
• Date: 01 May 2020

ACADEMIC PAPER

Interaction of real effective exchange rate with economic

growth via openness of the economy: Empirical evidence from

India

Nihar Ranjan Jena

1

| Narayan Sethi

2

1

Department of Economics, K. E. T.'s V. G.

Vaze College of Arts, Science & Commerce,

University of Mumbai, Mumbai, Maharashtra,

400081, India

2

Department of Humanities and Social

Sciences, National Institute of Technology

Rourkela, Rourkela, India

Correspondence

Narayan Sethi, Department of Humanities and

Social Sciences, National Institute of

Technology Rourkela, Rourkela 769008,

Odisha, India.

Email: nsethinarayan@gmail.com

This paper examines the interaction between real effective exchange rate (REER)

with select macroeconomic variables such as gross domestic product (GDP), foreign

direct investment, foreign institutional investors (FII), fiscal deficits, terms of trade,

trade openness, and foreign exchange reserves from 1981–2017. Autoregressive dis-

tributed lag bounds test results confirm the existence of long-run relationships

among the considered variables. The study finds that among the selected macroeco-

nomic variables, GDP and remittances have positive and significant impact on REER.

The study also reveals that although the variables official development assistance,

FII, and fiscal deficit have positive impacts on REER, the results are not statistically

significant. Further, our study indicated that the speed of convergence of REER

towards long-run equilibrium is 30% per annum, which is below standard in nature.

JEL CLASSIFICATION

F4; F6

1|INTRODUCTION

In recent times, the economic growth of India has been more funda-

mentally driven by domestic consumption and investment. This leaves

India with another avenue by which economic growth can be acceler-

ated further through export-led industrialization. The acceleration of

structural reforms, the pace towards a rule-based policy framework

coupled with the 3Ds—demographic dividend, democracy and

demand—is working wonders for the national economy. The political

economy irrespective of party affiliation is ever eager to showcase

the country as a destination of investments, growth, development,

and prosperity. Sustained improvement in the ease of doing business

index rank of India is a testimony to such endeavors. In recent times,

sluggish private investments have been a major cause of concern,

which is mainly due to excessive leveraging balance sheet of major

companies besides relatively high corporate income tax rate, a slow

and troublesome land acquisition process, and high nonperforming

assets of the banking sector, which has hamstrung their lending capa-

bilities (International Monetary Fund, 2019). Many international agen-

cies and experts have opined that although India is growing rapidly

and there is visible reduction in the absolute level of poverty, inequal-

ity is growing, which is a major cause of concern. A way to address

this is by way of a comprehensive tax reform. The first towards this is

the implementation of goods and services tax. Although the goods

and services tax has been implemented, much remains to be done to

make it a sustainable tax regime and one that works for the better-

ment of small businesses and traders and in no way to their detriment.

Another such exercise would be the early finalization of the proposed

Direct Tax Code, which contains, among other measures, a more equi-

table distribution of income tax and gradual rationalization of corpo-

rate tax architecture in the country. These measures, when

implemented in their full steam, would support competitiveness,

investment, and economic growth (Organisation for Economic Co-

operation and Development, 2017).

The real effective exchange rate (REER) is the weighted average

of a country's currency in relation to an index or basket of other major

currencies adjusted for the effects of inflation. The weights are deter-

mined by comparing the relative trade balance of a country's currency

against each other within the index. The REER takes into account any

changes in relative prices and shows what can actually be purchased

Received: 16 August 2019 Accepted: 23 October 2019

DOI: 10.1002/pa.2042

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