Fluctuations in the Exchange Rate of Indian Rupees with U.S. Dollar

Abstract

The exchange rate is very important monetary policy tool for emerging economies like India. India has adopted inflation targeting and has less flexible exchange rate arrangements. It intervenes quite frequently in the foreign exchange market than their advanced economy counterparts. The enhanced role of the exchange rate reflects these economies’ greater vulnerability to exchange rate shocks and their less developed financial markets. Some of the principal factors that cause fluctuations in the exchange rate between two countries are interest rates, inflation rates, and current account deficits, public debt, trading terms, political stability and economic performance. This study aims to observe the impact of interest rates, inflation rates and current account deficit on exchange rate of rupee with U.S. dollar during the year between 1990 and 2011. This study hypothesis lower interest rate would decrease the rupee value, and higher inflation and higher current account deficit will lower the rupee value. To observe the impact of interest rates, inflation rates and current account deficit on exchange rate of rupee with U.S. dollar, the exchange rate is treated as dependent variable and regressed with independent variables (interest rates, inflation rates and current account deficit). The regression results show that all three independent variables taken together explained 79 per cent of variation in the exchange rate of rupee with U.S. dollar. The regression co-efficient of each independent variable individually also support the hypotheses of the study. This study has identified only three independent variables for analyzing the fluctuations in the exchange rate of rupee. We can further add other major factors to explain the volatility of Indian rupee’s exchange rate. Certain factors like public debt, gold reserves, foreign direct investment, bank rates, trading terms, etc., can be added to the independent variables and a multiple regression of the same can give a better picture of the dependence of exchange rate on these factors.