Exchange rate and monetary fundamentals: Long run relationship revisited

Abstract

This study re-examines the long run validity of the monetary approach to exchange rate determination for India. In particular, the long run association of bilateral nominal exchange rate of Indian rupee vis-à-vis USD, Pound-sterling, Yen and Euro against the corresponding monetary fundamentals that the model underlines has been tested using Johansen-Juselius maximum likelihood framework and Gregory-Hansen co-integration approach. Irrespective of the exchange rates the study finds a co-integrating relationship among the variables using Johansen-Juselius maximum likelihood approach. The Gregory-Hansen co-integration method allows for one break determined endogenously in three specifications also confirms the long run relationship. Our results, hence, suggest that the monetary model is a valid theory of long run equilibrium condition for the rupee-dollar, rupee-pound, rupee-yen and rupee-euro exchange rates.

Keywords

• Monetary approach
• Exchange rate determination
• India