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The theoretical as well as empirical relationship between the interest rate and exchange rate has been a debatable issue among the economists. Interest rates, inflation rates and exchange rates are highly linked: the interaction between these economic phenomena is often complicated by a range of additional factors such as levels of government debt the sentiment of financial markets, terms of trade, political stability, and overall economic performance. An exchange rate is the price or value of one currency in relation to another. Those countries with relatively stable and low inflation rates tend to display an appreciation in their currencies, as their purchasing power increases relative to other currencies, whereas higher inflation typically leads to a depreciation of the local currency. When the value of one currency appreciates against another, then that country’s exports become more expensive and its imports become cheaper. According to Mundell-Fleming model, an increase in interest rate is necessary to stabilize the exchange rate depreciation and to curb the inflationary pressure and thereby helps to avoid many adverse economic consequences. The high interest rate policy is considered important for several reasons. Firstly, it provides the information to the market about the authorities’ resolve not to allow the sharp exchange rate movement that the market expects given the state of the economy and thereby reduce the inflationary expectations and prevent the vicious cycle of inflation and exchange rate depreciation. Secondly, it raises the attractiveness of domestic financial assets as a result of which capital inflow takes place and thereby limiting the exchange rate depreciation. Thirdly, it not only reduces the level of domestic aggregate demand but also improves the balance of payment position by reducing the level of imports. But the East Asian currency crisis and the failure of high interest rates policy to stabilize the exchange rate at its desirable level during
1997-1998 have challenged the credibility of raising interest rates to defend the exchange rate. Critics argue that the high interest rates imperil the ability of the domestic firms and banks to pay back the external debt and thereby reduce the probability of repayment. As a result, high interest rates lead to capital outflows and thereby depreciation of the currency.
The exchange rate regime in our country has undergone a significant change during 1990s. Until February 1992, exchange rate in India was fixed by the Reserve Bank of India. Thereafter a dual exchange rate system was adopted during March 1992 to
Exchange Rate/ Call Money Rate 60 50 40 30 20 10 0
Nominal Exchange Rate and Call Money Rate in India, April 1993 to March 2003
Jul-94 Jul-99 Sep-93 Feb-94 Sep-98 Feb-99 Jun-97 Aug-96 Jan-97 Aug-01 Jan-02 Oct-95 Oct-00 Mar-96 Mar-01 June-02 Apr-93 Dec-94 Apr-98 Dec-99 Nov-97 Nov-02 May-95 May-00 Month Exchange Rate Call Money Rate
India reaps the benefit of flexible exchange rate system on the one hand and less volatility in the foreign exchange market on the other. the Reserve Bank of India has been using high interest rate policy to contain the excessive volatility of exchange rates in the foreign exchange market (See. It is said that because of this regime. declines in the value of the exchange rate may themselves prompt monetary authorities to raise domestic interest rates.75 percent in March 1996. The present exchange rate regime in India is popularly known as managed floating with no fixed target.75 percent in January 1998 to contain the excessive market pressure on rupee in the foreign exchange market.February 1993 which also came to an end and a unified market came into being in March 1993. and again 28.37 per USA $) during March 1993 to August 1995 (See Fig 1). It has been observed that our economy witnessed nearly a constant exchange rate (around Rs 31. it is unlikely to accept the changes in interest rate policy to be purely exogenous to stabilize the exchange rates because the monetary authorities in many countries resort to high interest rates policy when the currency is under pressure and low interest rates policy when the currency is in normalcy. after restoration of normal condition in the foreign exchange market the call money rate is brought back to its normal level. However. political instability etc. the call money rate was allowed to increase to 34. Besides the foreign exchange intervention in terms of purchasing and selling of foreign securities. Malaysia. and the Philippines during 1997-98 was associated with rising interest rates and vice versa. Indonesia. However. border conflict. For example. exchange rates depreciation in Thailand.83 percent in November 1995. The monetary . For example. rise in oil prices. 28. However. after that the external value of the rupee was found to be under pressure for a few episodes because of various reasons like the East Asian and Russian currency crisis. In other words. Figure: 1). Korea.
etc may outweigh the benefits of a more nominal appreciated exchange rate. In other words. there is a need to answer empirically the questions such as: what is the relationship between the interest rate and exchange rate in India? Whether and how far the exchange rate depreciates or appreciates due to an increase in interest rate? Can the exchange rate be stabilized during the downward pressure on rupee by raising the domestic interest rates in India? What is the causal relationship between interest rate and exchange rate? Is interest rate exogenously or endogenously determined in the context of stabilizing exchange rate? Can the opportunity cost of stabilizing nominal exchange rate through raising interest rate is too high? . exchange rate depreciation may cause the rise in interest rate. even if one identifies a set of policies and conditions under which raising interest rates successfully defend the value of rupee. Therefore. but the costs of doing so in terms of output loss. financial system fragility. In other words.authorities in India might be using high interest rate policy whenever there is a pressure on rupee (See Fig 1). Therefore. both the interest rate and exchange rate might be affecting each other. Finally. the question is about the desirability of raising interest rates to stabilize the exchange rate. decline in investment.
this will lead to a fall in the quantity of imports. On the imports side. DEPRECIATION AND APPRECIATION: Depreciation refers to a fall in the value of one currency in terms of another currency. and to make any international trade payments. this means that the British have to give £1 to obtain or purchase $2. appreciation refers to a rise in the value of one currency in terms of another. depreciation causes an increase in the domestic currency price of imports. For instance. thus. if the value of £ changes from £1 = $2 to £1 = $1. Depreciation causes a reduction in the foreign currency price of exports. For instance.50. Hence. while $ has appreciated. making imports to become expensive ( need more domestic currencies to buy the same quantity of imports). On the other hand. if £1 = $2. making exports to become more competitive (few foreign currencies will be obtained). This in turn will lead to an increase in quantity of exports. appreciation causes a rise in the foreign currency price of exports and a fall in the domestic currency price of imports. these rates must be considered. . On the other hand.EXCHANGE RATES: Exchange rate shows the rate at which one currency can be exchanged for another and can be regarded as the price of one currency in terms of another currency. Exchange rates are essential in real life because countries have different currencies. this means that £ has depreciated.
Hence. it is often argued that exchange rate can be an instrument of government policy to achieve policy goals. In fact. making exports more expensive to foreigners but imports become cheaper to domestic customers as the price of imports fall. These count in the measure of a country’s inflation rate as these imported goods comprise a large proportion in a household basket of goods. in certain circumstances. Besides. These. it is better for the country to face appreciation of its currency. have double-edged arguments. Hence. The lower price of imported finished goods will also put pressure on domestic firms to keep their prices low in order to remain competitive. but at the expense of some other economic consequences. A higher exchange rate will cause prices of finished imported products to be relatively low. depending upon the country’s position and priorities. Indeed. Downward pressure on inflation (easing inflationary pressure): First and foremost. appreciation of a country’s currency is likely to inhibit (prevent or moderate) inflation. and investment in and out of the country. changes in the exchange rate. . appreciation and depreciation. 1. that is.MACRO-ECONOMIC IMPACT OF CHANGES IN EXCHANGE RATE: Variations in exchange rate are a matter of great concern to every government. Changes in the exchange rate will affect the competitiveness of exports and imports. a government may accept e ither an appreciation or depreciation of its currency. Beneficial outcomes of Appreciation: An appreciation of a country’s currency will tend to increase the price of its exports. affect the level of income and employment. in turn.
the creditworthiness of the nation improves. then the UK residents can now import 4 US goods costing $5 each. assume the initial exchange rate of £ is £1 = $1. More imports can be purchased for a given quantity of exports the higher the exchange rate rises.the low price of imported raw materials will keep cost of production down. when foreign firms repatriate their profits to their home countries. Hence. appreciation may boost foreign confidence in the currency. Thus. Hence. UK residents can only import 3 goods from US costing $5 each. encourages Foreign Direct Investment in the country.5. the higher exchange rate will lead to a fall in aggregate demand due to a fall in exports and a rise in imports. The fall in aggregate demand then leads to a fall in inflation (easing demand-pull inflation). To the extent that appreciation is viewed as a sign of economic strength (consequence of a booming economy). appreciation encourages investor confidence ion the country’s economy and as a result. Given a £10 export earnings. For example. . Hence. 2. Improvement in terms of trade and living standards: Furthermore. and thus. a currency’s appreciation is one of the reasons for a low inflation rate. Moreover. Since export prices rise due to appreciation there is an improvement in the purchasing power of the country’s currency. they will be worth more in their domestic currency. an appreciation improves the country’s terms of trade and living standard. 3. However. if the £ appreciates to £1 = $2. Encourage FDI: All the more. the living standard for UK residents improves. the country can secure foreign investment. wages claim may also be modified if prices of some consumer products fall (easing costpush inflation).
Drawbacks of the outcomes of Appreciation: However. Reports are regularly made by some country leaders about their concern that their currencies are appreciating in value too much or too quickly. 2. 1. The volume of imports is likely to rise leading to higher import values. This is because appreciation will make domestic firms less price competitive internationally. Lower Economic Growth: Besides. firms will witness their profit margins erode as a result of the currency’s . appreciation is also regarded as an evil to an economy. the balance of trade is likely to deteriorate. Domestic exporters will find their orders falling as foreign customers switch to other cheaper sources. local firms will find that foreign imports are undercutting their prices and gaining market share. Unemployment: Moreover. Worsen BOT: The first negative impact of appreciation is that exports are hurt. a rise in the exchange rate will tend to increase unemployment. The drastic economic impacts on various stakeholders explain the sudden outcry against appreciation. In general. appreciation will dampen output in the short term. leading to a fall in aggregate demand or national income. In domestic markets. 3. A rise in exchange rate will lead to lower exports as they become less price competitive in the global markets. a higher exchange rate which discourages exports and encourages imports may lead to lower domestic investment. The fall in national income will in turn cause a worsening in standard of living. As a result. Assume an elastic price elasticity of demand for exports and imports.
consumption. But the outcome of depreciation on BOT depends on the PED of exports and imports. This may help to increase the country’s exports and decrease imports. Hence. depreciation of currency is more conducive to economic growth creating increase in income. Eventually. leading to a rise in unemployment. .appreciation. The rise in income will in turn cause an improvement in living standard. Beneficial outcomes of Depreciation: A fall in the exchange rate may have some desirable outcomes in the economy. and may therefore help to reduce current account deficit. Economic Growth: A fall in the exchange will lead to rising exports and falling imports. these firms will be forced to lay off workers in order to survive. through the multiplier process. 1. investment and employment. This injection. the trade balance improves causing a net injection of money in the circular flow. Thus. Marshall-Lerner + diagram 2. thus discouraging imports. Improvement in BOT: Depreciation makes the country’s exports relatively less expensive for foreigners and it makes the foreign products relatively more expensive for domestic consumers. causes a more than proportionate increase in national income.
Besides. 2. 3. Inflationary pressure. aggregate demand will rise as exports become more price competitive and imports less price competitive.Drawbacks of the outcomes of Depreciation: 1. Prices of all imported products. depreciation may dampen investor confidence in the country’s economy and hurt the country’s ability to secure foreign investment. the economy is likely to experience inflationary pressure (demand-pull). Unfavourable Terms of Trade: Price of exports fall Insufficient export earnings Will be able to acquire less imports . Discourage FDI: To the extent that depreciation is viewed as a sign of economic weakness. As a result. A significant danger is that by increasing the price of imports and stimulating greater demand for domestic products. depreciation can feed through a rise inflation in the economy. will cost more expensive. Thus. both finished goods and raw materials. the creditworthiness of the nation may be jeopardized.
Interests rates are fundamental to a capitalist society Interest rates are normally expressed as a percentage rate over the period of one year Interest rates targets are also a vital tool of monetary policy and are taken into account when dealing with variables like investment. a small company borrows capital from a bank to buy new assets for their business. and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to the borrower. . The economy can be influenced easily by interest rates. The opposite is also true. inflation. For example. When interest rates are high. This also bodes well for investors.. The effects of a lower interest rate on the economy are very beneficial for the consumer. and unemployment…. people are more likely to take loans out of the bank in order to pay for things like houses and cars. When the market for those things gets strong. and the number of purchases of cars and homes goes down. who perceive less risk in taking out a loan and investing it in something because they would have to pay less back to the bank. price decreases and more people can purchases these things. When interest rates are low. people do not want to take loans out from the bank because it is more difficult to pay the loans back.INTEREST RATE: An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender.
This means that banks may find themselves having to lower the interest rates accrued on money deposited in the bank in order to maintain a steady profit. though.When people do not have to spend as much money on bank payments. who are seeing less of a return on their loan than in times when interest rates are high. Or they can increase foreign investment . The opposite happens. they have more disposable income to put toward things they want to purchase. interest rates can drive up consumer spending. a trip to the ice cream store is not so much of a budget crunch and a weekend at the spa seems more doable. Although much of it is contained within consumers' perception of the economy and their income. though. When interest rates increase. driving up its value in the international market. investment and the amount of loans people take out of the bank. This causes more demand for the dollar. although certainly not direct. Suddenly. when the interest rates are decreased. interest rates do not really have an effect on how much people save. foreign investment can increase because people outside of the country want a larger return for their investment and they are more likely to get it in a state of high interest rates. are enough to stimulate the market when interest rates are low. However. These effects. Low interest rates are not beneficial for lenders. because an increased amount of disposable income means that they are more likely to spend it than to save it.
If he chooses one. Most economists advocate independent central banks to limit the influence of politics on interest rates. he forgoes the returns from all the others. Inflationary expectations: Most economies generally exhibit inflation. Alternative investments: The lender has a choice between using his money in different investments. The quick boost can influence elections. most economists think a cut in interest rates will only give a short term gain in economic activity that will soon be offset by inflation. Since according to time preference theory people prefer goods now to goods later. in a free market there will be a positive interest rate. Deferred consumption: When money is loaned the lender delays spending the money on consumption goods. The borrower needs to compensate the lender for this.Reasons for interest rate change Political short-term gain: Lowering interest rates can give the economy a short-run boost. meaning a given amount of money buys fewer goods in the future than it will now. Different investments effectively compete for funds. . Under normal conditions.
Liquidity preference: People prefer to have their resources available in a form that can immediately be exchanged. or otherwise default on the loan. he is compensated for those that fail. rather than a form that takes time or money to realize. abscond. across his investments. the lender may insist on a higher rate to make up for this loss. . Risks of investment: There is always a risk that the borrower will go bankrupt. This means that a lender generally charges a risk premium to ensure that. Taxes: Because some of the gains from interest may be subject to taxes..
Increases the cost of borrowing. Interest payments on credit cards and loans are more expensive. Investors are more likely to save in British banks if UK rates are higher than other countries) A stronger Pound makes UK exports less competitive .000 mortgage by £60 per month.reducing exports and increasing imports. Therefore this discourages people from borrowing and saving. People who already have loans will have less disposable income because they spend more on interest payments.IMPACTS OF HIGHER INTEREST RATES Higher interest rates have various economic effects: 1. This is because a 0. Higher interest rates increase the value of £ (due to hot money flows. 3. . 5% increase in interest rates can increase the cost of a £100. This has the effect of reducing Aggregate demand in the economy. 4. 2. Higher interest rates make it more attractive to save in a deposit account because of the interest gained. Related to the first point is the fact that interest payments on variable mortgages will increase. Increase in mortgage interest payments. Increased incentive to save rather than spend. This will have a big impact on consumer spending. Therefore other areas of consumption will fall. This is a significant impact on personal disposable income.
Higher interest rates increase the cost of government interest payments. A rise in interest rates discourages investment. Government debt interest payments increase. .5. Interest rates have an effect on consumer and business confidence. 6. Reduced Confidence. The UK currently pays over £23bn a year on its own national debt. 7. it makes firms and consumers less willing to take out risky investments and purchases. Therefore the economy is likely to experience falls in consumption and investment. This could lead to higher taxes in the future. Rising interest rates affect both consumers and firms.
would lead depreciation of domestic currency to maintain the exchange rate as per the purchasing power theory. According to one view uncovered interest parity theory which implies that domestic interest rate is the sum of world interest rate and expected depreciation of home currency is the basis of exchange rate determination. we hypothesize exchange rate as a function of interest rate (or interest rate differential). and net intervention. which. Therefore. The latter view has also been supported by Furman and Stiglitz(1998) who argue that the high interest rates imperil the ability of the domestic firms and banks to pay back the external debt and thereby reduces the probability of repayment. the interest rate differential between domestic and world interest rate is equal to the expected change in the exchange change in the domestic exchange rate. As a result. a higher domestic inflation results in high domestic exchange rate depreciation. inflation differential.The Model and Methodology Relationship between interest rate and exchange. There is a direct relationship between domestic and world inflation differential and domestic exchange rate. The rationale behind this hypothesis and a priori relationship between exchange rate and other factors including interest rates can be stated as follows: There are two views regarding the relationship between the interest rate and exchange rate. On the other hand. monetarists believe that higher interest rate reduces the demand for money which leads to depreciation of currency due to high inflation. . in turn. a higher interest differential would attract capital inflows and result in exchange rate appreciation. In other words. In other words. This is so because an increase in domestic inflation as compared to world inflation would increase the domestic demand for foreign commodities and lowers the foreign demand for domestic commodities. high interest rates lead to capital outflows and thereby depreciation of the currency.
As a result. Therefore. domestic exchange rate would appreciate.Similarly a decrease in domestic inflation as compared to world inflation causes appreciation of domestic currency. 30 . and t is time period. The regression coefficients in the case of above equation are expected to have the following signs: 1 or 0. 20.. In the same way. the higher the inflation differential between domestic and foreign countries. Based on the above-discussed rationale. IR=Interest Rate. the higher will be the depreciation of domestic currency and vice versa. a decrease in net purchase of foreign currency assets would lead to depreciation of domestic currency in terms of foreign currency. An increase in net purchases of foreign currency assets from the foreign exchange market by the Central Bank would reduce the supply of foreign currency in the foreign exchange market. a negative relationship can be expected between the net intervention of the Central Bank and the exchange rate. Therefore. INFDIFF= Inflation differential between domestic and foreign countries. C=constant.(1) Where ER= Exchange Rate. the relationship between exchange rate and interest rate can be studied by the following exchange rate function: ERt=C+1IRt+ 2INFDIFFt+3INTERt+Ut ……………………………. INTER= Net intervention by the Central Bank.
Variance Decomposition. and Impulse Response Technique. Granger Causality between interest rate and exchange rate. 1995. 1994).The relationship between interest rate and exchange rate in this Paper has been studied by using Co-integration. Net intervention is the monthly net purchases . Hamilton. Error Correction. from April 1993 to March 2003 and from June 1995 to March 2003 because of the unavailability of data for some variables in the former time period. and Exogenity of interest rate have also been studied which is an improvement over the earlier Indian studies (Enders. The exchange rate is measured by the Indian rupee in terms of USA dollar. The study uses monthly data for two time periods namely. Inflation differential is the monthly inflation difference between domestic inflation measured in terms of Wholesale Price Index (1980-81=100) and USA inflation measured in terms of Producer Price Index (1980-81=100). All variables are expressed in level form. The required data for the purpose of estimation have been obtained from the various publications of Reserve Bank of India and the International Monetary Fund. Interest rate is the monthly call money rate.
whereas the variables like net intervention and expected inflation rate differential between India and world were found to be stationary. The variables like call money rate.Summary and Conclusions The exchange rate regime in our country has undergone a significant change during 1990s. rise in oil prices. Both call money rate and net intervention have negatively and significantly influenced the exchange rate. The present exchange rate system in our country is popularly known as ‘managed floating exchange rate regime’. exchange rate in India was fixed by the Reserve Bank of India. the Paper has attempted to study the relationship between interest rate and exchange rate in India by using cointegration based on vector autoregression model during April 1993 to March 2003 and June 1995 to March 2003 and by using a theoretic vector autoregression model during June 1995 to March 2003. political instability etc. In this context. exchange rate were found to be non-stationary. It was found that there has been a long-run relationship between the above mentioned variables. But the external value of the rupee was found to be under pressure for a few episodes because of various reasons like the East Asian and Russian currency crisis. Thereafter a dual exchange rate system was adopted during March 1992 to February 1993 which also came to an end and a unified market came into being in March 1993. . where as the expected rate of inflation differential between the India and world has not played significant role in the behaviour of exchange rate in India. border conflict. The Reserve Bank of India has been using high interest rate policy to contain the excessive volatility and to contain the excessive market pressure on rupee in the foreign exchange market. Until February 1992.
Interest rate in India was also found to be endogenous by both weak and block exogenity tests. It is so because the Granger cause test indicates a bidirectional causality or feedback between interest rate and exchange rate in India during April 1993 to March 2003 and June 1995 to March 2003. the over all appreciation of exchange rate was found to be 9 paise due to one standard deviation change (around 3. Similarly. there is a strong case for an increase in interest rates to stabilize the value of rupee during the downward pressure in India because the cost of doing so . the variance decomposition. the changes in interest rate policy were found to be endogenous in stabilizing the exchange rate. both the interest rate and exchange rate were affecting each other. in a VECM at 50 month horizon. changes in exchange rate explain about 27 variation of interest rates in a VAR model during June 1995 to March 2003. Similarly. Therefore. In other words. Similarly.34 percentage increase) in interest rate in a VAR model.It has been found that the overall appreciation of exchange rate was found to be 5 paise and 16 paise due to one standard deviation change (around 3. Finally. But. declines in the value of the exchange rate have prompted monetary authorities to raise domestic interest rates. and June 1995 to March 2003 respectively.30 percentage increase) in interest rate in a CVAR model during April 1993 to March 2003.18 and 3. indicates that changes in exchange rate accounts for about 41 and 35 percent variation in interest rate during April 1993 to March 2003 and June 1995 to March 2003 respectively.
in terms of output loss. decline in investment. . etc may not outweigh the benefits of a more nominal appreciated exchange rate. financial system fragility.
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