Macroeconomic Factors Causing Variations in the Exchange Rate of the Indian Rupee

Karen Fernandes*
*Assistant Professor, Dnyanprassarak Mandal’s College & Research Centre, Assagao, Goa, India

Abstract

This paper is directed towards a study into what factors affect the movements in the exchange
value of the Indian Rupee against the US Dollar. The value of a domestic currency is of immense
significance. Therefore it is necessary to study and analyse various parameters that cause variations
in the value of a currency so as to be able to control such factors. This paper has considered annual
data of 6 variables viz. Gross Domestic Product (GDP), interest rates, foreign exchange reserves,
imports, exports and inflation for a period of 26 years i.e. from 1990-2016. Multiple regression
technique indicates that inflation, forex reserves and interest rates are the factors that have a
significant impact on the Exchange rate of the Indian rupee. Granger causality was used to study if
there exists a causal link between the variables. Results indicated a uni-directional causal
relationship between GDP and exports, GDP and Inflation rate and between Imports and inflation
rate. The results of the Johansen Cointegration test indicated that all the chosen variables were highly
cointegrated in the long run.
Keywords: Foreign exchange, Grangers Causality, Johansen’s Co-integration, Multiple regression.

I. Introduction

Foreign exchange refers to the price of a domestic currency in terms of another foreign
currency. The exchange rate of a country is tracked and monitored daily by various parties mainly
the government, exporters and importers, speculators, arbitrageurs, hedgers, traders, investors,
travellers and consumers at large. This is because foreign exchange fluctuations have an immediate
impact on the income and expenditure of the government; the volume and value of imports and
exports; profit potential for speculators, arbitrageurs, hedgers, investors and traders; cost of
international travel and ability to consume essential imported commodities by the consumers of a
country.
Till the year 1991 the Indian foreign exchange market was regulated and the Indian economy
was still a closed economy. Restrictions were imposed on the transactions India could have with
other countries. There were barriers imposed on trade and therefore the value of the Indian rupee
against other foreign currencies was not a major concern. Another important aspect which existed till
1991 in India was a fixed exchange rate system. However in the year 1991 the Indian Economy
became a part of a globalised market through the LPG program engineered by the then Finance
minister of the country Dr. Manmohan Singh. Since then the rupee has experience high volatility as
the Liberalized Exchange Rate Management System was introduced which was later replaced by the
Unified Exchange Rate System in 1993 resulting in the devaluation of the rupee.

The inflow of foreign exchange into the Indian foreign exchange market come in the form of
export earnings, invisibles in the current account and inflows in the capital account such as FDI,
portfolio investments, external commercial borrowings (ECB) and NRI deposits. However the
demand i.e. outflow of foreign exchange comes from imports and invisible payments in the current
account, external aid, redemption of NRI deposits as well as outflows on account of direct and
portfolio investment. International trade and investment decisions become more difficult due to
volatile exchange rate because volatility increases exchange rate risk. Therefore it is important to
understand the reason behind what leads to fluctuations in the exchange rate value of the Indian
Rupee.

Factors Influencing Rupee Fluctuations

Following are the factors studied and analyzed as the factors that lead to variation in the
exchange rate of the Rupee

International Journal of Global Business Management & Research Vol6, issue 2, Aug 2017 Page 49