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Exchange rate and the economic growth in India: An empirical analysis

Article in Journal of Public Affairs · June 2020

DOI: 10.1002/pa.2177

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Received: 6 April 2020 Accepted: 2 May 2020
DOI: 10.1002/pa.2177

ACADEMIC PAPER

Exchange rate and the economic growth in India: An empirical

analysis

Khulsum Shaik | Babu Rao Gona

Department of Economics, Dr. Abdul Haq

Urdu University, Kurnool, India
Correspondence
Dr. Babu Rao Gona, Assistant Professor,
Department of Economics, Dr. Abdul Haq
Urdu University, Kurnool-518002, Andhra
Pradesh, India.
Email: baburaopcu@gmail.com
In the present globalization economic world, exchange rate plays a major role in
every country's economic activity. Here, exchange rate policy has been identified as
one of the endogenous factors that can affect the economic performance of a nation.
Exchange rate plays a key role in international economic transactions because no
nation can remain in isolation due to varying factor endowment. Movements in the
exchange rate have ripple effects on other economic growth. The study used second-
ary data that were collected from the World Development Indicators data base and
analysed. The study used the ordinary least square and VECM Granger Causality
method of estimation for data covered the period from 1990 to 2017. The results
from the econometric analyses show that there is a short-run relationship between
exchange rate, inflation rate, interest rate and GDP. The result obtained from the unit
root analysis indicates that least one time series variable property is stationary. The
study concludes that in India, the factors that influence the level of growth rate are
extent of exchange rate and its variables. Based on the findings, from the Granger
causality investigation procedure at 5% critical value are EXCH, INT, INF, IMP and
EXP among other variables that affect economic growth. The study recommends the
need to be technologically inclined in all sectors of Indian economy; excess and over
budgetary inflation and implementation should be cut to barest minimal level to avert
the ideal of external borrowing which most consequently result in external debt and
services. The Indian government should show the path of redirecting its investment
profile by channelling it towards capital projects of the government.
JEL CLASSIFICATION

D51; E00; E6; F430; G010

1 | I N T RO DU CT I O N on. These facts underscore the importance of exchange rate to the

Exchange rate refers to the value of one currency (the domestic cur-
rency) in relationship to another (foreign currency). It can also be
defined as the price at which one unit of a country's domestic cur-
rency exchanges for any other country in the world. Osiegbu and
Onuorah (2011) posit that exchange rate plays a key role in interna-
tional economic transactions because no nation can remain in isola-
tion due to varying factor endowment. Movements in the exchange
rate have screwed up effects on other economic variables such as
interest rate, inflation rate, import, export and output, and so
economic well-being of every country that opens its doors to interna-
tional trade in goods and services. The importance of exchange rate
derives from the fact that it connects the price systems of two differ-
ent countries making it possible for international trade to make direct
comparison of traded goods. In other words, it links domestic prices
with international prices. Through its effects on the volume of imports
and exports, exchange rate exerts a powerful influence on a country's
balance of payments position.
In emerging market economies like India, exchange rate has
gained more importance after adoption of flexible exchange rate

J Public Affairs. 2020;e2177. wileyonlinelibrary.com/journal/pa © 2020 John Wiley & Sons, Ltd 1 of 9
https://doi.org/10.1002/pa.2177
2 of 9
system. Devaluation means officially lowering the value of currency
in terms of foreign currencies. There could be many motives of the
devaluation. It stimulates exports of commodities and it restricts
import demand for goods and services. It also helps in creating a
favourable balance of payments. Almost all the countries of the
world have devalued their currencies at one time or the other with
a view to achieving certain economic objectives. During the great
depression of 1930, devaluation was carried by most countries of
the world for the correcting their over-valuation. Since 1951,
despite government attempts to obtain a positive trade balance,
India has experienced severe balance of payments deficits. Inflation
caused Indian prices to go high. When the exchange rate is fixed
and a country experiences high inflation relative to other countries,
that country's goods become more expensive and foreign goods
become cheaper. Therefore, inflation tends to increase imports and
decrease exports. From 2006, Indian currency continuously appre-
ciated and has the trade balance. Another reason, which played an
important role in the 1966 devaluation, was war with Pakistan. The
United States and other countries withdrew their aid, which further
necessitated devaluation. To improve fiscal position, Government
of India's need to consider the country's attractiveness to foreign
investors is increasing and signals optimism about the Indian econ-
omy more generally. India still had a fixed exchange rate system,
where the rupee was hooked to basket of currencies of major trad-
ing partner countries. Between 2003/04 and 2005/06, however,
the rupee appreciated against the dollar by 3% on average a year,
although there was considerable two-way movement of the rupee
from month to month. The average rupee–US dollar rate in May
2007 was lowest since 1990/2000. Although rupee–US dollar
exchange rate has the greatest impact on the Indian economy and
business sector, the rupee has also appreciated against other cur-
rencies (Jashandeep, Drishty, & Anjali, 2018).
In connection with the above discussion, the Indian Rupee
exchange rate has witnessed some period of relative stability since
the implementation of the Structural Adjustment Programme (SAP) in
1991; its continued depreciation, however, mars the economic perfor-
mance of the country. The challenge of the combined effect of
increase in oil prices and exchange rate instabilities on macroeco-
nomic stability and economic growth for non-oil producing nations
like India is really enormous. According to Usman (2009), huge inflow
of oil revenues in Nigeria is more often associated with expansion in
the level of Government spending while periods of dwindling oil reve-
nues are usually accompanied by budget deficits. There is no gain say-
ing that Nigeria relies so much on revenue from oil exports, but, it
equally massively imports refined petroleum and other related
products.
1.1 | Statement of the problem
In any country, foreign exchange policy is an important policy instru-
ment. Up to the time of SAP, it appeared that India's exchange rate
SHAIK AND GONA
policy tended to encourage over-valuation of the rupee, because in
1991, it was Rs 18.11 to Rs 25.79. This, in turn, encouraged exports,
and discouraged non-oil export and over dependence on exported
inputs. India imports bulk of its oil imports and higher crude prices
puts pressure on domestic inflation and current account and fiscal
deficits.
India's exchange rate has been more volatile in the post-SAP
period due to its excessive exposure to external shocks. The effect of
the recent global economic meltdown on India's exchange rate was
phenomenal as the rupee exchange rate vis-à-vis the dollar rose astro-
nomically from about Rs 18.11/$ to more than Rs 53.01/$ (about
50% increase) between 1991 and 2011. This is attributable to the
sharp drop in foreign earnings of India as a result of the persistent
raise of crude oil price, which plunged from an all-time high of US$
72.48 per barrel in November 2018. Although various factors like,
demonetization, bank rate and oil prices hike have been adduced to
the economic performance of India, it is necessary to examine the
growth process of India under the various exchange regimes that had
been adopted in the country, the effect of inflation and interest rate
and impact of trade. India's over dependence on importation and less
emphasis on manufacturing local goods and services depreciated the
value of the rupee.
With continuation of the above discussion, this study has made
following objectives.
The main objective of this study is to examine the effects of
exchange rate on the economic growth of India, particularly focused
on these objectives:
• To examine the effect of exchange rate, interest rate, import and
export on the economic growth of India.
• To examine the impact of inflation rate on the economic growth in
India.
2 | LI T E RA T U R E RE V I E W
2.1 | Theoretical issues
Existing literature has two basic views on the transmission mechanism
of the impact of exchange rate on economic activities. They are tradi-
tional point of view and empirical point of view.
From the traditional point of view, the exchange rate operates
through the aggregate demand channel. It has become an argu-
ment that the depreciation of the exchange rate allows interna-
tional competitiveness of domestic goods which helps to improve
the current account balance of the country. The improvement of
international competitiveness of domestic goods facilitates
increase in export which, in turn, increases the aggregate demand
in the economy. A study done by Edwards (1989) acknowledged
that if there is any misalignment in exchange rate in the form of
currency devaluation, it will impair tradable activities and thus low-
ering net export and aggregate demand in the economy. He argues
SHAIK AND GONA
that, when there is a real depreciation, it generates adverse effects
resulting in overall economic contraction. Contraction occurs
through some fundamental process as described later: First, a
nominal depreciation of currency causes a rise in the general price
level resulting in low aggregate demand. This in turn causes eco-
nomic contraction. Second, it is often an argument that a real
depreciation can help transfer income from individuals with high
marginal propensity to consume to those with a low marginal pro-
pensity to consume.
Exchange rate movements and exchange rate uncertainty are
important determinants of international transactions. In India,
these fluctuations according to Omojimite and Akpokodje (2010)
have been influenced by changing pattern of international trade,
institutional changes in the economy and structural shifts in pro-
duction. Further, Englama, Duke, Ogunleye & Ismail (2010)
pointed that the real exchange rate in Nigeria has been principally
influenced by external shocks resulting from the vagaries of world
price of agricultural commodities and oil price, both major sources
of Nigerian export and foreign exchange earrings, contending that
when the economy depended on agricultural exports, real
exchange rate volatility was less pronounced given the fact that
these products were subject to less volatility and that there were
more trading partners' currencies involved in the calculation of
the country's real exchange rate. In connection with above discus-
sion, Lama and Medina (2010) said this minimally affected the real
exchange rate fluctuating by only 0.14% between 1970 and 1977.
The increased dependence of the country on oil resulted in severe
trade shocks from global oil price stocks are fluctuating in the
naira exchange rate by 10% in the period 1978–1985.
The movements in the exchange rate point of view some stud-
ies have been highlighted. Iyoha and Oriakhi (2002) analysed the
movements in real exchange rate during this period were nominal
stocks resulting from fiscal deficits. Collaborating, Aliyu (2009) dis-
tinguished that the oil windfall resulted in excessive fiscal expendi-
ture in ambitious development projects, and when the windfall
ended, the government resorted to financing its expenditures
through money creation. This expansionary monetary fiscal policy
according to Lu and Zhang (2003) exerted upward pressure on
inflation, aggravating sharp movements in real exchange rate
movements.
From 1986, a study by Oyejide and Ogun (1996) posits the
adoption of the structural adjustment program became a contribu-
tory factor in shaping the dynamics of real exchange rate in Nigeria.
One of the cardinal points of this policy was floating nominal
exchange rate policy. As the naira was allowed to float, the nominal
exchange rate movement became more pronounced, contributing
to stronger movements in exchange rate during this period. Babu
Rao (2019) examined on the exchange rate regimes and its impact
on growth of BRICS countries, the data spanning from 1970 to
2012. The study found that by adopting a pegged regime can pro-
mote trade for BRICS countries and led to an increase in economic
growth.
3 of 9
2.2 | Empirical evidence
Several empirical studies that have undertaken to identify the possible
effects of economic growth in India and elsewhere have been identi-
fied as exchange rate and its variables. Anietie, Olumide, Frances, and
Friday (2004) using co-integration and error correction models
analysed the impact of real effective exchange rate on economic
activities in Nepal to determine which of the transmission channels
(aggregate demand channel and aggregate supply channel) the effect
of variation in real exchange. The traditional view has it that the real
exchange rate operates through the aggregate demand channel. By
this, it means that the depreciation of real exchange rate, enhances
the international competitiveness of domestic goods, boosts net
exports and eventually enlarges GDP. Haker and Hatemi (2004) follow
the GDP function approach of Mordi (2006), which allows sufficient
flexibility in terms of functional forms to provide estimates of import
demand and export supply elasticity in 117 countries. The policy
implications drawn from this study are therefore significant in view of
their contributions to informed decision making in India and others
who share the same economic structure. Antonia and Bara (2008)
examined the relationship between the real effective exchange rate
and aggregate real trade balance for major OECD countries in the
post-Bretton Woods era. Using a variety of parametric and non-
parametric techniques, the results suggest that there is little evidence
that the exchange rate significantly affects the trade balance.
Bahmani-Oskoee and Kovyryalova (2008) using VECM estimated
the long-run effects of exchange rate devaluation on the trade bal-
ance of South Africa. The results provide evidence supporting the
view that devaluation of the exchange rate worsens the trade balance
of South Africa in the long run. Odusola (2006) applied co-integration
and error correction model approaches investigated the behaviour of
Indian aggregate import demand during the period 1971–1995. The
results obtained indicate that import volume is co-integrated with rel-
ative import price and real GDP. The output of the econometric model
estimate shows that import demand in India is largely explained by
real GDP and generally less sensitive to import price changes. Modi,
Chandrashekar, and Chittedi (2016) examined the relationship
between macroeconomic variable and capital inflows in India during
2004–2014 by applying Augment Dickey Fuller (ADF), Variance
Decompositions Technique and Impulse Response Function methods
and reported a majority of the macroeconomic variables have posi-
tively related with capital inflows. Vadivel, Veeramani, and Rag-
hutla (2020) investigated the nexus between exchange rate and whole
sale price index for India by adopting Flexible Least Square method
and found that exchange rate changes whole sale price and
highlighted that both the imports and exports also changes exchange
and whole sale price in local market. Also, Obadan (2006) practicalised
with the VECM to test for Marshall-Lerner condition in the exchange
rate–balance relationship in the Baltic States. The condition is found
to be met for Lithuania, but not for Estonia, while the results con-
cerning Latria are ambiguous. Although the traditional influencers are
sufficient at explaining trade dynamics in Baltic countries, the analysis
4 of 9 SHAIK AND GONA

reveals that a long-run equilibrium relationship among them exists. X

a2 X
b2
ΔInEXCHt = α20 + β2i ΔInRGDPt− i + δ2i ΔInEXCHt − i
Sampath (2011) examined the relationship between macroeconomic i=0 i=1
variables and stock prices for India, spanning the period from X
c2 X
d2 X
e2
+ ω2i ΔInINT t − 1 + ε2i ΔInINFt −1 + λ2i ΔInEXPt − 1
1993–2010. The study found that economic growth has a positive i=0 i=0 i=0
impact on stock prices. X
f2 X
g2
+ μ2i ΔInIMPT t − 1 + V2i ΔInMSt −1 + ;21 RGDPt −1 + ;22 EXCHt −1
i=0 i=0
+ ;23 INT t −1 + ;24 INFt −1 + ;25 EXPt − 1 + ;26 IMPT t −1 + ;27 MSt − 1 + ϵ2t
3 | D A T A A N D M E T H O D O LO G Y ð5Þ
X
a3 X
b3

In order to analyse the above objectives, the data for the study are ΔInINT t = α30 + β3i ΔInRGDPt −i + δ3i ΔInEXCHt− i
i=0 i=0
collected from secondary sources such as World Development indi- X
c3 X
d3 X
e3
cator (WDI), Reserve Bank of India (RBI), International Financial + ω3i ΔInINT t − 1 + ε3i ΔInINFt −1 + λ3i ΔInEXPt − 1
i=1 i=0 i=0
Statistics (IFS). The study period has covered from 1990 to 2017
X
f3 X
g3
on the following variables such as gross domestic price (GDP), real + μ3i ΔInIMPT t − 1 + V3i ΔInMSt −1 + ;31 RGDPt −1 + ;32 EXCHt −1
i=0 i=0
exchange rate (EXCH), inflation rate (INF), interest rate (INT),
+ ;33 INT t −1 + ;34 INFt −1 + ;35 EXPt − 1 + ;36 IMPT t −1 + ;37 MSt − 1 + ϵ3t
import (IMP) and export (EXP). The study examines the effect of
ð6Þ
economic growth (GDP) using exchange rate variables such as real
X
a4 X
b4
exchange rate, inflation rate, interest rate, import and export as the ΔInINFt = α40 + β4i ΔInRGDPt −i + δ4i ΔInEXCHt − i
exogenous variables. All variables are converted into natural loga- i=0 i=0

rithms (Guntukula, 2018; Raghutla, 2020; Raghutla, Sampath & X

c4 X
d4 X
e4
+ ω4i ΔInINT t − 1 + ε4i ΔInINFt −1 + λ4i ΔInEXPt − 1
Chittedi, 2018; Raghutla, Sakthivel, et al., 2018; Raghutla & i=0 i=1 i=0

Chittedi, 2020; Raghutla, Sampath, & Vadivel, 2019; Shahbaz, X

f4 X
g4
+ μ4i ΔInIMPT t − 1 + V4i ΔInMSt −1 + ;41 RGDPt −1 + ;42 EXCHt −1
Raghutla, Song, Zameer, & Jiao, 2020). i=0 i=0

The functional linear regression equation is stated as follows: + ;43 INT t −1 + ;44 INFt −1 + ;45 EXPt − 1 + ;46 IMPT t −1 + ;47 MSt − 1 + ϵ4t
ð7Þ
RGDP = f ðEXCH, INT, INF, IMP, EXP, MSÞ ð1Þ
X
a5 X
b5
ΔInEXPt = α50 + β5i ΔInRGDPt − i + δ5i ΔInEXCHt −i
i=0 i=0
The econometric model is expressed as below:
X
c5 X
d5 X
e5
+ ω5i ΔInINT t − 1 + ε5i ΔInINFt −1 + λ5i ΔInEXPt − 1
RGDP = β0 + β1 EXCH + β2 INT + β3 INF + β4 EXP + β5 IMP + β6 MS + u ð2Þ i=0 i=0 i=1
X
f5 X
g5
+ μ5i ΔInIMPT t − 1 + V5i ΔInMSt −1 + ;51 RGDPt −1 + ;52 EXCHt −1
where, RGDP is the real gross domestic product, EXR is the exchange i=0 i=0
+ ;53 INT t −1 + ;54 INFt −1 + ;55 EXPt − 1 + ;56 IMPT t −1 + ;57 MSt − 1 + ϵ5t
rate, INT is the interest Rate, INF is the inflation rate, EXP is the
ð8Þ
export, IMP is the import, μ is the Stochastic Disturbance (Error Term),
f is the functional relationship, β0 is the Intercept of relationship in the
X
a6 X
b6
model/constant, β1to β5 is the coefficients of each of the independent ΔInIMPT t = α60 + β6i ΔInRGDPt − i + δ6i ΔInEXCHt −i
variables. i=0 i=0

By log linearizing, the model becomes, X

c6 X
d6 X
e6
+ ω6i ΔInINT t − 1 + ε6i ΔInINFt −1 + λ6i ΔInEXPt − 1
i=0 i=0 i=0

LogðRGDPÞ = β0 + β1 LogðEXCHÞ + β2 logðINT Þ + β3 logðINFÞ X

f6 X
g6

ð3Þ + μ6i ΔInIMPT t − 1 + V6i ΔInMSt −1 + ;61 RGDPt −1 + ;62 EXCHt −1

+ β4 logðEXPÞ + β5 IMPT + β6 MS + u i=1 i=0
+ ;63 INT t −1 + ;64 INFt −1 + ;65 EXPt − 1 + ;66 IMPT t −1 + ;67 MSt − 1 + ϵ6t
The ARDL methodology is as follows: ð9Þ

X
a1 X
b1
X
a7 X
b7
ΔIn RGDPt = α10 + β1i ΔInRGDPt − i + δ1i ΔInEXCHt −i ΔInMSt = α70 + β7i ΔInRGDPt − i + δ7i ΔInEXCHt −i
i=1 i=0 i=0 i=0
X
c1 X
d1 X
e1
X
c7 X
d7 X
e7
+ ω1i ΔInINT t −1 + ε4i ΔInINFt− 1 + λ5i ΔInEXPt − 1 + ω7i ΔInINT t − 1 + ε7i ΔInINFt −1 + λ7i ΔInEXPt − 1
i=0 i=0 i=0 i=0 i=0 i=0
X
f1 X
g1
X
f7 X
g6
+ μ6i ΔInIMPT t − 1 + V7i ΔInMSt −1 + ;11 RGDPt −1 + ;12 EXCHt −1 + μ7i ΔInIMPT t − 1 + V7i ΔInMSt −1 + ;71 RGDPt −1 + ;72 EXCHt −1
i=0 i=0 i=0 i=1
+ ;13 INT t −1 + ;14 INFt −1 + ;15 EXPt −1 + ;16 IMPT t− 1 + ;17 MSt − 1 + ϵ1t + ;73 INT t −1 + ;74 INFt −1 + ;75 EXPt − 1 + ;76 IMPT t −1 + ;77 MSt − 1 + ϵ7t
ð4Þ ð10Þ
SHAIK AND GONA 5 of 9

In Equation(4), Δ stands for first difference, β1i, δ1i, ω1i, ε1i,λ1i, μ1i, V1i X
h4 X
i4
ΔInINFt = λ40 + β4i ΔInRGDPt −i + δ4i ΔInEXCHt− i
indicated error correction, a1, b1, c1, d1, e1, f1, g1 denote the optimal lag i=1 i=1
length, φ11, φ12, φ13, φ14, φ15, φ16, φ17 signify the long-run association X
j4 X
k4 X
l4
+ ω4i ΔInINT t −1 + ε4i ΔInINFt − 1 + λ4i ΔInEXPt −1 ð14Þ
among the variables of the study, and ε1t is the error term in the model. i=1 i=1 i=1
The ARDL technique is to verify the long-term co-integration relation- X
m4 X
n4
+ μ4i ΔInIMPT t −1 + V4i ΔInMSt − 1 + ϵ4t
ships among the variables with the null of no long-run co-integration i=1 i=1
association as H0 : ;j1 = ;j2 = ;j3 = ;j4 = ;j5 = ;j6 = ;j7 = 0 and against the
alternative as H1 : ;j1 = ;j2 = ;j3 = ;j4 = ;j5 = ;j6 = ;j7 ¼
6 0. Nevertheless, X
h5 X
i5

in this research, the authors are more focused on studying null of ΔInEXPt = λ50 + β5i ΔInRGDPt− i + δ5i ΔInEXCHt −i
i=1 i=1
H0 : φj1 = φj2 = φj3 = 0 an alternative asH1 : φj1 = φj2 = φj3 ¼
6 0. In the X
j5 X
k5 X
l5
same way, the authors can clarify the Equations (5) to (10) in the model. + ω5i ΔInINT t −1 + ε5i ΔInINFt − 1 + λ5i ΔInEXPt −1 ð15Þ
i=1 i=1 i=1
The study uses the VECM Granger causality method (Granger
X
m5 X
n5
1990) analyse the direction of causality between variables after + μ5i ΔInIMPT t −1 + V5i ΔInMSt − 1 + ϵ5t
i=1 i=1
checking the long-term relationship among the variables. The Vec-
tor Error Correction Model (VECM) is a VAR limit. It includes a co-
X
h6 X
i6
integration concept expressed through the error correction term ΔInIMPT t = λ60 + β6i ΔInRGDPt− i + δ6i ΔInEXCHt − i
(ECT). Additionally; it restricts the endogenous variables to meet i=1 i=1
X
j6 X
k6 X
l6
the long-run associations, thus proving the dynamic changes in the + ω6i ΔInINT t −1 + ε6i ΔInINFt − 1 + λ6i ΔInEXPt −1 ð16Þ
short run. The ECT indicates that the differences of the endoge- i=1 i=1 i=1
X
m6 X
n6
nous variables depend on the level of disequilibrium in the long-run + μ6i ΔInIMPT t −1 + V6i ΔInMSt − 1 + ϵ6t
association it recovers. The VECM can potentially measure the i=1 i=1

short-run relationships, while the statistical value of ECT can indi-

cate the further presence of long-run relationships. However, the X
h7 X
i7
ΔInMSt = λ70 + β7i ΔInRGDPt− i + δ7i ΔInEXCHt − i
study estimates the process in two phases: (a) To calculate the i=1 i=1

Equations (5)–(7) then to extract the residues that are interrelated X

j7 X
k7 X
l7
+ ω7i ΔInINT t −1 + ε7i ΔInINFt − 1 + λ7i ΔInEXPt −1 ð17Þ
to the equilibrium differences. (b) To refer to the measurement of i=1 i=1 i=1
Equations (11)–(17) that comprise recovered residues. However, X
m7 X
n6
+ μ7i ΔInIMPT t −1 + V7i ΔInMSt − 1 + ϵ7t
the process calculates the coefficients related to both short-run i=1 i=1
and long-run adjustment rates. The equations of VECM modelling
are as follows:
Here λj0, βj, δj, ωj, εj, λj, μjvj j = 1…7 are the parameters and εjt(j = 1, …
X
h1 X
i1
7) indicates error terms. ECT is resultant of the long-term co-integration
ΔIn RGDPt = λ10 + β1i ΔInRGDPt −i + δ1i ΔInEXCHt− i
i=1 i=1 association, and ωj (j = 1, …7) of the ECT denotes the difference between
X
j1 X
k1 X
l1 the dependent variables and the long-term equilibrium.
+ ω1i ΔInINT t − 1 + ε1i ΔInINFt −1 + λ1i ΔInEXPt − 1 ð11Þ
i=1 i=1 i=1
X
m1 X
n1
+ μ1i ΔInIMPT t − 1 + V1i ΔInMSt −1 + ϵ1t
i=1 i=0
4 | ES TI M A T I ON A N D DI SCU SSI O N O F
EMP I RICAL R ES UL TS
X
h2 X
i2
ΔInEXCHt = λ20 + β2i ΔInRGDPt− i + δ2i ΔInEXCHt −i Table 1 shows that there is unit root among the time series when sub-
i=1 i=1
jected to ADF (Dickey, et al 1981) test at various levels and order dif-
X
j2 X
k2 X
l2
+ ω2i ΔInINT t − 1 + ε2i ΔInINFt −1 + λ2i ΔInEXPt − 1 ð12Þ ference in the time series of GDP, INF and INT have unit root at level,
i=1 i=1 i=1
at first order difference as the calculated ADF test values are less than
X
m2 X
n2
+ μ2i ΔInIMPT t − 1 + V2i ΔInMSt −1 + ϵ2t the critical value at 5% irrespective of sign difference at iteration lag
i=1 i=1
2. EXP, IMP, EXCH and Money Supply (MS) have unit root at first dif-
ference. In addition, there is no unit root in the series of INT and EXP
X
h3 X
i3
ΔInINT t = λ30 + β3i ΔInRGDPt −i + δ3i ΔInEXCHt− i at order 1 and level I (0) respectively since the ADF-test statistic is
i=1 i=1 greater than the critical value at 5% at lag 2. This confirms that all the
X
j3 X
k3 X
l3
+ ω3i ΔInINT t − 1 + ε3i ΔInINFt −1 + λ3i ΔInEXPt − 1 ð13Þ time series variables are not stationary at level or order except EXP
i=1 i=1 i=1 and INT. From the foregoing analyses, the result further does not
X
m3 X
n3
inform co-integration (Johansen and Juselius (1990)) but Vector Auto
+ μ3i ΔInIMPT t − 1 + V3i ΔInMSt −1 + ϵ3t
i=1 i=1 regression Analysis (VAR) model application for estimation to
6 of 9 SHAIK AND GONA

TABLE 1 Summary of result of unit

Variable At level Probability First difference Probability Remark
root test using augment Dickey Fuller
RGDP −5.975*** 0.000 −10.488 0.000 I(0) Test (ADF test) for time series variables
EXP −0.670 0.842 −3.014** 0.042 I(1)
IMP −0.966 0.755 −5.084*** 0.000 I(1)
INF −3.338** 0.019 −10.556 0.000 I(0)
INT −3.375** 0.017 −7.379 0.000 I(0)
EXCH −1.723 0.412 −4.509*** 0.000 I(1)
MS −0.865 0.788 −4.803*** 0.000 I(1)

Note: *,** and *** indicate 1, 5 and 10% at significant level. Source: Author's calculations.

TABLE 2 Bound tests for co-integration value of JB statistics is greater than 0.05 critical values. Hence, the

Model F-statistics Decision test confirms non-normality of the series (Figures 1).
The stability of the long-run coefficient is tested by the short-run
FRGDP = RGDP,EXCH,INT,INF, 11.794*** Co-integration
IMP,EXP,MS dynamics. Once the ECM model given by the equation has been esti-

Critical values
mated, the cumulative sum of recursive residuals (CUSUM) and the
CUSUM of square (CUSUMSQ) tests are applied to assess the param-
Significance level Lower bond I(0) Upper bond I(1)
eter stability. Figures 1 and 2 plot the results for CUSUM and
1% 2.88 3.99
CUSUMSQ tests. The results indicate that the absence of any instabil-
2.5% 2.55 3.61
ity of the coefficients because the plot of the CUSUM and CUSUMSQ
5% 2.27 3.28
statistic fall inside the critical bands of the 5% confidence interval of
10% 1.99 2.94
parameter stability.
Note: Source: Author's calculation.

4.1 | VECM Granger causality test results

determine the short- and long-run relationship rather suggests possi-
ble Granger Causality test (Granger and Lin 1995) to investigate the
impact of exchange rate variables on GDP.
Table 2 explains the Bound test for co-integration. The estimated
F-statistical value is 11.794 and coefficients value are 3.99, 3.61, 3.28
and 2.94 are significant at 1, 2.5, 5 and 10%, respectively. The F-
statistical value is higher than coefficient values; therefore, we con-
clude that there is a long-run relationship among the output, exchange
rate, inflation, interest rate, imports, exports and money supply vari-
ables under study.
The above table explains the diagnostic behaviour of the time
series variables. Coming to Table 3, the probability value of the
F-statistics of the LM test is 3.120 greater than critical value at .05,
this shows that there is no presence of serial correlation in the series.
We thereby fail to reject H0. When we look into the p-value of the
F-stat of the white heteroscedasticity is 3.244 greater than 0.05
showing absence of heteroscedasticity because there is presence of
Homoscedasticity in the model series. We fail to reject H0. In the case
of RESET it explains the probability value of F-Statistics of Ramsey
Reset test is (0.031) less than the critical value at 5% level. This result
show that the model is stable and in functional form as the null
hypothesis (H0) is rejected in favour of the alternative hypothesis (H1)
that the model is structurally stable and fit for prediction. Normality
test is not statistically significant at 5% as the probability value of JB
statistics is greater than 0.05 critical values. Hence, the test confirms
non-normality of the series. The result indicated that the series of the
Normality test is not statistically significant at 5% as the probability
The present study has confirmed that there is a long-run correlation
between gross domestic product, inflation rate, interest rate, export,
imports, exchange rate and money supply. Further, the study verified
the direction of causality between variables under the study. In doing
so, the researchers apply the VECM Granger Causality method in both
short run and long run. The paper displays the VECM test results in
Table 4.
In the short term, the findings show a unidirectional causal rela-
tion, from real GDP to exchange rate. There is a unidirectional causal
relation running from imports to GDP. There is a one-way causal rela-
tion running from inflation to GDP. There is a one-way causal relation
running from interest rate to GDP. There is a one-way causal relation
running from money supply to GDP. There is a one way causal rela-
tionship between export and real GDP. All the variables have a sub-
stantial positive impact on economic growth. The findings of the
study are demonstrated that exchange rate, exports and foreign trade
encourage economic growth.
In the long-run, the lagged coefficients for Equations (11) to (14)
are negative and statistically significant, where real GDP, exchange
rate and exports are the dependent variables. These results indicate
that when the system departs from the equilibrium, these three vari-
ables are the main adjustment factors. Therefore, the present study
confirms a feedback causal relationship between GDP and exchange
rate. The relationship implies that both GDP and exchange rate are
influencing one another. It means that both exchange rate and gov-
ernment policies need to be introduced together, and exports have a
SHAIK AND GONA 7 of 9

TABLE 3 Diagnostic test

Model χ 2 serial χ 2 arch χ 2 Ramsey χ 2 normal

FRGDP = RGDP, EXCH, INT, INF, IMP, EXP, MS 3.120 (0.242) 3.244 (0.080) 0.031 (0.870) 1.962 (0.374)
F

Note: Source: Author's calculation.

6 TABLE 4 Granger causality test results

Null hypothesis F-statistics t-statistics

4
IMPORT does not Granger 2.373 (0.108) −1.047 (0.298)
2 cause GDP
GDP does not Granger cause 0.411 (0.666) −4.744 (0.000)
0 IMPORT
INF does not Granger cause 1.110 (0.341) −0.539 (0.591)
-2 GDP
GDP does not Granger cause 0.410 (0.666) −3.997 (0.000)
-4 INF
INT does not Granger cause 0.523 (0.597) −1.024 (0.309)
-6
GDP
2015 2016 2017 2018
GDP does not Granger cause 3.255 (0.050) −3.841 (0.000)
CUSUM 5% Significance INT
MS does not Granger cause 2.080 (0.140) −1.886 (0.063)
FIGURE 1 Residual Function Analyses GDP
GDP does not Granger cause 0.304 (0.739) −4.522 (0.000)
MS
1.6
EXPORT does not Granger 2.657 (0.084) −1.002 (0.319)
cause GDP
1.2 GDP does not Granger cause 4.623 (0.016) −4.395 (0.000)
EXPORT
EXCH does not Granger cause 1.717 (0.194) −1.358 (0.178)
0.8 GDP
GDP does not Granger cause 0.303 (0.740) −5.368 (0.000)
EXCH
0.4
Note: *Significant at 5% level, p value < .05. Source: Author's calculations.

0.0

other values of the variables taken together. This means what drives
-0.4 inflow of exchange rate in India is the growth of the other macroeco-
2015 2016 2017 2018
nomic variables such as interest rate, import and exports which give
CUSUM of Squares 5% Significance rise to economic performance in India. Finally, these variables have
supported the feedback hypothesis.
FIGURE 2 Residual Function Analyses

substantial positive effect on growth. The study also reports a feed-
back causality between consumption of energy and financial sector
development. The study finding shows a bidirectional causal relation-
ship between real GDP and exchange rate in the long term. The cau-
sality test points out effects of exchange rate variables on GDP.
However, the value of the joint significance implies that the previous
values of exchange rate, interest rate and inflation rate are more influ-
ential in determining the performance of the economy (GDP) among
5 | CONCLU SION AND P OLICY
IMPLICATIONS
The study examined on the relationship between GDP and its
affected variables like exchange rate, interest rate, inflation, import
and exports of India using time series data spanning 1990 to 2017.
The study employed the ordinary least square (OLS) method of esti-
mation and VECM Granger causality test for data covering the period
8 of 9
from 1990 to 2017. The results from the estimation analyses revealed
that there is a short-run relationship between exchange rate, inflation
rate, interest rate and GDP. The result obtained from the unit root
analysis indicates at least one time series variable property is station-
ary. The study concludes that in India, the factors that influence the
level of growth rate are extent of exchange rate and its variables.
Based on the findings, from the Granger causality investigation proce-
dure at 5% critical value are EXCH, INT, INF, IMP and EXP among
other variables affects economic growth. The study recommends the
need to be technological incline in all sectors of Indian economy,
excess and over budgetary inflation and implementation should be cut
to barest minimal level to avert the ideal of external borrowing which
most consequently result in external debt and services. The Indian
government should show to the path of redirecting its investment
profile by channelling it towards capital projects of the government.
The policy implication of this work is that, economic growth can be
relied upon for advancing economic in India. The research outcome
could help policy makers and corporates to improve their domestic
resources.
ORCID
Babu Rao Gona https://orcid.org/0000-0001-7582-423X
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SHAIK AND GONA 9 of 9

AUTHOR BIOGRAPHI ES

Khulsum Shaik is Research Scholar, Department of Economics, Dr.

Abdul Haq Urdu University, Kurnool, Andhra Pradesh, India. Her How to cite this article: Shaik K, Gona BR. Exchange rate and

research interests cover Macroeconomics, Development Economics. the economic growth in India: An empirical analysis. J Public
Affairs. 2020;e2177. https://doi.org/10.1002/pa.2177
Babu Rao Gona is Assistant Professor, Department of Economics,
Dr. Abdul Haq Urdu University, Kurnool, Andhra Pradesh, India.
His research interests cover Macroeconomics, Monetary Econom-
ics, International Economics and Econometrics.

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