This paper studies the behaviour of the real exchange rate (RER) in India. The first part investigates the role of important macroeconomic (behaviour and policy) variables in explaining the movement of the RER. It is found that the investment-gdp ratio, the overall fiscal deficit of the public sector and the nominal exchange rates are important explanatory variables. The second part of the paper seeks to determine whether real exchange rate targeting has been used in India as a tool in enhancing the competitiveness of the tradable sector. It is found that this is indeed the case, and moreover, the correlation between inflation and nominal devaluations is found to be small.

P Srivastava

U Patel

English

Research Papers in Economics

 1 
CENTRE 
for
ECONOMIC PERFORMANCE
DISCUSSION PAPER NO. 323
January 1997
THE REAL EXCHANGE RATE IN INDIA: 
DETERMINANTS AND TARGETING
U. Patel and P. Srivastava 2 
ABSTRACT
The paper studies the behaviour of the real exchange rate (RER) in
India.  The first part investigates the role of important macroeconomic
(behavioural and policy) variables in explaining the movement of the
RER.  It is found that the investment-gdp ratio, the overall fiscal deficit
of the public sector and the nominal exchange rate are important
explanatory variables.  The second part of the paper seeks to determine
whether real exchange rate targeting has been used in India as a tool in
enhancing the competitiveness of the tradable sector.  It is found that
this is indeed the case, and moreover, the correlation between inflation
and nominal devaluations is found to be small. 
This paper was produced as part of the Centre’s 
Programme on International Economic Performance
THE REAL EXCHANGE RATE IN INDIA: 
DETERMINANTS AND TARGETING
Urjit R. Patel and Pradeep Srivastava 3 
JANUARY 1997
Published by
Centre for Economic Performance
London School of Economics and Political Science
Houghton Street
London WC2A 2AE
© U. Patel and P. Srivastava
ISBN 0 7530 1095 X 4 
THE REAL EXCHANGE RATE IN INDIA: 
DETERMINANTS AND TARGETING
Urgit R. Patel and Pradeep Srivastava
  Page
1.  Introduction     1
2. A model of the real exchange rate with 
money and a role for the fiscal deficit  2
3. Cointegration analysis  8 1 
4. Exchange rate targeting   10
5. Conclusion   15
Endnotes   17
Tables   19
References 27
The Centre for Economic Performance is financed by the Economic
and Social Research Council.  The Centre gratefully acknowledges
financial support from the Senior Business Forum.
THE REAL EXCHANGE RATE IN INDIA: 
DETERMINANTS AND TARGETING
Urgit R. Patel and Pradeep Srivastava
1. INTRODUCTION
Exchange rate problems have usually occupied centre stage in policy
discussions in reforming economies.  In fact, it has often been argued
that the inadequate economic performance of various countries has been
the result of inappropriate exchange rate policies.  It is now well
accepted at the theoretical level that excess volatility in real exchange
rates, and in particular situations of real exchange rate (RER)
misalignment, will be translated into important welfare costs.
Maintaining the RER at the ‘wrong’ level generates wrong signals and
greatly hurts the degree of competitiveness of the tradable sector.
Determining whether a country’s RER is at a particular time out of line
with its long-run equilibrium level is, both theoretically and practically,
one of the most difficult challenges faced by macroeconomic analysts
and policy makers under both predetermined and floating nominal
exchange rates.
Two broad strands can be discerned in the literature on real
exchange rates.  One line of research emphasises parsimonious models
that investigate the influence of several macroeconomic, financial andstructural (policy) variables — investment ratio, capital controls,
changes in government expenditure or (higher/lower) fiscal deficit,
tariffs, seigniorage and so on — in determining the RER.  These models
are obtained from a general equilibrium framework that 
explicitly recognises the influence of policy choices by the government
in determining the RER.  Establishing whether observed RER
measurements are a result of structural changes, or a response to
macroeconomic instability, or both is an empirical issue that is
investigated in this paper.
The other strand emphasises RER targeting, that is, the effectiveness
of nominal devaluations as a policy tool.  From a purely operational
point of view, the RER is probably the most popular real target in many
developing countries, in no small part because of the recent emphasis on
export-led growth in the context of policy reforms in developing
countries.  A policy of ‘real exchange targeting’ usually aims at
controlling the level of the real exchange rate, either in an effort to keep
it at a constant level in the face of domestic or external shocks, or
achieve a different (typically more depreciated) level to increase growth
by enhancing incentives for higher exports.  It is found that India is no
exception in this regard, especially since 1980/81 when the first tentative
steps towards reform were initiated, and which culminated in policies
during 1991-1993 designed to substantially liberalise both the trade and
external payments systems.  
The plan of the rest of the paper is as follows.  In section 2 we
sketch a parsimonious open economy model to delineate the main
factors that could impinge on the real exchange rate.  In section 3, using
annual data for the period 1960/61-1994/95, we present the first set of
results for India using the by now familiar unit root and cointegration
techniques.  The section investigates the role of several important
macroeconomic variables in determining the RER.  In section 4 we
present the second set of results which relate to exchange rate targeting
and analyse the well known trade-off between a depreciating exchange
rate and inflation.  Finally, section 5 concludes the paper.
2. A MODEL OF THE REAL EXCHANGE RATE WITH 
MONEY AND A ROLE FOR THE FISCAL DEFICIT
In order to model the behaviour of real exchange rates formally, it is
necessary to develop a complete, but parsimonious, intertemporal
framework able to capture how both policy induced disturbances and
exogenous shocks could impinge on relative prices in the economy.
1
A large number of profit maximising firms produce three goods —
exportable (X), importable (M), and non-tradable (N) — using constant
returns to scale technology, under perfect competition.  There are two- 3 -
periods only (1 and 2), and there is perfect foresight.  A tilde (~) over a
variable indicates that it is a period 2 variable.  Residents of this small
country hold money and can borrow or lend internationally.  There is,
however, a tax on foreign borrowing which ensures that the domestic
real interest rate exceeds the world interest rate.  Although we model the
wedge between the two interest rates as an ad-valorem tax, we can also
think of the tax as representing some sort of rationing mechanism.  The
intertemporal constraint states that at the end of period 2 the country
has repaid its debt.  The importation of M is subject to import tariffs (t
and t ˜).  Consumers maximise intertemporal utility, consume all three
goods and hold money balances, and the current account is equal to
saving minus investment in each period.
There is a government that, in the general case, consumes both
tradable and nontradable goods, and issues money to facilitate exchange.
Government expenditure is financed from five sources:  nondistortionary
taxes (net of transfers), printing money, proceeds from import tariffs,
proceeds from the taxation of foreign borrowing by the private sector,
and run a temporary fiscal deficit by borrowing both domestically and
from abroad.  The solvency criterion on the government ensures that it
is subject to an intertemporal constraint — the discounted value of
government expenditure (including domestic and foreign debt service)
has to equal the discounted value of income from taxation and
seignorage.  A third constraint — that for internal equilibrium —
requires that the non-tradable market clears in each period.
Production
Using duality theory, the production side of the economy is given by the
revenue function:
R = max{Qx + p(t ˜)QM + qQN; F(Q,V) # 0}, (2.1)
where Qx, QM and QN are quantities produced of exportable, importable
and non-tradable goods in that period.  Q is a vector that summarizes
production; V is a vector of factors of production; F() is the production
function that summarizes existing technology; p is the domestic price of
importable relative to exportable; and q is the price of non-tradables
relative to exportable in period 1.  Note that p and p ˜ are influenced by
t and t ˜ respectively.  Equation (2.1) can then be rewritten in the
following way:
R = R(p(t),q,V). (2.2)- 4 -
This is the maximised value of output in period 1 in terms of exportable.
Naturally, the revenue function for period 2 can be written in a similar
way.  The advantage is that the corresponding supply functions can be
derived from their derivatives with respect to prices.  Thus, if we denote
the partial derivatives with respect to a particular argument by a
subindex, we have that:
Rp = QM(p(t),...), supply function of M in period 1, (2.3)
R ˜ q ˜ =  Q ˜ N(q ˜,...), supply function of N in period 2. (2.4)
 
Another convenient property of revenue functions is that they are
convex, implying that Rpp $ 0 and that Rqq $ 0.  
Consumer behaviour
Consumers are assumed to maximise the present value of utility, subject
to their intertemporal constraint.  Assuming that the utility function is
time separable, with each subutility function homothetic, the
representative consumer problem can be stated as follows:
max W{U(CN, CM, CX), U ˜(C ˜N, C ˜ M, C ˜ X)} (2.5)
subject to:
CX + p(t)CM + qCN + d(C ˜ X + p ˜(t ˜)C ˜ M + C ˜q ˜N) # O where, (2.6)
       
O=wL+?K+H+T+d(w ˜L ˜ + ? ˜K ˜ + H ˜ + T ˜)+rB
G - (r
*+t
b)B
*,   (2.7)
In addition:
?(CX + p(t)CM + qCN) # H, and  (2.8)
? ˜[d(C ˜ X + p ˜(t ˜)C ˜ M + C ˜q ˜N)] # H ˜, where both ?, ? ˜ > 0; (2.9)
where W is the utility function; U and U ˜ are, respectively, periods 1 and
2 subutility functions; and CX, CM, CN  (C ˜ N, C ˜ M, C ˜ X) are consumption of
X, M and N in period 1 (2).  As before, p(t) and p ˜(t ˜) are the domestic
price of importable relative to exportable in periods 1 and 2;
2 and q and q ˜
are the price of non-tradables relative to exportable in periods 1 and 2.- 5 -
rB
G is the income to consumers if they choose to finance the
government’s deficit in period 1; (r
*+t
b)B
* is the interest and tax liability
in period 2 on their foreign borrowing in period 1; w is the wage rate on
labour; ? is the return on capital; T is the lump-sum transfer net of taxes
from the government; d is the domestic discount factor, equal to (1+r)
-1,
and r is the domestic real interest rate in terms of the exportable good.
The last two constraints are the cash-in-advance constraints, i.e.,
consumers must use money (H and H ˜) to purchase goods in the two
periods.
Wealth is the discounted sum of consumers income and money
holdings in both periods.  Given the nature of preferences, the consumer
optimisation problem can be thought of as taking place in two stages.
First, the consumers decide how to allocate their wealth across periods.
Second, they decide how to distribute expenditure across the three
goods in each period.  The demand side of the model can be
conveniently summarised by a twice-differentiable concave expenditure
function that gives the minimum discounted value of expenditure
required to attain a level of utility W ˆ  for given domestic prices in periods
1 and 2:
E = min{CX + pCM + qCN + d(C ˜ X + C ˜p ˜M + C ˜q ˜N)}
subject to W(U,U ˜) $  W ˆ . (2.10)- 6 -
This expenditure function can be written as a function of prices and
utility only:
E = E{p, q, dp ˜, dq ˜; W}. (2.11)
Furthermore, since we have assumed that the utility function is weakly
separable with each period subutility homothetic, equation (2.11) can
be written as:
E = E{p(p,q),dp ˜(p ˜,q ˜); W}, (2.12)
where p( ) and p ˜( ) are exact price indices for periods 1 and 2, and are
interpreted as unit expenditure functions.  A convenient property of the
expenditure function is that its partial derivatives with respect to prices
are equal to the respective compensated (Hicksian) demand function.
For example, the derivative of E with respect to p is equal to the
compensated demand function for importable in period 1.  In general,
the following relations hold for period 1 (exactly analogous conditions
hold for period 2, and therefore they are omitted for brevity):
Ep = Eppp = DM(p,...),  (2.13)
Eq = Eppq = DN(q,...), and (2.14)
?(CX + pCM + qCN) = H;  (2.15)
where D M and D N are the Hicksian demand functions for M and N in
period 1, and pp and pq are the derivatives of the exact price indexes with
respect to the relative prices of, respectively, importable and non-
tradables in period 1.  Since the ps are unit expenditure functions, these
derivatives can be interpreted as expenditure shares of M and N in
period 1.  By concavity of E it follows that the second derivatives are
negative — Epp, Eqq, Ep ˜p ˜, Eq ˜q ˜ Epp < 0 — reflecting the fact that the demand
curves slope downward.  Given our assumption of a time separable
utility function, expenditures in periods 1 and 2 are substitutes, implying
that all intertemporal cross elasticities are positive.  However, since in
every period there are three goods, any two of them can be
complements.  It is possible, then, that in each period one of the
intratemporal cross elasticities will be negative.

The Real Exchange Rate in India: Determinants and Targeting

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The Real Exchange Rate in India: Determinants and Targeting

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