Exchange Rate Dynamics In An Emerging Economy: Monetary Policy Transmission And Macroeconomic Influences On India’s Nominal Exchange Rate
DOI:
https://doi.org/10.66635/8sfwp551Keywords:
Nominal Exchange Rate, Output Gap, India, Trade Openness, Interest Rate, MonetaryAbstract
This study examines the macroeconomic determinants of the Nominal Exchange Rate (NER) in India using the data in the year-on-year from 1991-2024 within an ARDL framework. Drawing upon the monetary approach and contemporary exchange rate theories, the study investigates the influence of Money Supply, Interest Rate, Trade Openness, and Output Gap on the NER. The results confirm the existence of a long-run cointegration within the variables. In the long-run, monetary expansion & interest rate movements exert a positive & significant impact on the NER, while trade openness & output gap have a negative effect. In the short run, monetary policy variables show moderate significance, whereas the output gap exhibits a significant negative influence. Diagnostic tests confirm the robustness of the model. The findings highlight the importance of distinguishing between short-run and long-run dynamics and highlight the complex nature of monetary policy transmission (MPT) in shaping exchange rate behaviour in an emerging economy like India. Overall, the study provides an integrated assessment of monetary, external, and real-sector determinants of the nominal exchange rate, contributing to the literature by jointly analysing money supply, interest rate, trade openness, and output gap within a integrated framework and provide valuable insights for policymakers in designing appropriate monetary & exchange rate policies.
References
1.BILSON, J. (1978). The Monetary Approach to the Exchange Rate: Some Empirical Evidence. IMF Staff papers, 1978(001), 48-75. https://doi.org/https://doi.org/10.5089/9781451956498.024
2.Brandao-Marques, L., Gelos, G., Harjes, T., Sahay, R., & Xue , Y. (2020, February). Monetary Policy Transmission in Emerging Markets and Developing Economies. IMF Working Paper No. 2020/035, 2020(035). https://doi.org/https:// doi.org/10.5089/9781513529738.001
3.Cassel, G. (1918, December). Abnormal Deviations in International Exchanges. The Economic Journal, 28(112), 413-415. https://doi.org/https://doi.org/10.2307/2223329
4.Cassel, G. (1923, March). Money and Foreign Exchange After, 1914. Journal of the Royal Statistical Society, 86(2), 247-248. https://doi.org/https://doi.org/10.1111/j.2397-2335.1923.tb00886.x
5.Chinn, M., & Meredith, G. (2004, November). Monetary Policy and Long-Horizon Uncovered Interest Parity. IMF Staff Papers, 51(3), 409-430.
6.Clarida, R., Gali, J., & Gertler, M. (1999). The Science of Monetary Policy: A New Keynesian Perspective. Journal of Economic Literature, 37(2), 1661-1707. https://doi.org/10. 3386/w7147
7.Das , S., & Roy, S. (2025, February). Factors in the Determination of India’s Nominal Exchange Rate Behaviour. South Asian Journal of Macroeconomics and Public Finance, 14(2), 175-203. https:// doi.org/ https://doi.org/ 10.1177/22779787241312498
8.Dickey, D., & Fuller, W. (1979). Distribution of the Estimators for Autoregressive Time Series With a Unit Root. Journal of the American Statistical Association, 74(366), 427-431.
9.Dornbusch, R. (1976, December). Expectations and Exchange Rate Dynamics. Journal of Political Economy, 84(6), 1161-1176. https://www. jstor.org/stable/1831272
10.Eichenbaum, M., & Evans, C. (1995, November). Some Empirical Evidence on the Effects of Shocks to Monetary Policy on Exchange Rates. The Quarterly Journal of Economics, 110(4), 975-1009. https://doi.org/https://doi.org/10.2307/2946646
11.Engel, C. (2016, February). Exchange Rates, Interest Rates, and the Risk Premium. American Economic Review, 106(2), 436-474. https://doi.org/10.1257/aer.20121365
12.Engel, C., & West, K. (2005, June). Exchange Rates and Fundamentals. Journal of political Economy, 113(3), 485-517. https://doi.org/https: //doi.org/10.1086/429137
13.Faust, J., Rogers, J., Swanson, E., & Wright, J. (2003, September). Identifying the Effects of Monetary Policy Shocks on Exchange Rates Using High Frequency Data. Journal of the European Economic Association, 1(5), 1031-1057. https://doi.org/https://doi.org/10.1162/154247603770383389
14.Fleming, J. (1962). Domestic Financial Policies under Fixed and under Floating Exchange Rates. International Monetary Fund Staff Paper, 9(3), 369380.https://doi.org/https://doi.org/10.5089/9781451968873.024
15.Frankel, J., & Romer, D. (1999, June). Does Trade Cause Growth? American Economic Review, 89(3), 379-399. https://doi.org/10.1257/aer.89.3.379
16.Frenkel, J. (1976). A Monetary Approach To The Exchange Rate: Doctrinal Aspects And Empirical Evidence. Doctrinal Aspects and Empirical Evidence. The Scandinavian Journal of Economics, 78, 200-224. https://doi.org/http: //dx.doi.org/10.2307/3439924
17.Friedman, M. (1968, March). The Role of Monetary Policy. The American Economic Review, 58(1), 1-17. https://www.jstor.org/ stable/1831652
18.Galí, J. (2008). Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New Keynesian Framework. Princeton University Press.
19.Galí, J., & Monacelli, T. (2005, October). Monetary Policy and Exchange Rate Volatility in a Small Open Economy. The Review of Economic Studies, 72(3), 707-734. https://doi.org/https:/ /doi.org/10.1111/j.1467-937x.2005.00349.x
20.Goyal, A., & Agarwal, D. (2017, September ). Monetary transmission in India: Working of price and quantum channels. Indira Gandhi Institute of Development Research, Mumbai Working Papers 2017-017.
21.Ha, J., Kim, D., Kose, M., & Prasad, E. (2025). Resolving puzzles of monetary policy transmission in emerging markets. European Economic Review, 173. https://doi.org/https: //doi.org/10.1016/j.euroecorev.2025.104957
22.Hodrick, R., & Prescott, E. (1997). Postwar U.S. Business Cycles: An Empirical Investigation. Journal of Money, Credit and Banking, 29(1), 1-16. https://doi.org/https://doi.org/10.2307/2953682
23.Hossain, T., & Maitra, B. (2019, July). Monetary Policy, Trade Openness and Economic Growth in India Under Monetary-targeting and Multiple-indicator Approach Regimes. Arthaniti: Journal of Economic Theory and Practice, 19(1), 108-124. https://doi.org/https://doi.org/10.1177/0976747919852859
24.Khundrakpam, J., & Jain, R. (2012). Monetary Policy Transmission in India: A Peep Inside the Black Box. RBI WORKING PAPER SERIES, Vol. 2012, No. 11, 1-45.
25.MacDonald , R., & Taylor, M. (1992). Exchange Rate Economics: A Survey. IMF Staff Papers, 39(1), 157.https://doi.org/https://doi.org/10.2307/3867200
26.Mishkin, F. (2001). The Transmission Mechanism and the Role of Asset Prices in Monetary Policy. NBER Working Paper No. w8617. https://doi.org/https://doi.org/10.3386/w8617
27.Mishra, P., Spilimbergo, A., & Montiel, P. (2010, October). Monetary transmission in low income countries. IMF Working Paper No. 10/223. https://doi.org/https://doi.org/10.5089/9781455208883.001
28.Mohan, R., & Patra, M. (2009). Monetary Policy Transmission in India. In Monetary Policy Frameworks for Emerging Markets (pp. 153-179). https://doi.org/10.4337/9781848449190.00015
29.Mohanty, M., & Klau, M. (2004, October). Monetary policy rules in emerging market economies: issues and evidence. BIS Working Paper 149. https://doi.org/https:/ /doi.org/ 10.1007/3-540-28201-7_13
30.Mundell, R. (1963). Capital Mobility and Stabilization Policy Under Fixed and Flexible Exchange Rates. The Canadian Journal of Economics and Polictical Science, 29(4), 475-485. https://doi.org/https://doi.org/10.2307/139336
31.Orphanides, A. (2001, September). Monetary Policy Rules Based on Real-Time Data. American Economic Review, 91(4), 964-985. https: //doi.org/ 10.1257/aer.91.4.964
32.Patra, M., & Kapur, M. (2012, May). Alternative Monetary Policy Rules for India. IMF Working Paper 2012, 2012(118). https://doi.org/https://doi.org/10.5089/9781475503470.001
33.Pesaran, M., Shin, Y., & Smith, R. (2001). Bounds testing approaches to the analysis of level relationships. Journal of Applied Econometrics, 16(3), 289-326. https://doi.org/https:/ /www.jstor.org/stable/2678547
34.Ranadive, R., & Burange, L. (2015). Transmission mechanism of exchange rate pass-through in India. Foreign Trade Review, 50(4), 263-283. https://doi.org/https://doi.org/10.1177/0015732515598589
35.Rishad , A., Gupta, S., & Sharma, A. (2021, July). Official Intervention and Exchange Rate Determination: Evidence from India. Global Journal of Emerging Market Economies, 13(3), 357-379. https:// doi.org/https://doi.org/ 10.1177/09749101211031123
36.Rodrik, D. (2008). The Real Exchange Rate and Economic Growth. Brookings Papers on Economic Activity, 39(2), 365-412. https://doi.org/http:// dx.doi.org/10.1353/eca.0.0020
37.Spisso, K., Stelzer, A., & Zörner, T. (2025). Unconventional Monetary Policy: A Critical Assessment of the Empirical Literature. https://doi.org/Spisso, Karen and Stelzer, Anna and Zörner, Thomas O., Unconventional Monetary Policy: A Critical Assessment of the http://dx.doi.org/10.2139/ssrn.5021894
38.Svensson, L. (2000, February). Open-economy inflation targeting. Journal of International Economics, 50(1), 155-183. https://doi.org/ 10.1016/S0022-1996(98)00078-6
39.Taylor , J. (1993, December). Discretion versus policy rules in practice. Carnegie-Rochester Conference Series on Public Policy, 39, 195-214. https://doi.org/https://doi.org/10.1016/0167-2231(93)90009-L
40.Tenderere, M., & Mishi, S. (2025). Interest rates and capital flows: An application of the Mundell-Fleming model in emerging markets. Africa’s Public Service Delivery and Performance Review, 13(1). https://doi.org/https://doi.org/10.4102/apsdpr.v13i1.904
41.Woodford, M. (2003). Interest and Prices: Foundations of a Theory of Monetary Policy. Princteon University Press.
