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An analysis of impact of exchange rate on inflation rate in Indian economy.



Introduction

The effects of the uncertainties caused by the volatility in exchange rates and inflation on macroeconomic mac·ro·ec·o·nom·ics  
n. (used with a sing. verb)
The study of the overall aspects and workings of a national economy, such as income, output, and the interrelationship among diverse economic sectors.
 variables have been subject to extensive theoretical and empirical research Noun 1. empirical research - an empirical search for knowledge
inquiry, research, enquiry - a search for knowledge; "their pottery deserves more research than it has received"
. Empirical findings indicate significant impact of exchange rate uncertainty on macroeconomic variables such as output, trade and investment. Similarly, inflation uncertainty appears to affect variables such as output, employment and interest rates. The relationship between exchange rate and inflation uncertainties, on the other hand, has been largely overlooked in the literature. This paper attempts to investigate the impact of exchange rate on inflation rate in India.

India in the past has mostly been a closed economy, following protectionist pro·tec·tion·ism  
n.
The advocacy, system, or theory of protecting domestic producers by impeding or limiting, as by tariffs or quotas, the importation of foreign goods and services.
 policies of development. Foreign exchange management and control has been an important tool of lending protection to the domestic economy, checking capital flight, maintaining a comfortable reserve of valuable foreign exchange for development needs and import of essential goods and encouraging exports. To attain these objectives India followed a 'fixed exchange rate' system till the economic crisis of 1991.

The Indian forex market had been heavily controlled since the 1950s, along with increasing trade controls designed to foster import substitution. Consequently, both the current and capital accounts were closed and foreign exchange was made available by the RBI RBI
abbr. Baseball
runs batted in

Noun 1. rbi - a run that is the result of the batter's performance; "he had more than 100 rbi last season"
run batted in
 through a complex licensing system. India's post-independence development strategy was both inward-looking and highly interventionist, consisting of import protection, complex industrial licensing requirements, financial repression, and substantial public ownership of heavy industry. However, macroeconomic policy sought stability through low monetary growth and moderate public sector deficits. The current account was in surplus for most years until 1950, and there was a reasonable cushion of official reserves Official reserves

Holdings of gold and foreign currencies by official monetary institutions.
.

Since 1950, India ran continued trade deficits that increased in magnitude in the 1960s. Furthermore, the government of India The Government of India (Hindi: भारत सरकार [3]Bhārat Sarkār), officially referred to as the Union Government, and commonly as Central Government  had a budget deficit problem and could not borrow money from abroad or from the private corporate sector; due to that sector's negative savings rate Savings rate

Personal savings as a percentage of disposable personal income.
. As a result, the government issued bonds to the RBI, which increased the money supply.

In 1966, foreign aid was finally cut off and India was told it had to liberalise Verb 1. liberalise - become more liberal; "The laws liberalized after Prohibition"
liberalize

change - undergo a change; become different in essence; losing one's or its original nature; "She changed completely as she grew older"; "The weather changed last
 its restrictions on trade before foreign aid would again materialize. The response was devaluation devaluation, decreasing the value of one nation's currency relative to gold or the currencies of other nations. It is usually undertaken as a means of correcting a deficit in the balance of payments.  accompanied by liberalization lib·er·al·ize  
v. lib·er·al·ized, lib·er·al·iz·ing, lib·er·al·iz·es

v.tr.
To make liberal or more liberal: "Our standards of private conduct have been greatly liberalized . . .
.

The foreign Exchange Regulation Act (1973) was consolidated and amended in 1947 to regulating certain payments, dealings in foreign exchange and securities, transactions indirectly affecting foreign exchange and the import and export of currency, for the conservation of the foreign exchange resources of the country and the proper utilization thereof in the interests of the economic development of the country.

During the first half of the 1980s, the current account deficit stayed below one and a half percent of GDP GDP (guanosine diphosphate): see guanine. . While export growth was slow, the trade deficit was kept in check, as a rapid rise in domestic petroleum production permitted savings on energy imports. At the same time, the high proportion of concessioner external financing In the theory of capital structure, External financing is the phrase used to describe funds that firms obtain from outside of the firm. It is contrasted to internal financing which consists mainly of profits retained by the firm for investment.  kept debt service down.

In the second half of the 1980s, current account deficits widened. India's development policy emphasis shifted from import substitution towards export-led growth, supported by measures to promote exports and liberalize lib·er·al·ize  
v. lib·er·al·ized, lib·er·al·iz·ing, lib·er·al·iz·es

v.tr.
To make liberal or more liberal: "Our standards of private conduct have been greatly liberalized . . .
 imports for exporters. The government began a process of gradual liberalization of trade, investment, and financial markets. Import and industrial licensing requirements were eased and tariffs replaced some quantitative restrictions. Export growth was rapid, due to the initial measures of deregulation Deregulation

The reduction or elimination of government power in a particular industry, usually enacted to create more competition within the industry.

Notes:
Traditional areas that have been deregulated are the telephone and airline industries.
 and improved competitiveness associated with the real depreciation of the rupee RUPEE, comm. law. A denomination of money in Bengal. In the computation of ad valorem duties, it is valued at fifty-five and one half cents. Act of March 2, 1799, s. 61; 1 Story's L. U. S. 627. Vide Foreign coins.
     2.
.

By 1990-91, India was increasingly vulnerable to shocks as a result of its rising current account deficits and greater reliance on commercial external financing. Exports markets were weak in this period leading up to India's crisis, as world growth declined steadily from 4/4 percent in 1988 to 2% percent in 1991. The decline was even greater for U.S. growth, India's single largest export destination. U.S. growth fell from 3.9 percent in 1988 to 0.8 percent in 1990 and to -1 percent in 1991. Consequently, India's export volume growth slowed to 4 percent in 1990-91.

India's balance of payments in 1990-91 also suffered from capital account problems due to a loss of investor confidence. The widening current account imbalances and reserve losses contributed to low investor confidence, which was further weakened by political uncertainties and finally by a downgrade Downgrade

A negative change in the rating of a security.

Notes:
For example, an analyst may downgrade a stock from strong buy to buy, or a bond rating agency may downgrade a bond from AAA to AA.
 of India's credit rating by the credit rating agencies Credit Rating Agencies

Firms that compile information on and issue public credit ratings for a large number of companies.
. The government's economic policies changed drastically in that year, the 1991 liberalization was an extension of earlier, albeit slower, reform efforts that had begun in the 1970s when India relaxed restrictions on imported capital goods Capital Goods

Any goods used by an organization to produce other goods.

Notes:
Examples of capital goods include office buildings, equipment, and machinery.
See also: Capital Expenditure, Disinvestment



Capital goods
 as part of its industrialization industrialization

Process of converting to a socioeconomic order in which industry is dominant. The changes that took place in Britain during the Industrial Revolution of the late 18th and 19th century led the way for the early industrializing nations of western Europe and
 plan. The Import-Export Policy of 1985-1988 replaced import quotas Import quotas are a form of protectionism. An import quota fixes the quantity of a particular good that foreign producers may bring into a country over a specific period, usually a year. The U.S. government imposes quotas to protect domestic industries from foreign competition.  with tariffs. After 1991, the Government of India further reduced trade barriers by lowering tariffs on imports. In the postliberalization era, quantitative restrictions have not been significant. At that time Indian economy was opened up and foreign exchange regulations were significantly relaxed, the exchange rate fluctuated according to according to
prep.
1. As stated or indicated by; on the authority of: according to historians.

2. In keeping with: according to instructions.

3.
 market demand and supply caused by international trade and capital flows to and from India and other speculative forces.

In July 1991 the Indian government devalued de·val·ue   also de·val·u·ate
v. de·val·ued also de·valu·at·ed, de·val·u·ing also de·val·u·at·ing, de·val·ues also de·val·u·ates

v.tr.
1. To lessen or cancel the value of.
 the rupee by between 18 and 19 percent. The government also changed its trade policy from its highly restrictive form to a system of freely tradable EXIM EXIM Export & Import
EXIM Export and Import Bank of India
 scrips which allowed exporters to import 30 percent of the value of their exports (Gupta, pp.73-74)

The task facing India in the early 1990s was, therefore, to gradually move from total control to a functioning forex market. The move towards a market--based exchange rate regime in 1993 and the subsequent adoption of current account convertibility were the key measures in reforming the Indian foreign exchange market.

Reforms in the foreign exchange market focused on market development with prudential safeguards without destabilizing the market. Authorized Dealers of foreign exchange have been allowed to carry on a large range of activities. Banks have been given large autonomy to undertake foreign exchange market, a large number of products have been introduced and entry of newer players has been allowed in the market.

The Indian approach to opening the external sector and developing the foreign exchange market in a phased manner from current account convertibility to the ongoing process of capital account opening is perhaps the most striking success relative to other emerging market economies.

Chronology of India's exchange rate policies

* 1947 (When India became member of IMF IMF

See: International Monetary Fund


IMF

See International Monetary Fund (IMF).
): Rupee tied to pound

* 18 September, 1949: Pound devalued; India maintained par with pound

* 6 June, 1966: Rupee is devalued

* 18 November, 1967: UK devalued pound, India did not devalue

* August 1971: Rupee pegged to gold/dollar, international financial crisis

* 18 December, 1971: Dollar is devalued

* 20 December, 1971: Rupee is pegged to pound sterling again

* 1971-1979: The Rupee is overvalued Overvalued

A stock whose current price is not justified by the earnings outlook or price/earnings (P/E) ratio and thus, expected to drop in price. Overvaluation may result from an emotional buying spurt, which inflates the market price of the stock or from a deterioration in a
 due to India's policy of import substitution

* 23 June, 1972: UK floats pound, India maintains fixed exchange rate with pound

* 1975: India links rupee with basket of currencies of major trading partners. Although the basket is periodically altered, the link is maintained until the 1991 devaluation.

* July 1991: Rupee devalued by 18-19 %

* March 1992: Dual exchange rate, LERMS LERMS Liberalized Exchange Rate Management System , Liberalised Exchange Rate Management System

* March 1993: Unified exchange rate: $1 = Rs 31.37

* 1993/1994: Rupee is made freely convertible for trading, but not for investment purposes

In the present study, an attempt has been made to evaluate the impact of exchange rate on India's inflation rate. Section I presents the link behind exchange rate and inflation rate. Section II gives the survey of literature related to foreign exchange rate and inflation rate. In Section III of the paper data source and methodology of the study has been dealt with. Section IV attempts to statistically evaluate the impact of exchange rate on India's inflation rate. In the last section V, summary and conclusions of the study has been given.

The effects of the uncertainties caused by the volatility in exchange rates and inflation on macroeconomic variables have been subject to extensive theoretical and empirical research.

Exchange rate system has an important role in reducing or minimizing the risk of fluctuations in exchange rates, which will have an impact on the economy. In the system of floating exchange rates, exchange rate fluctuations can have a strong impact on the level of prices through the aggregate demand (AD) and aggregate supply (AS). On the aggregate supply, depreciation (devaluation) of domestic currency can affect the price level directly through imported goods that domestic consumers pay. However, this condition occurs if the country is the recipient countries of international prices (international price taker Price Taker

1. An investor whose buying or selling transactions are assumed to have no effect on the market.

2. A firm that can alter its rate of production and sales without significantly affecting the market price of its product.

Notes:
1.
). Non direct influence from the depreciation (devaluation) of currency against the price level of a country can be seen from the price of capital goods (intermediate goods) imported by the manufacturer as an input. The weakening of exchange rate will cause the price of inputs more expensive, thus contributing to a higher cost of production. Manufacturers will certainly increase the cost to the price of goods that will be paid by consumers. As a result, the price level aggregate in the country increases or if it continues it will cause inflation.

Exchange rate movements can influence domestic prices via effect on aggregate supply and demand. On the supply side, exchange rates could affect prices paid by the domestic buyers of imported goods directly. In an open economy (an international price taker), when the currency depreciates it will result in higher import prices and vice-versa. Exchange rate fluctuations could have an indirect supply effect on domestic prices. The potentially higher cost of imported inputs associated with an exchange rate deprecation dep·re·cate  
tr.v. de·pre·cat·ed, de·pre·cat·ing, de·pre·cates
1. To express disapproval of; deplore.

2. To belittle; depreciate.
 increases marginal cost Marginal cost

The increase or decrease in a firm's total cost of production as a result of changing production by one unit.


marginal cost

The additional cost needed to produce or purchase one more unit of a good or service.
 and leads to higher prices of domestically produced goods (Hyder and Shah, 2004). Further import-competing firms might increase prices in response to an increase in foreign competitor in order to improve profit margins. The extent of such price adjustment depends on a variety of factors such as market structure, nature of government exchange rate policy, or product substitutability.

Exchange rate fluctuations can also affect aggregate demand. To a certain extent, exchange rate depreciations (appreciations) increase (decrease) foreign demand for domestic goods and services In economics, economic output is divided into physical goods and intangible services. Consumption of goods and services is assumed to produce utility (unless the "good" is a "bad"). It is often used when referring to a Goods and Services Tax. , causing increase (decrease) in net exports and hence aggregate demand (Hyder and Shah, 2004). This may increase real output. Furthermore, the expansion in domestic demand and gross national product may bid up input prices and accelerate wage demands by workers seeking higher wages to maintain real wages. The nominal wage rise may result in further price increases.

Review of Literature
Study                  Author

The Empirical          Jyh-Lin Wu (1996)
Investigation Of
Long-Run Purchasing
Power Parity: The
Case Of Taiwan
Exchange Rates

Exchange Rates and     Patrick Honohan and Philip
Inflation under EMU:   R. Lane (2004)
An Update

Granger Non-           Jean-Claude Maswana
Causality Test of      (2006)
the Inflation-
Exchange Rate in the
Democratic Congo

The impact of Real     Nyugen Thi Thuy Vinh
exchange Rate on       and Seiichi Fujita (2007)
Output and Inflation
in Veitnam: A VAR
approach

Exchange Rate Pass-    Michele   Ca'   Zorzi, Elke
Through in Emerging    Hahn and Marcelo Sanchez
Markets                (2007)

Do Exchange Rate       George   Chouliarakis and
Regimes Matter for     PKG Harischandra (2008)
Inflation
Persistence? Theory
and Evidence from
the History of UK
and US Inflation

Uncertainty            Murat Tacdemir and Murat
Spillovers between     Aslan (2009)
Exchange Rates and
Inflation: Evidence
from Turkey

Inflation and          Darine   Ghanem Lameta
Exchange Rate          (2010)
Regimes: Evidence
from MENA Countries

Exchange Rates and     Bahram Adrangi and Mary
Inflation Rates:       E. Allender (2010)
Exploring Nonlinear
Relationships

The Relationship       Noer Azam Achsani, Arie
between Inflation      Jayanthy F A Fauzi and
and Real Exchange      Piter Abdullah (2010)
Rate: Comparative
Study between
ASEAN+3, the EU and
North America

Exchange Rate          B Imimole and A Enoma
Depreciation and       (2011)
Inflation in Nigeria
(1986-2008)

Investigating          Siok Kun Sek, Cheau
the Relationship       Pian Ooi and Mohd. Tahir
between Exchange       Ismail (2012)
Rate and Inflation
Targeting

The Exchange Rate-     Glenville Rawlins
Inflation Link: The
Experience of Some
Caribbean and
Central American
Countries

Study                  Methodology

The Empirical          Co-integration
Investigation Of       Test
Long-Run Purchasing
Power Parity: The
Case Of Taiwan
Exchange Rates

Exchange Rates and     Generalized
Inflation under EMU:   Least Squares
An Update

Granger Non-           Granger Casuality
Causality Test of      Test
the Inflation-
Exchange Rate in the
Democratic Congo

The impact of Real     VAR Approach
exchange Rate on
Output and Inflation
in Veitnam: A VAR
approach

Exchange Rate Pass-    VAR Model
Through in Emerging
Markets

Do Exchange Rate       Structural Stability
Regimes Matter for     Tests
Inflation
Persistence? Theory
and Evidence from
the History of UK
and US Inflation

Uncertainty            GARCH Model
Spillovers between
Exchange Rates and
Inflation: Evidence
from Turkey

Inflation and          Panel data Model
Exchange Rate
Regimes: Evidence
from MENA Countries

Exchange Rates and     GARCH Model
Inflation Rates:
Exploring Nonlinear
Relationships

The Relationship       Panel Data model
between Inflation      with Fixed effects
and Real Exchange
Rate: Comparative
Study between
ASEAN+3, the EU and
North America

Exchange Rate          ARDL
Depreciation and       Cointegration
Inflation in Nigeria   Procedure
(1986-2008)

Investigating          GARCH Models
the Relationship
between Exchange
Rate and Inflation
Targeting

The Exchange Rate-     Johanssen
Inflation Link: The    Cointegration
Experience of Some     Techniques
Caribbean and
Central American
Countries

Study                  Results

The Empirical          Long-run equilibrium relationships
Investigation Of       between exchange rates and
Long-Run Purchasing    consumer price indices.
Power Parity: The
Case Of Taiwan
Exchange Rates

Exchange Rates and     The strength of the US dollar had
Inflation under EMU:   an important impact on inflation
An Update              divergence.

Granger Non-           Granger causality between inflation
Causality Test of      and the exchange rate is
the Inflation-         bidirectional in the short-run, but in
Exchange Rate in the   the long--run only exchange rate
Democratic Congo       causes inflation without a feedback
                       effect.

The impact of Real     Real devaluation has positive
exchange Rate on       impact on both output and inflation.
Output and Inflation
in Veitnam: A VAR
approach

Exchange Rate Pass-    Positive relation between
Through in Emerging    Exchange Rate Pass Through and
Markets                inflation.

Do Exchange Rate       Inflation persistence can vary with
Regimes Matter for     exchange rate regimes.
Inflation
Persistence? Theory
and Evidence from
the History of UK
and US Inflation

Uncertainty            The inflation uncertainty contributes
Spillovers between     significantly to the nominal
Exchange Rates and     exchange rate uncertainty. In the
Inflation: Evidence    managed exchange rate period,
from Turkey            there is no evidence of uncertainty
                       spillover between the nominal
                       exchange rates and inflation.

Inflation and          Strong relationship between the
Exchange Rate          choice of exchange rate regime
Regimes: Evidence      and inflation
from MENA Countries

Exchange Rates and     Explains nonlinearities between
Inflation Rates:       monthly exchange rates and
Exploring Nonlinear    inflation rates.
Relationships

The Relationship       There is a strong correlation
between Inflation      between the movements of inflation
and Real Exchange      with real exchange rate in most
Rate: Comparative      countries to be analyzed. For Asia,
Study between          there is a significant one-way
ASEAN+3, the EU and    causal relationship, where the
North America          nominal and real exchange rates
                       have a significant impact on the
                       rate of inflation.

Exchange Rate          Depreciation has positive and long
Depreciation and       --run effect on exchange rate.
Inflation in Nigeria
(1986-2008)

Investigating          Inflation Targeting leads to higher
the Relationship       volatility in exchange rate
between Exchange       movement in majority economies.
Rate and Inflation     Significant correlation between
Targeting              exchange rate movements and
                       inflation and output movements in
                       both sub-periods.

The Exchange Rate-     The existence of a stable long term
Inflation Link: The    relationship between current
Experience of Some     inflation differentials and the
Caribbean and          bilateral nominal exchange rate for
Central American       each country.
Countries


The above studies show mixed and inconclusive INCONCLUSIVE. What does not put an end to a thing. Inconclusive presumptions are those which may be overcome by opposing proof; for example, the law presumes that he who possesses personal property is the owner of it, but evidence is allowed to contradict this presumption, and show who is  results on the relationship between exchange rate and inflation. Most of the studies reveal that there is positive relation between exchange rate depreciation and inflation rate. It has also been seen that the research on impact of exchange rate and inflation is largely overlooked in the Indian Economy.

Data Source and Methodology:

Data Source:

To achieve the stated objective of the paper, secondary data has been used. Major data source is Economic Survey of India The Finance Ministry presents the Economic Survey in the parliament every year, just before the Union Budget. It is the ministry's view on the annual economic develepment of the country.

External links
  • Economic Survey 2005-06
, especially on Database on Indian economy. The time period of the study is 1991 Q1 to 2009 Q2. For theoretical explanation standard work on the subject including internet has been consulted.

For finding empirical results eviews has been used.

Methodology:

The first step is to test for stationarity of the series with the help of unit root tests. In the presence of non-stationary variables, there is possibility of spurious spu·ri·ous
adj.
Similar in appearance or symptoms but unrelated in morphology or pathology; false.



spurious

simulated; not genuine; false.
 regression. The second step is to test for cointegration if the variables are non-stationary in their levels and stationary in first difference. Once the cointegration has been established amongst the variables, the third step is to formulate Error-Correction Model (ECM (1) (Enterprise Change Management) See version control and configuration management.

(2) (Error Correcting Mode) A Group 3 fax capability that can test for errors within a row of pixels and request retransmission.
) to examine the casual relationship between exchange rate and inflation rate.

For correcting the problem of autoregression and heteroscedasticity we have used GARCH GARCH Generalized Autoregressive Conditional Heteroskedasticity  model for finding long-run impact. Generalised Autoregressive Conditional Heteroskedasticity Autoregressive Conditional Heteroskedasticity (ARCH)

A nonlinear stochastic process, where the variance is time-varying, and a function of the past variance. ARCH processes have frequency distributions which have high peaks at the mean and fat-tails, much like fractal distributions.
 (GARCH) models are specifically designed to model and forecast conditional variances. The variance of the dependent variable is modeled as a function of past values of the dependent variable and independent, or exogenous Exogenous

Describes facts outside the control of the firm. Converse of endogenous.
 variables.

The GARCH (1,1) Model:

GARCH (1,1) model specifications:

Yt = X't [sup.[theta Theta

A measure of the rate of decline in the value of an option due to the passage of time. Theta can also be referred to as the time decay on the value of an option. If everything is held constant, then the option will lose value as time moves closer to the maturity of the option.
]] + [[member of].sub.t] (1)

[[sigma].sup.2.sub.t] = [omega] + [alpha] [[member of].sup.2.sub.t-1] + [beta] [[sigma].sup.2.sub.t-1] (2)

in which the mean equation given in equation 1 is written as a function of exogenous variables with an error term. Since is the one-period ahead forecast variance based on past information, it is called conditional variance In statistics, conditional variance is a special form of the variance. If we have a conditional distribution Y|X the conditional variance is defined as



where
. The conditional variance equation is specified in equation 2 is a function of three terms:

The constant term [omega]

News about volatility from the previous period, measured as the lag of the squared residual from the mean equation [[member of].sup.2.sub.t-1] (the ARCH term). Last period's forecast variance [[sigma].sup.2.sub.t-1] (the GARCH term).

The (1, 1) in GARCH (1, 1) refers to the presence of a first-order autoregressive GARCH term (the first term in parentheses) and a first-order moving average ARCH term (the second term in parentheses). An ordinary ARCH model is a special case of a GARCH specification in which there are no lagged forecast variances in the conditional variance equation--i.e., a GARCH (0, 1).

This specification is often interpreted in a financial context, where an agent or trader predicts this period's variance by forming a weighted average of a long term average (the constant), the forecasted variance from last period (the GARCH term), and information about volatility observed in the previous period (the ARCH term). If the asset return was unexpectedly large in either the upward or the downward direction, then the trader will increase the estimate of the variance for the next period. This model is also consistent with the volatility clustering In finance, volatility clustering refers to the observation, as noted by Mandelbrot, that "large changes tend to be followed by large changes, of either sign, and small changes tend to be followed by small changes.  often seen in financial returns data, where large changes in returns are likely to be followed by further large changes. There are two equivalent representations of the variance equation that may aid in interpreting the model:

* If we recursively substitute for the lagged variance on the right-hand side of equation 2 we can express the conditional variance as a weighted average of all of the lagged squared residuals:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII ASCII or American Standard Code for Information Interchange, a set of codes used to represent letters, numbers, a few symbols, and control characters. Originally designed for teletype operations, it has found wide application in computers. .] (3)

[[sigma].sup.2.sub.t]

We see that the GARCH(1,1) variance specification is analogous to the sample variance, but that it down-weights more distant lagged squared errors.

* The error in the squared returns is given by [V.sub.t] [[epsilon].sup.2] - [[sigma].sup.2.sub.t]. Substituting for the variances in the variance equation and rearranging terms we can write our model in terms of the errors:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.] (4)

Thus, the squared errors follow a heteroskedastic ARMA(1,1) process. The autoregressive root which governs the persistence of volatility shocks is the sum of a plus p in many applied settings, this root is very close to unity so that shocks die out rather slowly.

Testing for causality causality, in philosophy, the relationship between cause and effect. A distinction is often made between a cause that produces something new (e.g., a moth from a caterpillar) and one that produces a change in an existing substance (e.g.  

One of the good features of VAR models is that they allow us to test for the direction of causality. Causality in econometrics econometrics, technique of economic analysis that expresses economic theory in terms of mathematical relationships and then tests it empirically through statistical research.  is somewhat different to the concept in everyday use; it refers more to the ability of one variable to predict (and therefore cause) the other. Suppose two variables, say [Y.sub.t] and [X.sub.t], affect each other with distributed lags. The relationship between those variables can be captured by a VAR model. In this case it is possible to have that a) [Y.sub.t] causes [X..sub.t], b) [X.sub.t] causes [Y.sub.t], c) there is bi-directional feedback (causality among the variables), and finally d) the two variables are independent. The problem is to find an appropriate procedure that allows us to test and statistically detect the cause and effect relationship among the variables.

I) The Granger causality Granger causality is a technique for determining whether one time series is useful in forecasting another. Ordinarily, regressions reflect "mere" correlations, but Clive Granger, who won a Nobel Prize in Economics, argued that there is an interpretation of a set of tests as  test

Granger (1969) developed a relatively simple test that defined causality as follows: a variable

[Y.sub.t] is said to Granger-cause [X.sub.t] t, if [X.sub.t] can be predicted with greater accuracy by using past values of the [Y.sub.t] variable rather than not using such past values, all other terms remaining unchanged. The Granger causality test for the case of two explanatory variables [Y.sub.t] and [X.sub.t], involves as a first step the estimation of the following VAR model:

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.] (1)

[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII.] (2)

Where it is assumed that both [e.sub.2t] and [e.sub.1t] are uncorrelated white-noise error terms. In this model we can have the following different cases:

Case 1: the lagged x terms in (1) may be statistically different from zero as a group, and the lagged y terms in (2) not statistically different from zero. In this case we have that [x.sub.t] causes [y.sub.t]

Case 2: the lagged y terms in (2) may be statistically different from zero, and the lagged x terms in (1) is not statistically different from zero. In this case we have that [y.sub.t] causes [x.sub.t].

Case 3: both sets of x and y terms are statistically different from zero in (1) and (4.11), so that we have bi-directional causality.

Case 4: both sets of x and y terms are not statistically different from zero in (1) and (1), so that [x.sub.t] is independent of [y.sub.t].

The Granger causality test, then, involves the following procedure. First, estimate the VAR model given by equations (1) and (2). Then check the significance of the coefficients and apply variable deletion tests first in the lagged x terms for equation (1), and then in the lagged y terms in (2). According to the results of the variable deletion tests we may conclude about the direction of causality based upon the four cases mentioned above.

Empirical results:

Here, in this section we will deal with both the long--run run and short- run impact of exchange rate on inflation rate i.e. whether exchange rate has any impact on inflation rate in the long--run or in the short- run.

Long-Run Analysis:

We used Engle-Granger procedure to see the impact of exchange rate on inflation rate. But we found the problem of heteroskedasticity. We also applied ARDL ARDL Akron Rubber Development Laboratory, Inc.
ARDL American Roller Derby League
ARDL Applied Research & Development Laboratory (Mt. Vernon, IL) 
 procedure but still the problem was high and insignificant elasticity. To check this problem we checked for problem of heteroskedasticity through LM statistic. Then we shifted to Generalized Autoregressive Conditional Heteroskedasticity (GARCH) model for determining long-run impact of exchange rate on the inflation rate.

By testing through GARCH we found that there exists no long-run impact of exchange rate on inflation rate as the residual term must be negative and significant in Error Correction

Model. It was negative but not significant. This showed that there is no long-run relationship between exchange rate and inflation rate which means that exchange rate does not have any impact on inflation rate. The studies reviewed showed that there is positive and significant impact of exchange rate on inflation rate. But the studies we reviewed are of other countries. Very few studies are conducted on relationship of exchange rate with inflation rate in Indian economy.

Table 1 is showing GARCH results but for testing the long--run impact we will apply Error Correction Model (ECM). The residual term in ECM must be negative and significant. The results in ECM are shown in Table 2.

Table 2 is giving us the results of long-run results. The residual term is negative but not significant indicating that there is no long--run impact of exchange rate on inflation rate.

Short- run Analysis

There is no long--run impact of exchange rate on inflation rate so we switched to Granger Causality Test to find short- run impact of exchange rate on inflation rate. Table 3 is showing short- run analysis of relationship between exchange rate and inflation rate. Table 3 is indicating that exchange rate is not impacting inflation rate in short- run but inflation rate has impact on exchange rate in short- run. The p-value is significant at 5% level of significance when we see impact of inflation rate on exchange rate. The relationship between the two is unidirectional.

Thus, the results in table 3 are indicating that there is not even short- run impact of exchange rate on inflation rate. But inflation rate has impact on exchange rate in short- run. The relationship thus is unidirectional.

Summary and conclusions

This paper has empirically examined the impact of exchange rate on inflation rate. The estimated GARCH model took into consideration exchange rate and WPI WPI - Worcester Polytechnic Institute  (as an indicator of inflation) data from 1991 (Q1) to 2009 (Q2). The findings show that there no long- run impact of exchange rate on inflation rate. The residual term is negative but not significant indicating that there is no long--run impact of exchange rate on inflation rate. For finding short- run relationship we applied Granger Causality Test which indicates that there is unidirectional relationship between exchange rate and inflation rate. Exchange rate has no impact on inflation rate in the short- run but inflation rate has short- run impact on exchange rate. This is indicator of that monetary and fiscal policies can help in improving exchange rate conditions in short- run. Our study contradicts with the other studies which showed that there is positive and significant impact of exchange rate on inflation rate. This can be due to the fact that the studies reviewed are of countries other than India. Indian economy data shows that there is no impact of exchange rate on inflation rate both in the short- run and the long--run.
Table 1: Garch Model

                       Coefficient   Std. Error

C                      6.212838      0.688132
LNEX                   -2.554002     0.256425
Variance Equation
C                      0.109239      0.057231
RESID[(-1).sup.^2]     0.789807      0.427019
Garch (-1)             0.144997      0.191387
R--squared             0.526272      mean dependent var
Adjusted R--squared    0.498809      S. D. dependent var
S. E. of regression    1.288366      Akaike infor criterion
Sum squared resid      114.5322      Schwarz criterion
Log likelihood         -81.35818     F-statistic
Durbin -Wastson stat   0.316628      Prob. (F-statistic)

                       Z-Statistic   Prob.

C                      9.028551       0.0000
LNEX                   -9.960052      0.0000
Variance Equation
C                      1.908742       0.0563
RESID[(-1).sup.^2]     1.849580       0.0644
Garch (-1)             0.757613       0.4487
R--squared                           -1.048580
Adjusted R--squared                   1.819859
S. E. of regression                   2.334005
Sum squared resid                     2.489685
Log likelihood                       19.16329
Durbin -Wastson stat                  0.000000

Table 2: Error Correction Model (ECM)

Variable               Coefficient   Std. Error

C                       0.003193     0.013306
D(LNWPI (-1)            0.029859     0.139340
D(LNWPI (-2)            0.054792     0.139379
D(LNWPI (-3)            0.019976     0.139501
D(LNWPI (-1)            0.038805     0.109931
D(LNWPI (-2)            0.051250     0.108573
D(LNWPI (-3)            0.027063     0.106323
R--squared              0.025188     mean dependent var
Adjusted R--squared    -0.084872     S. D. dependent var
S. E. of regression     0.110187     Akaike info criterion
Sum squared resid       0.752755     Schwarz criterion
Log likelihood         59.31220      F-statistic
Durbin -Wastson stat    1.995753     Prob. (F-statistic)

Variable               T-Statistic   Prob.

C                       0.239964      0.8111
D(LNWPI (-1)            0.214286      0.8310
D(LNWPI (-2)            0.393113      0.6956
D(LNWPI (-3)            0.143193      0.8866
D(LNWPI (-1)            0.352995      0.7253
D(LNWPI (-2)            0.472033      0.6386
D(LNWPI (-3)            0.254538      0.7999
R--squared                            0.003586
Adjusted R--squared                   0.105789
S. E. of regression                  -1.466063
Sum squared resid                    -1.209092
Log likelihood                        0.228856
Durbin--Wastson stat                  0.976880

Table 3: Granger Causality Test

Sample : 1991 Q1 and 2009 Q 2

Lags: 1
Null Hypothesis                     Obs   F-Statistic   Probability

LNEX does not Granger Cause LNWPI   73    0.58300       0.44770
LNWPI does not Granger Cause LNEX         4.70994       0.03338
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Author:Payal; Makkar, Suman
Publication:Political Economy Journal of India
Geographic Code:9INDI
Date:Jan 1, 2012
Words:4752
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