Call rate, repo rate differentials and year-on-year inflation differentials as determinants of the us dollar-indian rupee exchange rate

Abstract

The fluctuations in the value of domestic currency depend on the central bank’s policy objectives, liquidity situations in the economy, free flow of foreign exchange reserves, and differentials in the interest yield on securities of concerned economies. This paper aims to test the validity of this hypothesis in regard to the US Dollar (USD)-Indian Rupee (INR) exchange rate. In particular, an effort is made to examine the effects of repo rate differentials and call rates on the exchange rate. The impact of inflation differentials between India and the US on the exchange rate is also analyzed. The present research studies the effect of these determinants on the USD-INR exchange rate through a monthly time series econometric analysis from 2006 to 2022. It draws a conclusion on whether the empirical results align with the theoretical notions in respect to the Indian economy. The paper will focus on understanding the extent of the impact of the changes in the interest rate and inflation differentials that lead to the appreciation or depreciation of the exchange rate. Another aspect considered here is the effect of events such as the global financial crisis, demonetization, and Covid-19 pandemic, which may have had a significant impact on how the USD-INR exchange rate could have been affected by the call rate, repo rate, and inflation differentials over time. One model brings out a high statistical significance of call rate, repo rate differentials and year-on-year inflation differentials on the exchange rate without considering the potential issue of autocorrelation. Another model, which considers dummy variables and addresses the problem of autocorrelation, depicts an impact of call rate and repo rate differentials on the exchange rate with year-on-year inflation differentials as relatively insignificant determinant of the exchange rate. This model also shows the enhanced explanatory power of the independent variables in the determination of the exchange rate.