Determining the fundamentals of the real exchange rate using a simple general equilibrium model: A case study of India

The purpose of this paper is to find the determinants of the RER for India where determinants is defined as forces affecting the demand and supply of foreign currency and RER is viewed as a relative price variable. The determinants selected for study were technological change, tariffs, foreign aid, foreign investment and government expenditure. These determinants were picked for testing only after a careful study of India's economic history. Only those policies that were consistently followed over fifty years and became dominant concerns of India's policy makers were used to select the determinants. To find the effects of these determinants on the long-run RER, the flow approach was followed by building a balance of payments model with traded and nontraded goods. The model was first developed by McDougall and is an extension of Mundell's model with only traded goods. Comparative statics using the determinants in the model only shows that it is not possible to know in advance whether the RER will appreciate or depreciate. Empirical testing using a regression equation with RER as the dependent variable and the determinants as the independent variables shows that only the government consumption determinant is significant for the 1960--1975 fixed exchange rate period. The sign is positive indicating a depreciation (in real terms) of the Indian Rs. which is perhaps an explanation for the trend decline of the rupee for India since 1965. Furthermore an AR(1) correction for the same period shows government consumption and foreign aid to be significant in determining the next period's RER. For the 1976--1990 managed exchange rate period, tariff is found to be a significant determinant.