Testing Structural Break in the Relationship Between Exchange Rate and Macroeconomic Variables

Abstract

The article aims to study the relationship between those macroeconomic factors that the affect (INR/USD) exchange rate (ER). Time series data of 40 years on ER, GDP, inflation, interest rate (IR), FDI, money supply, trade balance (TB) and terms of trade (ToT) have been collected from the RBI website. The considered model has suggested that only inflation, TB and ToT have influenced the ER significantly during the study period. Other macroeconomic variables such as GDP, FDI and IR have not significantly influenced the ER during the study period. The model is robust and does not suffer from residual heteroscedasticity, autocorrelation and non-normality. Sometimes the relationship between ER and macroeconomic variables gets affected by major economic events. For example, the Southeast Asian crisis caused by currency depreciation in 1997 and sub-prime loan crisis of 2008 severely strained the national economies. Any global economic turmoil will affect different economic variables through ripple effect and this, in turn, will affect the ER of different economies differently. The article has also diagnosed whether there is any structural break or not in the model by applying Chow’s Breakpoint Test and have obtained multiple breaks between 2003 and 2009. The existence of structural breaks during 2003–2009 is explained by the fact that volume of crude oil imported by India is high and oil price rise led to a deficit in the TB alarmingly, which caused a structural break or parameter instability.

Exchange rate and volatility: A bibliometric review

“…The events influence in economic agent decisions to maintain national or foreign assets (Andersen, Bollerslev, & Dievold, 2007;Ayadi, Omrane, Wang, & Welch, 2019). Factors such as inflation and interest rate differentials between countries generate volatility in the exchange rate (Jeelani, Tomar, Das, & Das, 2019). Also, the variation in the exchange rate in one country may be caused by situations in other economies (spillovers) as monetary or fiscal policy (Fisher & Chairman, 2015;Hung, 2019).…”