Unveiling the Relationship Between Oil Price and Exchange Rate: New Insight from Time-varying Versus Fixed Coefficient Cointegration

Abstract

This study provides a brief analysis of time-varying cointegration between the INR–USD bilateral exchange rate and Brent crude oil prices in the post–subprime crisis period. Prior studies established this relationship using the assumption that the long-run relation is intertemporally constant. However, there is much recent evidence demonstrating that this assumption may not be feasible. To address this issue and to go beyond the restrictive time-invariant environment, we employed the time-varying cointegration framework of Bierens and Martins (2010) , which was assessed through orthogonal Chebyshev time polynomials. The result shows that the Rupee was decoupled from oil price shocks in the first two samples. However, the oil price pass-through effect will become stronger in the third and fourth samples. The endogenous structural break test suggests the presence of serious parameter instabilities due to fluctuations in oil prices and the exchange rate over the period under study. This indicates the ability of international crude oil prices to influence domestic economic activities through the exchange rate. Policymakers should consider this factor while making monetary and foreign exchange policies. JEL Codes: E44, G14, G15