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The Indian Foreign Exchange Market and the Equilibrium Real Exchange Rate of the Rupee

NCAER

Peter Pauly

University of Toronto

This article seeks to analyze changes in the forex market in India and to explain the behaviour of the rupee in the nineties when India moved from a fixed to a f loating exchange rate. The analysis attempts to identify the underlying economic forces that are submerged under an interventionist market structure. The exchange rate is determined in the more slowly adjusting output markets in the long run and in volatile asset markets in the short run. The long run equilibrium exchange rate is seen to be determined by a version of the purchasing power parity condition. In the short run, the real exchange rate deviates from that determined by real interest parity due to risk. As long as pressures are not extreme, the Reserve Bank of India (RBI) is able to intervene effectively to influence the exchange rate. Its policy of 'keeping the rupee in line with fundamentals' has usually amounted to preventing a nominal appreciation of the rupee so that it does not effectively turn into a real appreciation. Other than attempting to keep exports competitive, the Reserve Bank has intervened to reduce volatility in forex markets. More recently, indirect intervention using interest rates has also played an increasingly important role in the RBI's foreign exchange policy.

Global Business Review, Vol. 2, No. 2, 195-212 (2001)
DOI: 10.1177/097215090100200204


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