Academic journal article IUP Journal of Applied Economics

On the Relationship between Nominal and Real Effective Exchange Rates in India: Evidence from the ARDL Bounds Tests

Academic journal article IUP Journal of Applied Economics

On the Relationship between Nominal and Real Effective Exchange Rates in India: Evidence from the ARDL Bounds Tests

Article excerpt

This study investigates the relationship between nominal and real effective exchange rates. Both short run and long run relationships between the two are examined by employing Autoregressive Distributed Lag (ARDL) bounds testing approach to cointegration. The results of the study reveal that nominal and real exchange rates bear a long-run relationship (cointegrated), while the error correction results confirm short-run deviations in the relationship.

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The Nominal Effective Exchange Rate (NEER) captures the overall variation in the value of a country's currency against the currencies of all trading partners. It measures the changes in overall nominal value of a currency. In contrast, the Real Effective Exchange Rate (REER) measures changes in real value of a currency by incorporating the price levels in its construction. Thus, it is the REER which reflects changes in external competitiveness of a country. However, it is the nominal exchange rate which is used as a policy tool to improve a country's trade balance as the central bank manipulates it. There are two channels through which nominal depreciation could lead to an improvement in the trade balance. One is by making a country's exports cheaper in terms of foreign currencies, leading to an increase in exports. The other channel is by making a country's imports expensive in terms of her domestic currency leading to a decline in imports. However, it also has its negative effects as expensive imports usually do contribute to domestic inflation which over time spreads into the export sector and this may wipe out the favorable effects that nominal depreciation could have on the exports. Therefore, to investigate the impact of exchange rate adjustment, one has to take account of the price change as well, both domestic and foreign. Thus, nominal depreciation could lead to improvement in trade balance only if it leads to real depreciation. The present study investigates whether nominal exchange rate depreciation eventually leads to depreciation in real exchange rate in the short run as well in the long run. To achieve this objective, we perform cointegration analysis through the Autoregressive Distributed Lag (ARDL) bounds test which has an edge over the conventional cointegration tests such as Engle-Granger, Johansen, Johansen and Juselius, etc.

Literature Review

A few studies in the literature have concentrated on the relation between changes in the nominal exchange rate and its impact on the real exchange rate. An early study by Vaubel (1976) gave new direction by showing that nominal devaluations were effective in achieving real effective adjustment during 1959-1975. He also noted that the relationship between nominal and real effective exchange rates is time varying. Later, Connolly and Taylor (1976 and 1979), Bruno (1978) and Edwards (1988 and 1994) concluded that nominal devaluation leads to real devaluation only in the short span of time to medium term. DeGrauwe and Holvoet (1978), on the basis of input-output tables for European Community, concluded that the outcome is clearly sensitive to the assumption of wage indexing. While under zero wage indexation, a 0.70% real devaluation, was led by 1% increase in nominal devaluation, with complete wage indexation, 1% increase in nominal devaluation leads to 0.5% real changes in exchange rate. On the contrary, Donovan (1981), Bautista (1981) and Morgan and Davis (1982) claimed that the lead impact of nominal devaluation on real devaluation begins to erode in a long span of time. Edwards (1988) showed that the impact of nominal devaluation on the real exchange rate erodes over the following 16 quarters. Again in another study in 1994, he concluded that nominal devaluations are translated into real devaluations in the short to medium run. Bahmani-Oskooee (2001) assessed long-run response of trade balance to nominal devaluation and real depreciation in case of Middle Eastern countries and showed that real depreciation has favorable long-run effect on the trade balance of most non-oil exporting Middle Eastern countries. …

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