Real Exchange Rate Stabilisation and Managed Floating: Exchange Rate Policy in India

Real Exchange Rate Stabilisation and Managed Floating: Exchange Rate Policy in

India, 1993-99

Renu Kohli*

The paper examines the exchange rate management strategy of the Indian central bank after the shift to a

floating exchange rate regime in 1993. A policy reaction function tests for its intervention behaviour and

finds significant effort to lean against the wind during 1993-99. This is tempered with purchasing power

parity considerations as evidenced by the central bank’s response to deviations of the spot rate from

moving relative prices’ target. This indicates a real exchange rate stabilisation policy by the Indian

authorities.

Keywords: Exchange rate; intervention; exchange rate management; purchasing power

parity; real exchange rate; managed floating; exchange rate target;

JEL Classification Nos. E 58, F3, F31

*

The author is employed by the Reserve Bank of India and currently on deputation to ICRIER. The views

expressed here are however, the author’s own and not of the institution to which she belongs. The support

of Ford Foundation is gratefully acknowledged. I am grateful to John Williamson, Montek Ahluwalia,

Michael Melvin, Prof. von Hagen, George Stadtman and Sanjib Pohit for helpful comments on an earlier

version of this paper and the excellent research assistance rendered by Richa Samant. The responsibilities

for errors are solely mine. All correspondence to be addressed to the author at renuk@icrier.res.in.

I. Introduction

Economic theory predicts that a floating exchange rate will automatically adjust

balance of payments deficits through variations in the market price of foreign exchange

and insulate the domestic economy from external shocks. Since the authorities do not

have to intervene in the foreign exchange market, monetary policy can be assigned

exclusively to domestic objectives, giving complete monetary policy autonomy. These

propositions however, have been belied by the post-Bretton Woods' experience with

freely floating exchange rates. Increased exchange rate volatility, misalignment from

equilibrium levels for long periods, prolonged current account imbalances and a rise in

capital mobility underscored the need to ‘manage’ exchange rates. This consensus

emerged by 1985 and instances of intervention by respective central banks in support of

weak currencies, or to prevent exchange rate instability, have become fairly common