Exchange Rate Dynamics and Recent Shocks in India

Exchange rate stability in the economy is one of the most important determinants of its economic performance. This study highlights the role of several macroeconomic variables like trade balance, Foreign Direct Investment (FDI) inflows, foreign exchange reserves, interest rate differentials, and GDP growth differential and the influence of volatile events like the 2007-2008 global financial crisis, India’s 2016 demonetization drive, and the COVID 19 pandemic on the Indian Rupee (INR) against the US Dollar (USD). The study employs annual time-series data for the 1979-2024 period based on the Federal Reserve Economic Data (FRED) Database and the World Bank and Ordinary Least Squares (OLS) regression model as a reference point with Autoregressive Distributed Lag (ARDL) and Error Correction Models (ECM) to study short-run dynamics and long-run equilibrium relationships. The INR/USD exchange rate is extremely reliant on trade balance, foreign exchange reserves, GDP growth differentials, and FDI flows, while interest rate differentials have a relatively weaker relationship. The study employs ECM and finds that exchange rate volatility due to events or shocks fails to revert to the level of equilibrium in time. Policymakers can benefit by the findings of this study since it quotes the determinants of the INR/USD exchange rate to enhance the economic resilience against future shocks.