Objectives: To study ERPT - a case for India; to examine the vulnerability of various macroeconomic variables with a unit difference in exchange rate considering the liberalization policies adopted in the economy in 1991.
Methods: The study proposes various time series econometric tools like Johansen co-integration, Vector error correction mechanism (VECM), "impulse response function" and "variance decomposition" in order to test the objectives empirically. The proposed empirical analysis will be based on secondary data. Variables considered for this analysis are exchange rate, inflation, money supply, forex reserves, output and international oil price. And the sample period lies between 1993 April-2015 December.
Findings: From the co-integration analysis, a long-run relationship between the variables under consideration is found. Further from the error correction table, it has been noticed that all the variables are "mean reverting" and the "speed of adjustment parameter" reveals that forex reserves and prices are likely to be correcting the error more quickly. Further, by utilizing the "impulse response function" it has been observed that a shock to exchange rate pulls down forex reserves drastically; whereas it pushes prices on to the positive region. However, money supply did not respond to the changes in exchange rate much. In addition from the impulse response analysis, it is noticed that shocks in crude oil prices reduces the foreign exchange reserves substantially. Further, the "variance decomposition" analysis advocates that the forecast error variance of exchange rate has largely been explained by oil and forex reserves and prices in the later quarters. From this it is evident that financial sector variables are not in fact fully insulated from the supply side shocks. The forecast error variance of forex reserves is mostly explained by exchange rate and prices. This finding corroborates the earlier empirical evidence obtained from the ECM analysis. However, the "variance decomposition" of prices reveals that its forecast error variance is by and large explained by oil prices, which shows that prices are indeed more vulnerable to the supply side shocks.
Applications: This study enquires into the relevant concern that "is ERPT a case in India?" After conducting a thorough empirical examination, it has been found that the answer to this question is "yes". The fluctuations in exchange rate do have some impact on some of the important macroeconomic variables such as forex reserves and price levels. Therefore, it requires a serious attention of macroeconomic experts and monetary authority of India to redesign exchange rate management policy such a way that monetary instruments of monetary policy will do its best without getting neutralised by inflation and changes in foreign exchange reserves.