Linkages of real effective exchange rate flexibility and economic growth in India: An empirical study

In this paper we analyze the relationship between exchange rate flexibility and economic growth in India. Undervaluation of the currency (a high real exchange rate) stimulates economic growth.

This finding is robust to using different measures of the real exchange rate and different estimation techniques. A formal model elucidates the linkagesbetween the real exchange rate and the rate of economic growth.Economists have long known that poorly managed exchange rates canbe disastrous for economic growth. Avoiding significant overvaluationof the currency is one of the most robust imperatives that can be gleanedfrom the diverse experience with economic growth around the world, and is true in case of India. The objective of the paper is to investigate co-integration between REER and economic growth under the VAR framework using Co integration, VECM, Variance Decomposition Analysis, Impulse Response and Granger causality. The results reveal that relationship between exchange rates and GDP are complex and can have severe implications for economic growth. The results of co integration confirm this fact that they share long term relationships, with more adjustments done in REER to move towards equilibrium. Granger Causality shows unilateral granger relationships from GDP to REER.These results have some policy implications, Real exchange rate should be kept at competitive levels as they can be critical for jump-starting growth excessive volatility. It can also facilitate efforts to benefit from on these fundamentals by encouraging the Re- deployment of resources into manufacturing and reaping immediate productivity gains by encouraging the redeployment of resources into manufacturing and acquiring immediate efficiency gains.