Causal Analysis of the Relationship between Exchange Rate and Government Deficit : Evidence from India

Causal relationship between the exchange rate and government deficit has a long time debate in economic circle. A number of theories emerged in the past explained their relationship, but still it is inconclusive. This paper attempts to investigate the dynamic relation between exchange rate and government deficit in India during a period from April 2001 to March 2017. The results of VAR Granger causality found unidirectional causality that moves from exchange rate to government deficit. ARDL co-integration test results exhibit no long run relation between the variables. The results of Impulsive Response Function indicate that government deficit responses positively to the one SD shock in exchange rate; exchange rate, in the similar fashion responses positively to the one SD shock in government deficit. The variance decomposition results indicated that a shock to the exchange rate causes 2.069 percent fluctuation in the government deficit in short run and up to 9.04 percent in long run, while a shock to government deficit does not cause any fluctuation in the exchange rate in short run and in long run a shock to government deficit causes 3.65 percent fluctuation in the exchange rate that is very less