Causal Relation between Money Supply and Exchange Rate in India Under the Basket Peg and Market Determination Regimes : A Time Series Analysis

Mundell-Fleming model of open economy macroeconomics has amply established that the nature and direction of causal relationship between money supply and exchange rate depend on the exchange rate regimes. Particularly bidirectional causal relation between domestic money supply and exchange rate is the common phenomenon in the pegged regime of exchange rate, while unidirectional causality running from money supply to exchange rate is the feature of the market determination regime. This study is devoted to inquire into these issues in the context of Indian exchange rate regimes. Using quarterly time series data of the variables concerned, the study bears the evidence that under the basket peg and market determination exchange rate regimes money supply and rupee/dollar exchange rate in India are co-integrated. In the era of basket peg, bidirectional Granger causality is established, while in the era of market determined regime, unidirectional Granger causality running from money supply to exchange rate has been testified