The Interaction Between Exchange Rate, Interest Rate and Inflation Rate: The Case of India.

Abstract

The purpose of this article is to empirically analyze the long and short runs association of exchange rate, interest rate and inflation rate in Indian context.  In order to establish this relationship monthly data from January 2021 to March 2025 were used. Unit Root Test (Augmented Dickey Fuller test) revealed that   all the variables are stationery at second difference and hence was used for further long run investigation. Johansen and Juselius co-integration test suggest the existence of actual long-run relationship between exchange rate, inflation rate and interest rate in India. The coefficient of the second error correction term in the exchange rate equation is positive which shows a strong evidence of a stable long-run relationship between the exchange rate and the explanatory variables (interest rate and inflation). In the short run, none of the lagged values of interest rates and inflation rate are statistically significant in influencing the Exchange Rate. Results of Granger Causality indicated the presence of unidirectional causal association between Inflation rate and Exchange rate which indicates causality is running from the inflation rate to the exchange rate. Further the results also suggest that Interest rates and Exchange rates do not have any causality relationship among them.