Dynamics of Rupee-Dollar Exchange Rates: Bayesian Analysis and Modelling

Abstract

Exchange rate movement is an important subject of macroeconomics analysis and market surveillance and affects decesions of foreign exchange investors, exporters, importers, bankers, businesses, financial institutions, policymakers and tourists in the developed as well as developing world. The objective of this paper is to find the points of structural shift in the exchange rate model under a Bayesian framework which incorporates the possibility of shift or no shift in both disturbances precision and regression parameter. The Bayesian analysis of a linear regression model has been carried out under the mixture of prior distributions for the parameters. In order to find the structural shift points, a test based on posterior odds ratio for testing the hypothesis of no structural shift against the alternative hypothesis of shift due to change in disturbances precision and regression parameters has been developed. Further, as a particular case to test the validity of proposed model, the effect of interest rate, growth rate of trade balance and GDP growth rate (market price) on Indian rupee-US dollar exchange rate has been considered. Finally, a numerical simulation of the proposed model indicates that the strongest structural shift points of exchange rate captured in the year 1997-98 and 2007-08. The stability in the foreign exchange market was disrupted due to intensification of East Asian crises during 1997-98 and the impact of global financial crisis in 2007-08.