Exchange Rate Movement of Developing Countries like India: An Alternative Theoretical Framework

In the context of explaining exchange rate behaviour theories pertaining to the latter have been negligent with regard to the role of foreign exchange reserve. Either it has been excluded as a determinant or treated as a mere residual factor. Yet foreign exchange reserve has been playing a reasonably important role in determining the nominal exchange rate of countries, more specifically for developing countries with current account deficits coupled with substantial capital account surpluses leading to growth in growing foreign exchange reserve. This characteristic of the developing countries shares a similarity with India?s external balances. It may not hold true for the countries with currencies used as international money to a reasonable extent. This paper develops a theoretical framework, in order to understand the exchange rate movement for developing countries by keeping foreign exchange reserve in conjunction with capital flows at the centre stage. It also suggests that the movement of speculative capital needs to be restricted to avoid a currency crisis.