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Real Exchange Rate Overshooting in Real Business Cycle Model - An Empirical Evidence From India

The objective of this paper is to establish the ability of a Real Business Cycle (RBC) model to account for the behaviour of the real exchange rate, using Indian data (1966-1997). We calibrate the dynamic general equilibrium open economy model (Minford, Sofat 2004) based on optimising decisions of rational agents, using annual data for India. The first order conditions from the households' and firms' optimisation problem are used to derive the behavioural equations of the model. The interaction with the rest of the world comes in the form of uncovered real interest rate parity and current account both of which are explicitly micro-founded. The paper discusses the simulation results of 1 percent per annum productivity growth shock, which shows that the real exchange rate appreciates and then goes back to a new equilibrium (lower than the previous one), producing a business cycle. Thus the behaviour of the real exchange rate may be explicable within the RBC context. Finally we test our model and evaluate statistically whether our calibrated model is seriously consistent with the real exchange rate data, using bootstrapping procedure. We bootstrap our model to generate pseudo real exchange rate series and find that the ARIMA parameters estimated for the actual real exchange rate data lie within the 95% confidence limits constructed by bootstrapping. We find the same result for the nominal rigidity version of the RBC model. So we conclude that the behaviour of the Indian real exchange rate (US $ / Indian Rupees) can be explained by RBC.

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Paper provided by Cardiff University, Cardiff Business School, Economics Section in its series Cardiff Economics Working Papers with number E2008/1.

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Length: 63 pages
Date of creation: Jan 2008
Date of revision:
Handle: RePEc:cdf:wpaper:2008/1
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  1. McCallum, B.T. & Nelson, E., 1998. "Nominal Income Targeting in an Open-Economy Optimizing Model," Papers 644, Stockholm - International Economic Studies.
  2. Maurice Obstfeld and Alan M. Taylor., 1997. "Nonlinear Aspects of Goods-Market Arbitrage and Adjustment: Heckscher's Commodity Points Revisited," Center for International and Development Economics Research (CIDER) Working Papers C97-088, University of California at Berkeley.
  3. Bennett T. McCallum & Edward Nelson, . "An Optimizing IS-LM Specification for Monetary Policy and Business Cycle Analysis," GSIA Working Papers 1997-71, Carnegie Mellon University, Tepper School of Business.
  4. Anton Braun, R., 1994. "Tax disturbances and real economic activity in the postwar United States," Journal of Monetary Economics, Elsevier, vol. 33(3), pages 441-462, June.
  5. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
  6. Bela Balassa, 1964. "The Purchasing-Power Parity Doctrine: A Reappraisal," Journal of Political Economy, University of Chicago Press, vol. 72, pages 584.
  7. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, vol. 50(6), pages 1345-70, November.
  8. King, Robert G & Plosser, Charles I, 1984. "Money, Credit, and Prices in a Real Business Cycle," American Economic Review, American Economic Association, vol. 74(3), pages 363-80, June.
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