Real exchange rate dynamics: Evidence from India

This paper examines the dynamic behavior of bilateral real exchange rates between India and 16 of its trading partner countries using annual data from 1960 to 2010. We use panel unit root test procedures, with and without structural breaks, to investigate if there is any evidence in India's bilateral real exchange rates data to support the Purchasing Power Parity (PPP) hypothesis. While the unit root null is rejected in all three cases-with no structural break, one structural break, and two structural breaks-at least at the 5% level of significance, the evidence is much stronger in the cases with structural breaks. Furthermore, we correct for small sample bias and time aggregation bias to obtain unbiased estimates of half-life. However, in the case with no structural break, although we find evidence of mean reversion, an unbiased half-life estimate of about 8 years implies an extremely slow speed of mean-reversion. When we consider the cases with structural breaks, the unbiased half-life estimates are greatly reduced. With two structural breaks, the unbiased half-life estimate is about one year.