Interest Rate And Exchange Rate Volatility In India, 2011-2020

Abstract

In this study, we have empirically investigated the role of interest rate on the volatility of the exchange rate using monthly data starting from January 2011 to January 2020. The conditional standard deviation of the GARCH (1,1) based on the ARIMA (1,1,0) model is used as a proxy for exchange rate volatility. To test the causal effect of the interest rate on the exchange rate volatility, we employed the Granger causality test, Shannon’s transfer entropy causality test, and the bootstrap impulse response function. Each test is performed with two separate lag lengths. The results of the study suggest that the interest rate has a positive causal effect on the exchange rate volatility unanimously supported by the Granger causality test and Shannon Transfer Entropy causality test. The IRF revels that a shock in the interest rate positively influences the exchange rate volatility between a lag of two to four months.