Asymmetric Shocks and the Role of Exchange Rate in Emerging Markets: Evidence from India

This paper examines the stabilization role of the flexible exchange rate in the face of asymmetric shocks for one of the prominent emerging markets and open economies, India, using a sign-identified structural Bayesian vector autoregression model and quarterly time series data over the post reform period 1996-2023. My results show that relative monetary policy and exchange rate shocks account for a larger fraction of the variation in the Indian rupee in the short run, compared to relative demand and supply shocks. Jointly, monetary policy and exchange rate shocks account for almost half of the variation in the Indian rupee. Although the Indian rupee floating exchange rate is able to absorb shocks in the long run, it plays a more dominant role as a source of shocks in the short run. This study holds important policy implications for currency stability in emerging markets operating under flexible exchange rate regime. Policymakers should be prepared to manage the exchange rate during times of excessive exchange rate volatility and disruptive capital flows.