Generally it is believed that the central monetary authority can, and should, exercise control over the exchange rate only in case of fixed/pegged exchange rate regime. However, such a regulation is essential even in an economy that has adopted floating exchange rate policy. This is because no economy can stay immune to the extreme external shocks that affect the domestic economic stability through exchange rate channel. These shocks may be due to changes in the trade balance and relative terms of trade, purchasing power of the two currencies, capital movements, and differences in the general price levels of the two economies under consideration. Especially, when the economy is open to capital movements, the expectations regarding forward exchange rate play an important role in deciding the capital flows as well as the actual exchange rates in future. And, if unguarded, the fluctuations in the exchange rate can cause deep financial crisis in any economy regardless of its size and dependence on the external sector. This paper makes an attempt to define such a relation between the capital movements and the forward exchange rate through the Covered Interest Parity (CIP) model. Monthly data from April 1996 to May 2008, relating to Indian and the US economies, are used for establishing this hypothesis. A comparative analysis of the CIP model with the Uncovered Interest Parity (UIP) model indicates that the former is more efficient in projecting the forward exchange rate movements with greater accuracy. The ability to forecast the future exchange rate based on the same model is an added advantage of adopting the CIP for monitoring the exchange rate and capital movements in India.

Determination of exchange rate between two currencies is becoming increasingly complex. In very simple terms, the exchange rate indicates the price of one currency in terms of the other, and hence, should depend on the demand and supply of one currency in the other economy where the other currency prevails as the price measurement unit. However, demand and supply of foreign currency in the domestic money market depends on a number of factors. These factors may include the trade balance between the two countries, volume and velocity of capital movements, inflation differentials, and relative prices of capital in the two countries. Thus, it is derived demand and derived supply of the currency that is at work and not autonomous demand or autonomous supply. This makes exchange rate determination process more complex than it is generally perceived.

At the same time, exchange rate movements over a long period of time cannot be taken lightly as these in turn affect the above-mentioned factors. Since these factors affect the functioning of the macro economy, stability of the entire economic structure of a country may be at stake with the exchange rate movements. This has been well-experienced by many economies that have faced financial crises of different types in the past. No wonder then, that monetary authorities of various economies try their best to maintain a regulatory control over the exchange rate of their currency with the major currencies of the world, such as the US dollar. Moreover, it has also been observed that attaining high economic growth, internal price stability and exchange rate stability all at the same time is not possible as these three operate in opposite directions each other. Following this, it is very likely that the monetary authorities may achieve one target, and lose their focus from the others.

Applied Economics Journal, Exchange Rate Expectations, Covered Interest Parity Model, Financial Crises, Economic Growth, Capital Movements, Long-term Maturity Bonds, Eurocurrency Markets, Indian Economy, Indian Capital Markets, Domestic Money Market.