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1. Introduction
There are voluminous studies that have examined the link between real exchange rate (RER) misalignment and economic growth (Williamson, 1990; Easterly, 1996; Razin and Collins, 1997; Domaç and Shabsigh, 1999; Nucci and Pozzolo, 2001; Gala and Lucinda, 2006; Bhalla, 2007; Prasad et al., 2007; Rodrik, 2008; Bereau et al., 2009; Dubas, 2009; Terra and Valladares, 2010, Elbadawi et al., 2012; Couharde and Sallenave, 2013; Schroder, 2013; Zhang and Chen, 2014; Owoundi, 2015). In this paper, we take empirical evidence as a starting point to ask a different but relative question in the case of India. Because India is no exception, in past few years, exchange rate problems have been attaining great prominence in economic and policy discussions. Therefore, it is important to examine whether the RER of a country is indeed misaligned. If there is misalignment in the exchange rate then how does it affect the economic growth in India? In the situation of an RER misalignment, a country’s actual RER diverges from its equilibrium RER (ERER) level. An exchange rate is undervalued when it is more depreciated and overvalued when it is more appreciated. Hence, misalignment is widely believed to influence the economic growth. In particular, an overvaluation is expected to dampen the economic growth. On the contrary, an undervaluation promotes economic growth. There is a conscious agreement that maintaining the RER at wrong level leads to greater economic instability (Willett, 1986).
The majority of studies in the literature found a negative correlation between exchange rate misalignments and growth since 1970s; the more overvalued the currency, the smaller the per capita growth rate. For instance, Gala and Lucinda (2006) examine RER misalignment on economic growth in 58 developing countries using panel data. Their results indicate that RER misalignment has a significant negative impact on economic growth. Similarly, Elbadawi et al. (2012) investigate the nexus between foreign aid, exchange rate misalignment and economic growth in sub-Saharan Africa and found that an overvaluation reduces the economic growth. Wong (2013) examined a relationship between RER misalignment and economic growth in Malaysia. He found that the exchange rate misalignment tends to reduce the economic growth. Schroder (2013) examined whether developing countries should undervalue their currencies to promote economic growth, and empirical results...