Does Pak-Rupee Exchange Rate Respond to Monetary Fundamentals? A Structural Analysis

Abstract

This study empirically examines the contribution of monetary fundamentals in explaining nominal exchange rate movements in the case of Pak-rupee vis-à-vis US-dollar over the period 1982Q2 to 2014Q2. The empirical results support the existence of cointegration relationship between nominal exchange rate and monetary fundamentals. The results reveal that relative money stocks and real income are the key drivers of exchange rate determination in Pakistan in the long-run. For dynamic interaction, the Structural Vector Autoregressive (SVAR) method is applied. Results from the SVAR show that the responses of exchange rate to shocks, originated from money supply, income, interest rate and inflation differentials, are consistent with the predictions of the flexible-price variant of the monetary model of exchange rate in the short-run. More specifically, the results indicate that inflation and interest rate differential explain maximum variations in exchange rate in the short-run. In essence, results suggest that monetary fundamentals are the key drivers of exchange rate fluctuations in Pakistan, especially in the short-run. JEL Classification: F31, F33, C32, F41 Keywords: Monetary Model, Exchange Rate, SVAR, Pakistan

Do Monetary Models Really Matter to Determine the Exchange Rate Behavior: A Case for Pakistan

“…As far as the proportion of variation is concerned inflation and interest rate difference are found dominant as observed both by Flood and Taylor (1996) and Khan and Nawaz (2018). The long run relationship of the nominal exchange rate with inflation is supported by Khan, Sattar and Rehman (2012) as well.…”

“…Since demand and supply of both domestic and foreign currencies determine the exchange rates where monetary policies of such countries play a key role. According to (Khan and Nawaz, 2018) monetary exchange models mainly establish a link between the purchasing power parity theory and the quantity theory of money. These models suggest that the difference between two countries in terms of money supply, real income, nominal, and real interest rate have been the prime factor(s) in the determination of bilateral exchange rate.…”

“…The evidence regarding Pakistan has been provided by (Khan and Nawaz, 2018) who have applied cointegration on quarterly data for US dollars only and proved that exchange rates are driven through relative money stock and real income in the long run whereas short-run variations in the exchange rates are mainly explained by inflation and interest rate. In a study by (Zakaria and Ahmad, 2009) seventeen trade partners countries of Pakistan have been evaluated with quarterly data and the flexible price monetary model proved highly effective to reflect the behavior of exchange rates in comparison to interest differential and sticky-price monetary models by using generalized methods of moment techniques in long run.…”

“…The complete description of these models has been mentioned by many researchers including (Khan and Nawaz, 2018); (Krolzig and Martin, 2012); (MacDonald, 2007); Gardeazabal, and Regulez, 1992) however, for the basic understanding some descriptions have been reported here. As per details mentioned by (Gardeazabal and Regulez, 1992), the monetary models are based on two major components (i) money demand and (ii) purchasing power parity.…”