Exchange rate effect on money demand in Pakistan

Abstract

PurposeThis paper aims to examine association of money demand with key macroeconomic variables in Pakistan. The paper also investigates the asymmetric effect of real effective exchange rate (REER) on money demand.Design/methodology/approachThe study employs both linear autoregressive distributed lag (ARDL) and non-linear autoregressive distributed lag (NARDL) model. Annual data from 1970 to 2018 is used which is subjected to non-linearity through partial sum concept. Empirical analysis is conducted to prove if money demand is influenced by currency appreciation or depreciation, for long and short run.FindingsCointegration test indicates existence of a long-run relationship between money demand and its determinants. Results from NARDL model suggest negative relation between money demand and inflation in long and short run. Real income shows positive but a very minimal and insignificant effect on money demand in long and short run. Impact of call money rates is statistically significant and negative on M1 and M2. Wald tests and differing coefficient sign confirm presence of asymmetric relation of REER in long run with M2, whereas in short run we observe a linear, symmetrical relation of REER with M1 and M2. Stability diagnostic tests (CUSUM and CUSUMSQ) verify stability of M2 demand model in Pakistan.Practical implicationsResults signify that role of money demand is imperative as a monetary policy tool and it can be utilized to achieve objective of price stability. Additionally, exchange rate movements should be critically examined by monetary authorities to avoid inflationary pressures resulting from an increase in demand for broad monetary aggregate.Originality/valueThe paper contributes to scarce monetary literature on asymmetrical effects of exchange rate in Pakistan. Impact of variables has been studied through linear approach, but this paper is unique since it attempts to explore non-linear relationships.

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“…This arises from the fact the exchange rate affects money demand for key sectors of an economy. According to Zehra et al (2020), money demand has been empirically observed to respond asymmetrically to macroeconomic indicators like inflation, interest rate and exchange rate, with resultant effect on the overall economy. Also, Ho and Saadaoui (2020) reported empirical results from Vietnam that when the exchange rate shock is symmetric, the money demand increases by 3.7 percent in the long term; when the shock is asymmetric, there was an increase of 15.6 percent in the money demand; and for a permanent nominal depreciation of one percent, there was a decrease of 7.4 percent in the money demand.…”

“…Monetary policy actions undertaken by central banks prompt instant effect on money supply which is often the intermediate target in developing countries (Zehra et al, 2020). This ultimately leads to enhanced credit availability which would spur funding to the real sector such as agriculture and increase productivity.…”

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