A Nexus between Devaluation and Inflation in Pakistan

Abstract

This study empirically analyzes the relationship between the devaluation of currency and inflation in Pakistan by using time series data from 2001 to 2018. Although the government in Pakistan adopted policies to stabilize prices and boost exports yet exchange rate depreciation is observed over the years coupled with an increase in inflation. The exchange rate is predominantly a key element of international trade because a country fails to meet the demand of its population through endowed natural resources in a close economy that they have. So, they depend on other markets for the fulfillment of their demand. Eventually, exchange rate and inflation are the main determinants of macroeconomic evaluation in a country. This research work examines the relationship between the devaluation of currency and inflation in Pakistan over the period from 2001 to 2018, with the application of the cointegration test, VECM model, and correlation analysis. In an econometric model Inflation (INF) is taken as a dependent variable and exchange rate (used as a proxy for currency devaluation EXC), gross domestic product (GDP), and money supply (MS) are independent variables in the study. The role of the central bank in this domain has always been crucial. Central Bank takes action to stabilize the currency in the country which sometimes is observed in inflationary pressure. The study employed a stationary test and the variables are found stationary at the second difference. The cointegration test describes that there is a long-run relationship between inflation and devaluation of the currency. The correlation coefficient reveals a negative correlation between inflation and currency devaluation. This study recommends that government should float feasible policies parallel to the exchange rate (currency depreciation/devaluation of PKR) to tackle the persistent rise in the inflation rate.