Analysis if the factors affecting exchange rate variability in Pakistan

Abstract

The Paper examines/analyzed the factors contributing exchange rate vitality in Pakistan. The study was conducted on some major factors contributing to exchange rate volatility, and their relative importance. Annual data for the period 1975-2010 is used, taken from Economic Survey of Pakistan (various issues) and International Financial Statistics. The main variables used to check variability are inflation, Growth rate, imports and exports on exchange rate volatility. Simple Linear Regression model with ordinary least method (OLS) is used to analyze the results. The study revealed that inflation is the main factor affecting exchange rate in Pakistan. The study further show that the second important variable which bring more variation in exchange rate is economic growth, while order of export and import in variation lies at third and fourth position. Based on the finding of the study it is recommended to harmonize fiscal policies with monetary policy first and then make effective link of both these policies with trade policy. For most of the twentieth century, exchange rates have been fixed by government action rather than determined in the marketplace. Before World War I the values of the world's major currencies were fixed in terms of gold, while for a generation after World War II the values of most currencies were fixed in terms of the U.S. dollar. However, some of the world's most important exchange rates change frequently. Equilibrium in exchange rate is determined in the foreign exchange market at a point where demand for and supply of foreign currency equates. Demand for a currency comes from net export while supply of the currency comes from net foreign investment. Any change in demand for and supply of currency effect its value just like a good market that is if demand for a currency increases its value (exchange rate) will be increased while increase in supply of the currency will reduce its value(exchange rate) in the foreign exchange market. Pakistani rupee was linked with British Pound Sterling till 1970 but in 1971 it was linked with US dollar because of the increasing influence of US in the region. Until 1982, The Pakistani Rupee was pegged to the US Dollar. The currency depreciated by 38.5% from 1982-1988, when the government of General Zia-Ul-Haq convert it to Managed float, and again depreciated as a result of bad relationship with donors agencies and trade partners due to nuclear test in 1998. The empirical studies relating to the link between exchange rate variability and its factors are not conclusive. Exchange rates are basically the prices of one currency in terms of other currencies driven by the normal forces of supply and demand. There are a fixed number of Euros, Dollars, Yen, etc issued at any given time (although governments can and do print extra money to buy other currencies and impact their currencies value). As the demand increases or decreases for any single currency, it drives the clearing price for that currency. Zada (2010) studied the factors affecting exchange rate of Pakistan for the period 1979 to 2008. The study used multiple regression model in which exchange rate was taken as dependent variable while Inflation, interest rate, Foreign exchange reserves, trade balance, money supply and Gross Domestic Product were the independent variables. The study showed that Inflation, interest rate and foreign