Exchange Rate and Inflation Dynamics

Abstract

This paper studies simultaneous determination of nominal exchange rate and domestic price level in Pakistan. The estimated model contains sufficient built-in dynamics to trace the pattern and speed of adjustment in the two variables in response to temporary or permanent shocks. The two domestic shocks considered in the paper are monetary and real shocks, while the three external shocks considered are import price, export price and foreign exchange reserves shocks. The study finds that the impact period effects of temporary shock on price level and exchange rate are divergent, while the long run effects are convergent. This means that, while purchasing power parity does not hold in the short run, there is a tendency in the system to regain relative parity in the long run. Further more continuation of shocks can produce a persistent but non-accelerating divergence between inflation rate and the rate of devaluation. Therefore the parity holds in a weaker sense that is for the marginal fluctuations in the rates of changes in price level and exchange rate over time. It is also observed that the direction of temporary disparity between the rates of inflation and devaluation depends crucially on the origin of the shock. The shocks with direct effect on price level (exchange rate) have more pronounced effects on the rate of inflation (devaluation). Finally, the relationship between price level and exchange rate is not unidirectional, though the short run effect of devaluation on inflation is smaller than the effect of inflation on devaluation. Since movements in exchange rate are mostly driven by price inflation, the practice of using exchange rate as an independent instrument is not sustainable in the presence of inflation. From policy perspective both the inflation and exchange rate could be considered as interrelated targets while focusing on the instruments that are in effective control of policy-makers, such as money supply.