Exchange Rate Volatility in Pakistan and Its Impact on Selected Macro Economic Variables (1980-2014)

Abstract

Among the developing countries, Pakistan experienced a unique downward trend in rupee value and frequent transitions in the exchange rate systems. These distinctive features make Pakistan economy an interesting case study for the empirical examination of the rupee exchange rate and its role in the monetary policy and macroeconomic performance. The purpose of the present study is to find out which of the macroeconomic indicators has led the Pak-rupee exchange rate volatility during the study period. Furthermore, the effect of the exchange rate volatility on foreign exchange reserves and selected macroeconomic variables has also been studied in the framework of a regression approach. Time series annual data covering the period of 1980 to 2014 has been used for the empirical analysis. Augmented Dickey Fuller test has been used for checking the unit root in the data. Ordinary Least Squares method is used for the estimation of regression equations. For avoiding the problems of spurious relationship between the variables and series implications for the standard errors, various diagnostic tests have been applied. Initially study has taken exchange rate as dependent variable and some selected macroeconomic variables as independent variables. The result show that exchange rate has negative relationship with the variables such as inflation (INF), foreign direct investment (FDI), imports (IMP) and positive with GDP per capita (PCGDP) and exports (X), which is also supported by the theory and results. As there is two-way relationship between exchange rate and several macroeconomic variables, some selected macroeconomic variables are taken as dependent variables and exchange rate as independent variable. The results show that exchange rate volatility has negative impact on foreign exchange reserves (FOREX), and imports (IMP) and positive on GDP per capita (PCGDP) and exports (X). On the basis of the findings, it has been recommended that foreign factors in addition to the domestic factors should also be taken into account for the stability of exchange rate. Moreover, instead of targeting the monetary aggregates, the State Bank of Pakistan should follow a rule based monetary policy where exchange rate fluctuations should also be taken into account. Moreover, instead of devaluations of rupee for increasing exports, the government is required to follow import substitution policies. Furthermore, to increase the inflow of foreign exchange reserves in the country, the development of export sector of the country can play an important role.