Nexus Between Real Exchange Rate Misalignment and Economic Growth:  A Case of Pakistan

Muhammad Asad Ali ,Muhammad Aqil

doi:10.52633/jemi.v4i1.171

Abstract

This study investigates the nexus between real effective exchange rate (REER) misalignment and the economic growth of Pakistan. It relies on a single equation model for estimating equilibrium exchange rate using the autoregressive distributive lags (ARDL) approach. The study further uses the growth equation to explore the effects of misalignment of RER on growth proxies. The data were obtained from the official websites of the World development indicator, IMF, Penn World Table, Pakistan Bureau of Statistics, and Ministry of Finance Pakistan. In terms of trade, the data was available on three different bases in different editions of the economic survey of Pakistan. All unit values of imports and exports were changed as per new base 1991 so that the data from editions of survey becomes uniform. The study takes data from 1970 to 2020. The study findings show that gross capital formation, trade openness, and government spending have a substantial role in defining the equilibrium REER. The findings also identify a positive and significant effect of REER misalignment on the economic growth of Pakistan. This paper contributes by measuring the degree of misalignment of real exchange rates using the single equation approach which is rare in the case of Pakistani literature. The single equation approach not only measures the misalignment by PPP factor but also considers basic economic fundamentals such as trade openness, terms of trade, productivity differentials etc. The study further provides evidence of misalignment with economic growth over a longer period (1970-2020). The findings suggest the effective use of exchange rate policy to control exchange rate misalignment to get higher and more sustainable economic growth. The study is useful for policymakers in the long-term economic planning of Pakistan. The results can be generalized for other economies with similar features.

Highlights

Earlier in the 16th to 18th centuries, an ideology existed in the Western countries called Mercantilism economic thought
If the cyclic and speculative factors are removed and there exists the natural rate of unemployment, the rate determined at that level is called the Natural Real Exchange Rate (NATREX) (Stein, 1994)
A vast amount of literature can be found on economic growth and on determinants of the exchange rate, but a little number of studies can be seen on the effect of real exchange rate on economic growth

Summary

INTRODUCTION

Earlier in the 16th to 18th centuries, an ideology existed in the Western countries called Mercantilism economic thought. The BEER approach considers the cyclic and impermanent changes in the exchange rate and attempts elucidating its behavior It takes into account some unemployment levels of essential factors of real exchange rates. It is more robust than the FEER approach. If the cyclic and speculative factors are removed and there exists the natural rate of unemployment, the rate determined at that level is called the Natural Real Exchange Rate (NATREX) (Stein, 1994) This approach relies on the standard national income equation, the addition of capital stock and debt changes, and convergence to a long-run static rate (Siregar, 2011). Where βi represents the trade weights of each currency in foreign trade which is computed by taking the percentage of total trade with the specific country, i as a percentage of total trade (sum of imports and exports X + M), E is the nominal exchange rate, P∗ is the price level of a foreign country and P is the domestic price level

LITERATURE REVIEW

METHODOLOGY

Findings

CONCLUSION AND RECOMMENDATIONS