The Dynamics of Current Account Imbalances in Pakistan

Abstract

This paper examines the dynamics of current account imbalances in Pakistan. Following the small open economy general equilibrium model of Obstfeld and Rogoff (2005), and adding few variations in model, we investigate the impact of external shocks induced changes in current account on the real exchange rate, inflation rate and outputs of tradable and non-tradable sectors in the small open economy. Using generalized method of moments (GMM) strategy, this study suggests three main findings: first, there are low elasticities of substitution between tradable and nontradable goods, and presence of home bias for the small open economy of Pakistan. Second, external shocks that change the current account position affect the relative prices of domestic nontradable have large impacts on inflation rate, real exchange rate, and on both sectors outputs, third, it changes the international relative prices and put massive pressures on real exchange rate only. Overall, external economic shocks lead to significant variations in economic activity in Pakistan.