The Effect of Oil Prices and Regime Switches On Real Effective Exchange Rate in Pakistan: A Markov Regime Switching Approach

Abstract

Abstract. This study takes into the account relationship between oil prices and real effective exchange rate by using different exchange rate regimes in Pakistan. In this study following (Meese & Rogoff, 1988) and (Throop,1993) Interest Rate Parity has been used to construct a model by using real effective exchange rate, Dubai crude oil price and interest rate differential from period of 1970m01 to 2014m03. Through examining the results all variables are found to be integrated of order one. The long run relationship has been examined between real effective exchange rate and Dubai crude oil price in case of all exchange rate regimes with the use of regime dummies and interaction terms except for no regime, two-tier exchange rate regime and unified exchange rate regime. Similarly between real effective exchange rate and interest rate differential long run relationship has been examined in all the exchange rate regimes. Long run and dynamic result has also been detected except for interest rate differential with the use of exogenous exchange rate regime dummies. Oil price impacting exchange rate positively in both long and short run, while interest rate differential negatively effects exchange rate in long run. Through examining the results for impact of exchange rate regime switching on exchange rate, during 1970-2000 structural shifts were causing the change in exchange rate regimes with depreciation being high during this period. Keywords. Interest rate parity, Exchange rate regime, Regime switching, Structural shift and Dubai crude oil price. JEL. E42, E43, F31.