Determinants of Exchange Rate in Pakistan: Revisited with Structural Break Testing

Abstract

This study examines the determinants of exchange rate in Pakistan by using the time-series data from 1972 to 2013. The results of the autoregressive distributed lag bound testing co-integration approach, the Johansen and Juselius co-integration approach and the Gregory and Hansen structural break co-integration approach confirm the significant long-run relationship between a few considered variables. The estimations of the long run indicate a significant negative association of exchange rates with terms of trade, trade openness and economic growth. However, money supply and inflation rate have a positive and significant effect on exchange rates. The outcomes of the error correction model suggest the negative and significant relationship of the terms of trade and trade openness on exchange rates of Pakistan in the short run. However, all other variables are found insignificant in the short run. The Granger causality test confirms the presence of a bidirectional causal relationship of the exchange rate with economics growth and trade openness in Pakistan. However, the inflation, money supply and terms of trade possess the unidirectional causality which runs from the explanatory variable to the exchange rate of the country. The present study may guide policymakers in formulating conclusive monetary and fiscal policies to ascertain the less volatile and productive exchange rate for Pakistan to attain sustainable economic growth for a long span of time.