Equilibrium Exchange Rate and Misalignment: A Case Study of Pakistan

There have been a lot of studies conducted on exchange rate around the globe as well as in Pakistan. But still various areas of exchange rate remain needed to be disclosed in academia. However, this study aims to investigate the long run relationship among real effective exchange rate (REER) and its macroeconomic fundamentals for Pakistan against its main trading partner USA, UK and Japan. The key macroeconomics fundamentals of exchange rate includes interest differential, term of trade, trade openness, relative price of non-tradable to tradable, government consumption and foreign exchange reserves. Along with these variables this study also includes another important variable in analysis to assess the impact of democratic effectiveness on exchange rate in Pakistan. In this regards, two different models are estimated based on behavioral equilibrium exchange rate (BEER) approach developed by (Clark and MacDonald, 1998). The Johansen cointegration approach and Vector error correction (VECM) model is also utilized to estimate the parameters of long run cointegration equation. This study found a long run relationship among REER and its fundamentals variables and indicate a significant impact of democratic effectiveness on REER in Pakistan. Moreover to bridge the research gap, this study has also calculated misalignment of REER from its equilibrium level for the period of 1975 to 2017. The level of misalignments varies from 17% to 48%, which can be categorized as large deviation from equilibrium exchange rate. Supervisor:- Dr. HASSAN MUHAMMAD MOHSIN

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Keywords : Behavioral Equilibrium Exchange Rate (BEER), Johansen cointegration, Real Effective Exchange Rate (REER), Vector Error Correction model (VECM)
Supervisor: Hassan Muhammad Mohsin

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