ABSTRACT

The study explores the extent to which coordination of monetary and fiscal policy has helped to reduce exchange rate volatility in Pakistan between 1980Q1–2024Q4, using quarterly macroeconomic data. Building on the Mundell–Fleming model and Dornbusch’s exchange rate overshooting theory, the paper examines the role of interest rates, money supply, government spending, inflation, and foreign shocks in driving exchange rate dynamics, particularly the inflationary pressures and low growth outcomes associated with policy misalignment. Employing a Vector Autoregressive (VAR) model, along with unit root tests, Johansen and Juselius’ cointegration analysis, and impulse response functions, the results show strong interdependencies: expansionary monetary policy fuels depreciation via liquidity expansion, while fiscal expansion initially strengthens the exchange rate but in the long run aggravates external imbalances. Coordination, modeled through a dummy variable, is found to stabilize inflation and output fluctuations, while U.S. interest rates emerge as key external shocks amplifying domestic vulnerabilities. The findings highlight that stability in Pakistan’s exchange rate requires more than institutional alignment of monetary and fiscal goals. Policy recommendations include strengthening institutional coordination through a joint SBP–fiscal authority committee; adopting a flexible and forward-looking monetary policy framework with inflation targeting; pursuing disciplined and counter-cyclical fiscal policy to ensure sustainability; reducing external vulnerabilities through export diversification, import management, and reserve accumulation; and addressing structural constraints by improving productivity, infrastructure, and energy supply. Further, the SBP should manage the exchange rate through a credible managed float regime with targeted interventions, while advancing macroeconomic data systems and econometric modeling capacity. Finally, expanding financial inclusion and reinforcing regulatory frameworks can improve monetary transmission, reduce cash dependence, and enhance stability. On balance, coordinated and comprehensive reforms rather than fragmented measures are crucial for exchange rate resilience, investor confidence, and sustainable long-term growth.