In this study an attempt has been made to examine the long-run relationship between Pakrupee vis-à-vis US-dollar bilateral exchange rate, relative money supplies, real income, nominal interest rates, and real exchange rate over the period 1982Q2 to 2005Q4. Attention has been focused on highlighting the theoretical aspect of the monetary model of exchange rate determination, reviewing the existing literature, testing the international parity conditions and examining the validity of the monetary model of exchange rate for Pakistan. The conclusions emerging from the survey of the literature shows that the idea about the monetary exchange rate approach is an unsettled issue at least at the empirical level. The analysis focuses on four issues. First, we test the assumptions underlying the monetary approach to exchange rate determination. We find supportive evidence for the validity of purchasing power parity (PPP), but not for uncovered interest parity (UIP) for the period 1982Q2-2005Q4. However, for the period 1991Q1-2005Q4 we find supportive evidence for UIP. Second, we attempt to analyze the validity of monetary approach to exchange rate determination in Pakistan. To this end, the standard monetary model of exchange rate and modified monetary model of exchange rate determination augmented by the relative real prices ratio of traded to nontraded goods have been tested using cointegration and vector error-correction modelling techniques to discern the relationship between Pak-rupee/US-dollar exchange rates. The results show the presence of cointegration between exchange rate, monetary fundamentals and relative real prices. This implies that monetary fundamentals and real factors play a significant role in determining the exchange rate over the period under consideration. Based on the cointegration tests, we identified two cointegrating vectors for both monetary models of exchange rate. After imposing overidentifying restrictions we have identified the first cointegrating vector as a representative of exchange rate equation while the second cointegrating vector represents international inflation rate differential equation for each model. Third, weak exogeneity test is implemented. The results of weak exogeneity test suggest that relative money supplies, interest rate differential and relative real prices are weakly exogenous, while nominal exchange rate, relative real income and inflation rate differential are appear to be endogenous. Hence we construct simultaneous equation systems model that incorporates the long-run equilibrium relationships and complex short-run dynamics. To check the accuracy of the parameters, a number of recursive tests have been implemented. The results of the error-correction models show that monetary fundamentals are still important in determining the exchange rate dynamics. Forth, to examine the impact of free floating exchange rate regime and financial sector reforms, we have estimated Groen (2002)-type monetary exchange rate model for the period 2000Q4-2005Q4. The results appear to be highly consistent with the predictions of monetary model of exchange rate and short-run behaviour of monetary fundamentals is highly responsive as compared to the standard and modified monetary exchange rate models. Based on the empirical findings, we derived three main conclusions: the monetary approach to exchange rate is still a valid representation in the determination of long-run exchange rates behaviour; and the restrictions based on the weak exogeneity test are in general valid and help to estimate the complex short-run dynamics in the exchange rate determination process in Pakistan. Second, besides the monetary factors, real factors play a significant and dominant role in the determination of exchange rate in Pakistan. Third, active pursuit of trade and financial liberalization policies are useful in maintaining exchange rate stability. Therefore, we may suggest that a prudent, proactive and simultaneous pursuit of monetary, fiscal and commercial policies is a pre-requisite for maintaining the stability in exchange rate in the long-run in Pakistan. Supervisor:-Dr. Abdul Qayyum Registrar PIDE, Islamabad Co-supervisor: Dr. Fazal Hussain Head Department of Business Administration PIDE, Islamabad.