The Effect of Exchange Rate, its Volatility and Financial Development on Private Consumption: A Case Study of Pakistan, India and China
Author: Nasib Jan

Consumption is one of the key determinants of aggregate demand. Hence, its behavior affects business cycle, employment, long-term economic growth and major macroeconomic policy decisions. Due to its significant contribution to the total economy, literature extensively discusses the determinants of consumption. The main determinants of consumption, which are frequently quoted in the empirical literature, are the disposable income and interest rate. However, recent literature also added exchange rate, volatility in exchange rate and financial development as determinants of consumption. There are few studies exist, which discuss the effect of those selected variables on private consumption by considering developed and developing countries other than Asian countries. In this study, we focus on three Asian emerging economies Pakistan, India, and China by applying yearly data for the period of 1975-2016. The present study use bound testing approach of cointegration along with error correction mechanism developed within ARDL model framework, which captures both short-run and long-run relationship simultaneously. The result confirms the presence of a long-run relationship between consumption and selected variables in all three cases. Moreover, volatility in REER for each year is measured as the standard deviation of 12 monthly REER within that year. The result confirms the positive and significance long-run relationship between exchange rate and consumption, implying that currency depreciation will shrink consumption in all three cases. On the other hand, volatility in exchange rate interestingly has a positive and significant influence on private consumption in long-run in all three cases, except India where the long-run impact is positive but insignificant, this suggests that currency depreciation induce consumer to consume more today to avoid future inflation or price uncertainty. In contrast to theory, the effect of financial development on private consumption is negative in case of Pakistan and India. However, in case of China, the effect is positive and significant. One striking reason for such negative relationship in case of Pakistan and India could be that both countries have lower credit to GDP ratio, which is far below the threshold level (60% of GDP). Based on these findings, this study suggests that banks and other financial institutions should increase loans mainly to those who have borrowing constraint i.e. small and medium-size enterprises, housing sector especially the low-income families, agriculture sector, and export sector. Furthermore, currency depreciation, which hurt domestic consumer through inflationary effect. Therefore, policy should be made to keep exchange rate stable, especially the active intervention of central banks is more desirable to avoid depreciation. Supervisor:- Dr. Saud Ahmad Khan

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Supervisor: Saud Ahmed Khan

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