The Political Economy of Exchange Rate Policy in Pakistan
The study provides the political economy analysis of the exchange rate policy of Pakistan. It maintains that exchange rate level, and the resulting misalignment, is mainly a political decision. Framing it exclusively in the context of economic factors, as standard practice in existing literature, can produce erroneous estimates and inefficient policy recommendations. We have extended Behavioral Equilibrium Exchange Rate (BEER) Model in two fold to assess exchange rate misalignment. First, we introduce political economy variables including central bank independence, election effect. Second, we use estimated value of economic fundamentals as the realized value of these fundamentals may not reflect the true state of respective economy. In our BEER model, we use estimated foreign reserves level to show that forex level build through public borrowing may underestimate the misalignment as it gives a higher equilibrium value of exchange rate. Results from BEER show that political economy factors are most significant predictors of exchange rate misalignment and associated misalignment of Real Effective Exchange Rate (REER) in Pakistan. We also find that election-day effect is evident in Pakistan and democratic regimes keep the rupee overvalued and resist devaluation especially prior to elections. We also provide evidence on persistence of alternative exchange rate regimes, overvaluation and undervaluation, in alternative political regimes, democratic and autocratic, using Markov Switching Model (MSM). Results from transition probabilities show that democratic regimes prefer overvaluation more as compared to autocratic regimes. Overvaluation has higher probability of persistence. In other words, transition from overvaluation to undervaluation regime is resisted atleast before elections. Supervisor:- Dr. Sajid Amin Javed Co- Supervisor:- Dr. Ahsan Ul Haq Satti
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