Exchange Rate Misalignments and Volatility: Implication for Economic Activity and Prices in Pakistan

Abstract

Exchange rate policy is considered vital for correcting the macroeconomic imbalances. In Pakistan, it has been observed that historically, misaligned exchange rate not only created external imbalance but also intensified internal imbalance. Several studies have examined the relationship between exchange rates and macroeconomic variables. However, fluctuations and misalignment of exchange rates have been usually used separately in the literature, which might have provided biased results and inappropriate policy implications. In this study, we have used combinations of misalignment and fluctuations of the exchange rate along with its volatility (uncertainty) to examine the effects of the exchange rate on economic activity and prices. For the analysis, monthly data have been used covering the period from 1980 to 2020. Purchasing Power Parity (PPP) and Behavioral Equilibrium Exchange Rate (BEER) methods have been applied to estimate the equilibrium exchange rate, whereas, in BEER, the equilibrium exchange rate is estimated through the simple regression framework as well as in the Autoregressive Distributed Lag (ARDL) model. In the next step, the state of misalignment (overvaluation or undervaluation of exchange rate), estimated from these models, has been combined with the state of exchange rate fluctuations (appreciation or depreciation), which results in four scenarios with respect to fluctuations and misalignment. Finally, Generalized Autoregressive Conditional Heteroscedasticity (GARCH) has been used to estimate the exchange rate uncertainty. The effects of exchange rate and its volatility on economic activity and general price level have been estimated in the context of these four scenarios using linear as well as nonlinear ARDL models. The economic activity in the analysis, proxied by the quantum index of Large-Scale Manufacturing (LSM), has been used as the response variable, while the exchange rate, in the context of combinations of misalignment and fluctuations, has been used as an independent variable, along with the interest rate, the inflation rate, oil prices, trade openness, and exchange rate volatility as control variables. The list of control variables has been altered by including money supply, fiscal deficit and aggregate income, while excluding the inflation rate in the model with the general price level, proxied by consumer price index, as response variable. It has been found that both fluctuations in the exchange rate as well as misalignment of the exchange rate, when considered separately, negatively affect economic activity and general price level. However, the results of conventional Nonlinear ARDL (NARDL) show that appreciation has a negative effect, while deprecation has a positive effect on economic activity. Moreover, the results show that the exchange rate fluctuations have a positive effect on the economic activity when such fluctuations make exchange rates converge to the equilibrium level; in case of divergence the effect has been found negative. The results further show that real appreciation has a positive effect, while real deprecation has a negative effect on the prices. Moreover, it has been found that the exchange rate has a negative (positive) effect on prices when its fluctuations result in convergence (divergence) towards equilibrium exchange rate. From our analysis, we conclude that currency depreciation or appreciation is not entirely harmful. Rather, the effects of fluctuations in exchange rate depend on whether or not such fluctuations move the exchange rate towards its equilibrium value. Thus, the findings implicate that the central banks’ intervention in foreign exchange market, directly or indirectly through changing interest rate, is justified only if the exchange rate is getting away from its equilibrium value.