4/15/2017 Relationship Between Exchange Rate and Inflation in Pakistan ­ Economics

economics.fundamentalퟠ�nance.com Custom Search
Search

  Relationship Between Exchange Rate and Inퟥ�ation in Pakistan

Home
Accounting The Relationship Between Exchange Rate and Inퟥ�ation
Economics in Pakistan
Economics Articles
Economic Data by Shagufta Kashif
Economics Glossary
Macroeconomics Abstract
Economic Indicators
Fiscal Policy
There has been a long-standing interest in studying the factors that are responsible for
uneven vacillation in the stable growth of the world economies. Lots and lots of
Microeconomics theoretical literature and empirical evidences have addresses this issue in the past. Hike
Comparative Advantage in prices of goods and services and foreign exchange are two important aspects which
The Supply Curve are deemed responsible for such potholed ퟥ�uctuations in the economic growth
Price Elasticity
The volatility of the nature of prices is a major source of concern in all countries since
Fixed & Variable Cost 1970s. The issue is of a more serious nature in the developing countries where inퟥ�ation
ATC & Marginal Cost in foreign countries known as �imported inퟥ�ation� is seen to be driving
Marginal Revenue �local/domestic inퟥ�ation�; making domestic policies to control inퟥ�ation ineퟂ�ective.
Output Decision Similarly, in Pakistan, the domestic price level rose from the mid-1970s. The exchange
Price Floor rate started depreciating continuously from the early 1980s. Continuous devaluation of
currency and inퟥ�ation in the 1980s seems to suggest a correlation between the two
Price Ceiling
variables.
Negative Externalities
Positive Externalities The studies by Rana and Dowling (1983) suggest that foreign inퟥ�ation is the most
Price Gouging inퟥ�uencing factor in explaining the change in local price level in nine less-developed
countries of Asia during the period 1973-79. This study suggests that these countries
Sunk Costs
cannot exercise much control over domestic inퟥ�ation, however, the policies of their
Game Theory major trading partners (through exchange rate) had a signiퟠ�cant impact on their
Game Theory Introduction domestic prices. Cooper (1971) and Krugman and Taylor (1978) have also studies this
Nash Equilibrium relationship.
Extensive Form
This research paper will provide the empirical evidence regarding the relationships
Monopolies between foreign exchange reserves and inퟥ�ation, focusing on the period between
Monopolies 1993-2010. We will use the Ordinary Least Square model to determine the long run
The Sherman Act
relationship.
The Clayton Act Our empirical analysis does not support the results of Ahmad and Ali (1999) that a
Papers devaluation has a signiퟠ�cant impact on inퟥ�ation. We believe that their results diퟂ�er
Bootstrap Method from ours because they estimate a model that is based on some fairly restrictive
assumptions. For example, they believe there is a complete exchange pass-through to
The CAPM Model
import prices. This assumption is important for their results, but is not supported by
Euro Creation and Crisis recent theoretical models or empirical evidence.
FX and Inퟥ�ation in Pakistan
Poverty and Crime 1. Introduction
General Finance
Does devaluation lead to an increase in prices? This is a critical question that policy-
Mergers / Acquisitions makers in Pakistan have faced continuously over the past three decades or so, and
Money Market particularly since 1982, following the adoption of a ퟥ�exible exchange rate policy. In the
Options beginning of 1972, the exchange rate was ퟠ�ve Pakistani Rupee to one US Dollar. After
the devaluation in 1972 and a small revaluation in 1973, the exchange rate remained
Real Estate ퟠ�xed at about ten rupees per dollar till the end of 1981. In January 1982, the exchange
Retirement rate was allowed to ퟥ�uctuate, eventually, rising to a rate around eighty rupees per
Stocks dollar over the next two decades. This escalation involved a number of major
devaluations in rupee value. Such devaluations received huge attention and often raised
Other Personal Finance the concern that they would further contribute to already-rising inퟥ�ation. The concern
Opinions / Essays about inퟥ�ation is based on the popular view, which has sometimes been voiced by
Excel experts in policymaking circles, that consumer prices are notably aퟂ�ected by imported
goods prices, which increase speedily in response to a devaluation.
Links
In a study on this subject, Ahmad and Ali (1999) emphasized that the �recent empirical
work in Pakistan provides unswerving proof that the domestic price level responds
Share signiퟠ�cantly but gradually to exchange rate devaluation� (p. 237).
0 Inퟥ�ation is, by and large, associated with monetary expansion. The case of Pakistan is
not diퟂ�erent from other countries. As a matter of fact, rise in general price level can be
Contact Us mapped on growth of money supply. In most of the developing economies of the world,
elasticity of exchange rate is favoured on the ground that it depoliticises the problem of
Site Map devaluation and creates less disruption in the economy. In the empirical literature, the
exchange rate regimes are also linked to domestic prices, trade patterns and current
Disclaimer account balance. However, ��exchange rate depreciation for a less developed country

http://economics.fundamentalfinance.com/exchange­rate­and­inflation­in­pakistan.php 1/6
4/15/2017 Relationship Between Exchange Rate and Inflation in Pakistan ­ Economics
would be ineퟂ�ective as an adjustment mechanism to the extent that domestic inퟥ�ation
persists�� [Meier (1984)].

Another adverse impact may be that real exchange rate may remain stable but in some
cases lead to anti-export predisposition.

2. Literature Review

The theory of Purchasing Power Parity (PPP) emphasizes that �under free international
trade, perfect information and free ퟥ�oating exchange rate the prices of traded goods,
when expressed in a common currency, are equalised across two countries�. While at
the macro level the theory envisaged a clear-cut relationship between nominal
exchange rate and domestic and world price levels, there are more than one ways to
express the PPP equation.

The recent event of currency devaluation and price inퟥ�ation in Pakistan provides an
exciting case to focus on the above issues. A widespread observation is that the practice
of repeated currency devaluation is the main cause of inퟥ�ation in Pakistan. This would
mean that the general price level in Pakistan adjusts quickly to the traded goods prices.

In the light of this background, this paper aims to study this relationship of nominal
exchange rate and domestic price level with each other and with other economic
variables in a vigorous context of Pakistan. The price level and exchange rates are
determined concurrently in a model that contains suퟂ�cient built-in dynamics. The
recent empirical work in Pakistan provides unswerving evidence that the domestic price
level responds signiퟠ�cantly but steadily to exchange rate devaluation [Khan and Qassim
(1996)], Ahmed and Ram (1991); Hassan and Khan (1994); Bilquees (1988)].

In case of Pakistan the mid-1970�s was the most inퟥ�ationary time, with inퟥ�ation rates
averaging more than 15 percent annually. The oil price hike and nationalization of the
economy greatly generated inퟥ�ationary pressures of an unmatched nature.

Accommodating monetary expansion also played a greater role in invigorating inퟥ�ation

in the 1970�s (Jones and Khilji 1988). Currency devaluation and devastating ퟥ�oods,
aퟂ�ecting agriculture production, aggravated these pressures. The role of apathy
seemed manifest in this era as people do consider expected inퟥ�ation while making their
optimization decisions.

The trend of inퟥ�ation in Pakistan remained low, compared to the other developing
nations in 1980s and early 1990s. The annual average inퟥ�ation rate from 1980 to 1993
was 7.4 percent, appreciably below as compared with its South Asian neighbours. The
combination of improved performance of commodity (goods plus services) producing
sector, lower public expenditures and turnaround of the nationalization policy played
the vital role. In addition, the country has a very middle-of-the-road rate of increase in
money stock when compared internationally.

The State Bank has allowed the money supply to increase by only about 15 percent
annually between 1970 and 1993. The 1990�s has witnessed an end to the period of
low inퟥ�ation and the trend reversed towards accelerating inퟥ�ation. Given Pakistan�s
wide-ranging price stability during the earlier decades, the surge of prices in the
1990�s threatened to reduce the rates of return on ퟠ�nancial assets and created a
general climate of uncertainty. The whole sale price index (WPI) almost reached twenty
percent by the middle of the decade, with the consumer price index (CPI) not lagging far
behind. Compared to the historical level of single digits, the inퟥ�ation of the 1990�s
created a serious disturbance.

It was the period of liberalized policies, frequent changes of the governments,

inconsistency of the policies and of nuclear explosion. Increase in procurement prices of
wheat (Hassan et al. 1995), government borrowing, private sector borrowing, exchange
rate depreciation and adaptive expectations were the main factors behind this surge in
inퟥ�ation. In the era of 2001-08, the inퟥ�ation has shown a mixed trend. During 2001-04
inퟥ�ation remained low but CPI shot up in 2004-05 and it reached to 9.3 percent. It
dropped to 8 percent in 2005-06 but it again shoot up in 2006-08 and reached to its
historical high level. Non-government sector borrowing and rise in import prices may be
the factors behind it. In the long-run, certainly, the inퟥ�ation is considered to be�as
Friedman (1963) stated�always and everywhere a monetary phenomenon.

The causing factors of inퟥ�ation in Pakistan remained inconclusive in both ퟠ�scal and
monetary aspects. Heavily dependent on speciퟠ�cations, the varying econometric results
have yet to resolve the debate. Some of the empirical studies (see for instance, Bilquees
1988; Hassan et al. 1995) found that contrary to popular perceptions about the
contribution of monetary expansions and supply shocks to inퟥ�ation, it was the rise in
procurement prices and administered prices, as well as the increase in indirect taxes in
the 1994-5 budget, that explain the spiralling inퟥ�ation.

Information plays an important role to change the business scenario and it also change
the expectation of the people regarding market. Therefore foreign investors require
more return if risk is more to relative country. Such information is perceived from

http://economics.fundamentalfinance.com/exchange­rate­and­inflation­in­pakistan.php 2/6
4/15/2017 Relationship Between Exchange Rate and Inflation in Pakistan ­ Economics
diퟂ�erent macroeconomic variables. For example, information related uncovered
interest rate can change the exchange rate and risk premium between two countries
(Duartea and Stockman, 2005).

Macroeconomic variables can change the economic phenomenon as well as it leads to

change the exchange rate at domestic level. Nominal or real change in the interest rate
is the main important feature of the monetary policy and it reason to change the
exchange rate. In addition, the positive change in real or nominal interest at domestic
level can appreciate the exchange rate at domestic level and vice verse (Kim and
Roubini, 2000). However, information regarding macroeconomic variables can be
divided into two types whether it is strong or weak. But strong announcement of
macro-economic variables reason to appreciate the exchange rate.

Although in long run there is a co movement in interest and exchange rate and this
movement also leads to require the risk premium (Fausta et. al., 2007). Moreover, daily
intervention by central economic authority also set the exchange rate but the beneퟠ�t
can be achieved for short term not for long term (Dominguez, 2006). Subsequently,
economic news related macroeconomic variables like interest; inퟥ�ation and monetary
policy increase or decrease the value of the currency.

In addition, positive change in fundamental of the economy can appreciate the value of
currency while unexpected negative change in the economic variable leads to decrease
the value the domestic currency (Ehrmann and Fratzscher, 2005). Consequently,
variation in inퟥ�ation also changes the spot and forward exchange rate while it depends
upon direction of the inퟥ�ation of one country to other country. In addition, it is
observed positive change in exchange rate if direction of inퟥ�ation in two countries is
same but domestic inퟥ�ation remains low as compare to other country (Simpson et. al.,
2005).

However, macroeconomic variable and exchange rate are positively correlated but it
depends upon the time duration (Ray, 2008). Accordingly, inퟥ�ation and interest rate
both have negative relation with nominal exchange rate. However, expectation
regarding real exchange rate has positive relation with nominal exchange rate (Hsing,
2007). On the other hand, thereis a co movement between interest rate and exchange
rate and sensitivity depends upon the monetary structure of the relative country. The
country having strong monetary structure has low co movement between exchange
rate and interest rate (Holtemoller, 2005). The above literature denotes the importance
of interest rate and inퟥ�ation in the determining the exchange rate. The existing work
also investigates the relation of inퟥ�ation and interest with exchange rate. However, less
work is done on this issue related to Pakistani scenario and the robust work enhances
the knowledge at academic level as well as domestic level.

The monetary policy in Pakistan aims at stabilizing the domestic and external value of
the currency and to foster economic growth. Therefore, the exchange rate pass-through
to domestic wholesale and consumer prices is an important link in the process of
monetary policy transmission. Since Pakistan�s economy has a considerable degree of
openness to foreign trade, the domestic price level cannot remain immune to external
price shocks i.e. exchange rate depreciation/appreciation and changes in import prices.
Any appreciation or depreciation of the exchange rate will not only result in signiퟠ�cant
changes in the prices of imported ퟠ�nished goods but also imported inputs that aퟂ�ect
the cost of the ퟠ�nished goods and services.

Speciퟠ�cally, exchange rate movements can inퟥ�uence domestic prices through direct and
indirect channels (see Chart 1). In case of direct channel, exchange rate movements can
aퟂ�ect domestic prices through changes in the price of imported ퟠ�nished goods and
imported inputs. In general, when a currency depreciates it will result in higher import
prices while lower import prices result from appreciation in price taker countries like
Pakistan. The potentially higher costs of imported raw material and capital goods
associated with an exchange rate depreciation increase marginal costs and lead to
higher prices of domestically produced goods. In case of indirect eퟂ�ect, the exchange
rate depreciation aퟂ�ects the net exports which in turn inퟥ�uence the domestic prices
through the change in aggregate demand, putting upward pressure on domestic prices.
In addition, import-competing ퟠ�rms might increase prices in response to foreign
competitor price increases in order to maintain proퟠ�t margins. However, the extent and
the speed of exchange rate pass-through depends on several factors such as market
structure, pricing policies, general inퟥ�ationary environment, involvement of non-
tradable in the distribution of tradable, relative share of imports in WPI and CPI basket,
etc.

http://economics.fundamentalfinance.com/exchange­rate­and­inflation­in­pakistan.php 3/6
4/15/2017 Relationship Between Exchange Rate and Inflation in Pakistan ­ Economics

Eatzaz and Saima (1999) explore the relationship between nominal exchange rate and
domestic price level and also their relationship with other economic variables for
Pakistan by using quarterly data form 1982-II to 1996-IV. This paper traces the pattern
and speed of adjustment in the two variables in response to diퟂ�erent types of shocks.
Cointegration method is used for the model estimation, the ퟠ�ndings of the study
suggest that one percent increase in price level of import, whether due to exchange
rate devaluation or rising world prices, results in 0.15 percent increase in CPI.

3. Methodology

In order to ퟠ�nd the relationship between inퟥ�ation and exchange rate, a monthly data of
same variables are used from 1970-2009. In addition, on the basis of previous literature,
following hypothesis has been developed.

Hypothesis 1:
H0: There is no relationship between inퟥ�ation and exchange rate

The following equation shows the mathematical relation of dependant and

independent variable.
ER= α + β 1 (Inf) + μ i

This equation will be converted to double-log for the purpose of E-Views

Log (ER) = α + β 1 Log(Inf) + μ i

Where:
Ex. Rate= Exchange rate
Inf = Inퟥ�ation
μ i = Error Term

In contemporary study, inퟥ�ation in Pakistan is taken as an independent variable while

exchange rate of Pak Rupee to US Dollar is taken as a dependent variable. Inퟥ�ation is
taken from SBP which is a reliable source at domestic level. Moreover, exchange rate is
taken from (www.oanda.com). The correlation matrix is used to check the negative or
positive relation of independent variable with dependant variable. In addition, OLS
model is applied to check the signiퟠ�cance of the variable at individual and collective
level.

http://economics.fundamentalfinance.com/exchange­rate­and­inflation­in­pakistan.php 4/6
4/15/2017 Relationship Between Exchange Rate and Inflation in Pakistan ­ Economics

4. Results and Discussion

The analysis regarding descriptive statistics of exchange rate and inퟥ�ation is shown in
Table 1.

Coeퟂ�cient Std. Error t-Statistic Prob.

α 4.064220 0.288632 14.08100 0.0000
β 2 -0.059049 0.136605 -0.432258 0.6713

R-squared 0.011543 Mean dependent var 3.943818

Adjusted R-squared -0.050235 S.D. dependent var 0.313163
S.E. of regression 0.320932 Akaike info criterion 0.669267
Sum squared resid 1.647962 Schwarz criterion 0.768197
Log likelihood -4.023401 Durbin-Watson stat 0.085469

Table 1: Source: Results from E-Views

The results shown in the above Table reveals a strong negative relation between
inퟥ�ation and exchange rate. The overall model is explained by 1.1% based on total
observations. The inퟥ�ation diퟂ�erential has a negative coeퟂ�cient while the t-value
(-0.432) shows that individually inퟥ�ation doesn�t reason to change the exchange rate
along with insigniퟠ�cant pvalue (0.6713) which is greater than 0.05.

On behalf of above mentioned results, it can be said that inퟥ�ation is not the most
important tool to determine the exchange rate in the Pakistani market scenario if it is
compared with US currency Dollar. This means that if inퟥ�ation has increasing trend, then
it lead to a decrease in domestic exchange rate.

5. Conclusion

The main objective of this robust work is to ퟠ�nd the impact of inퟥ�ation on the exchange
rate. On behalf of a total of 17 year�s data from 1993 to 2010, following results are
found which accept the null hypothesis.

There is an insigniퟠ�cant and a negative relationship between inퟥ�ation and

exchange rate of US $ and Pakistani Rupee.

This suggests that the argument of imported inퟥ�ation may not be valid in case of
Pakistan, which means that there is no evidence of a signiퟠ�cant pass-through of rupee
depreciations to consumer prices in the short-run. This ퟠ�nding is consistent with recent
theoretical analysis that suggests that a weak short-run association between exchange
rate changes and inퟥ�ation.

It would appear, therefore, that concerns about the inퟥ�ationary consequences of

devaluation in Pakistan are somewhat misplaced. Stability of the nominal exchange rate
may be desirable for many reasons, but not because of fears that exchange rate
ퟥ�uctuations will impose an inퟥ�ationary cost on the economy. Furthermore, these
results are for one foreign currency i.e., Pak Rupee and US Dollar. The exchange rate
variation with respect to other major currencies can be diퟂ�erent.

Our empirical analysis does not support the results of Ahmad and Ali (1999) that a
devaluation has a signiퟠ�cant impact on inퟥ�ation. We believe that their results diퟂ�er
from ours because they estimate a model that is based on some fairly restrictive
assumptions. For example, they believe there is a complete exchange pass-through to
import prices. This assumption is important for their results, but is not supported by
recent theoretical models or empirical evidence.

Moreover, lead-lag relation between interest and exchange rate can also be looked into
further research.

References

1. Kim S. And Roubini N. (2000), Exchange rate anomalies in the industrial countries:
A solution with a structural VAR approach, Journal of Monitory Economics, Vol. 45,
pp 560-587
2. Rehman R, Rehman A, Raoof A., (2010), Causal Relationship between
Macroeconomic Variables and Exchange rate, International Research Journal of
Finance and Economics, Issue 46, (www.eurojournals.com/ퟠ�nance.htm)
3. Hyder Z., Shah S., (2004), Exchange Rate pass-through to domestic prices in
Pakistan, SBP Working papers, (www.sbp.org.pk)
4. Khan R., Gill A., (2010), Determinants of Inퟥ�ation: A Case of Pakistan (1970-2010),
SBP Working Papers
5. Khan A, Qasim M, (1996), Inퟥ�ation in Pakistan Revisited, Pak Dev Rev. 35,
(www.ccsenet.org/ijef)
6. Khan M., A Schimmelpfennig (2006), Inퟥ�ation in Pakistan: Money or Wheat, SBP
Res Bull

http://economics.fundamentalfinance.com/exchange­rate­and­inflation­in­pakistan.php 5/6
4/15/2017 Relationship Between Exchange Rate and Inflation in Pakistan ­ Economics
7. Chaudhry I. Et. Al., (2011), Foreign Exchange Reserves and Inퟥ�ation in Pakistan:
Evidence from ARDL Modelling Approach, International Journal of Economics and
Finance Vol. 3, No.1, (www.ccsenet.org/ijef)
8. Khan A, Bukhari K, Ahmed Q, (2007), Determinants of Recent Inퟥ�ation in Pakistan,
Research Report No. 66, (SPDC website)
9. Agha A, Khan S, (2006) An Empirical Analysis of Fiscal Imbalances and Inퟥ�ation in
Pakistan, SBP Research Bulletin, Volume 2, Number 2, (SBP Website)
10. Rehman M., Rehman R, (2002) Relationship of Exchange Rate with various Macro-
Economic Variables, (www.ccsenet.org/ijef)
11. Siddiqui R., Akhtar N., (1999) The Impact of Changes in Exchange Rate on prices: A
Case Study of Pakistan, The Pak Dev Rev 38: 4 Part 11, (PIDE Website)
12. Choudhry E, Khan M (2002), The Exchange rate and Consumer Prices in Pakistan: Is
Rupee Devaluation Inퟥ�ationary?, The Pak Dev Rev 41:2 (Summer 2002) (IMF
Website)
13. Ahmed E, Ali S, (1999), Exchange Rate and Inퟥ�ation Dynamics, The Pak Dev Rev 38:
3 (Autumn 1999( (PIDE Website)

Other sites in the eonor.com llc network:

Aircraft Videos | Hiking | Book Club | Marathons | Sci Fi Quotes including Ender's Game Quotes | Gardening

http://economics.fundamentalfinance.com/exchange­rate­and­inflation­in­pakistan.php 6/6