Exchange Rate Misalignment in Pakistan: Evidence from Purchasing Power Parity Theory

This paper examines the validity of the purchasing power parity to evaluate whether the Pakrupee vis-à-vis the US-dollar has been overvalued since the introduction of managed floating exchange rate. The Johansen multivariate cointegration technique is applied for the period 1982Q2-2002Q4. A single cointegrating vector is identified whose coefficients conform in broad terms to the restriction implied by the PPP theory, lending support to the interpretation of the model as describing a long-run relationship. This support is reinforced by the results derived from the adjustment coefficient, which is identifies clear short-run tendency for the exchange rate to revert to the equilibrium value defined by the estimated long-run model. Furthermore, exchange rate misalignment is also calculated using the estimated long-run relationship to evaluate whether the Pak-rupee vis-à-vis the US-dollar was undervalued or overvalued since the inception of managed floating exchange rate system. Calculated misalignment shows a substantial undervaluation of the Pak-rupee vis-à-vis the US dollar.Exchange Rate, Pakistan

Exchange Rate Misalignment in Pakistan: Evidence from Purchasing Power Parity Theory

Exchange rate provides a key link between the domestic and world markets for goods and assets. Therefore, a proper and detailed analysis of the behaviour of exchange rate is required. There is also growing agreement that prolonged and substantial exchange rate misalignment can create severe macroeconomic disequilibria and the correction of external balance will require both exchange rate devaluation and demand management policies. Thus the policy-makers have used PPP theory as a guide to represent the external competitiveness of a country, and as a benchmark against which floating exchange rates are judged to be misaligned. Developments in 1990s and 2000s show that cost associated with exchange rate misalignment is very high. Hence, the analysis of exchange rate determination in the presence of exchange rate misalignment is crucial for the policy purpose because of its role as a component of an early warning system [Berg, et al. (2000)]