Special Edition-07.pdf - Lahore School of Economics

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142 M. Ashraf Janjua Actual Vs Equilibrium Real Effective Exchnage Rates (1992=100) Actual REER EREER3 200.0 185.0 170.0 155.0 140.0 125.0 110.0 95.0 80.0 FY78 FY79 FY80 FY81 FY82 FY83 FY84 FY85 FY86 FY87 FY88 FY89 FY90 FY91 FY92 FY93 FY94 FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY02 FY03 FY04 FY05 FY06 FY07 FY08 FY09 FY10 The above long-term relationships can be used to compute the ERERs by evaluating these coefficients at sustainable values of macroeconomic fundamentals. The rationale of using sustainable economic fundamentals is to eliminate short run fluctuations in the explanatory variables and only use long-term equilibrium values of the variables. The Hodrick-Prescott (HP) filter is used to remove the short-term variations from the explanatory variables. The Figure (above) presents the actual REER and the ERER derived by evaluating the coefficients at the HP filter series of economic fundamentals. The estimated ERER reflects a divergence in both directions from the actual REER in the first part of the sample while the behavior of the actual REER remained close in the latter part of the sample. More specifically, the rupee remained overvalued from 1978 to 1980 relative to the ERER due to a lower price differential and real depreciation of the US dollar against the major currencies. During the period 1981-86, the trend of the actual REER and ERER reveals that the rupee remained undervalued due to the real appreciation of the US dollar against hard currencies. This figure also reflects that the actual REER appears to have been close to its estimated equilibrium REER during the last five years. However, the spread between the forecasts of the REER and ERER appears to have widened during the period up to 2010 mainly on account of real appreciation of the Pak rupee against trading partners and competitors currencies.
Pakistan’s External Trade: Does Exchange Rate Misalignment Matter for Pakistan? 143 Short-term dynamics of the REER are examined through the estimation of error correction models (ECMs) which show that some of the long-term fundamentals such as trop, capinf, and govc are statistically significant and affect the short-run dynamics of the real exchange rate in the same direction as the variables did in the case of the long run. The estimated regressions also satisfied the post-diagnostic tests such as of no autocorrelation, homoskedasticity, normality of the residuals and stability of parameters. As described in the economic literature, macroeconomics policies such as the exchange rate policy, fiscal policy and monetary policy may impact the REER in the short run. We investigated the impact of macroeconomic polices and found that excess domestic credit was insignificant while a rise in fiscal deficit as a percentage of GDP and depreciation of the nominal exchange rate (ndev) led to depreciation of the REER in the short run. Monetary policy is statistically insignificant in all the short-run regressions which may reinforce the established view that monetary policy in Pakistan was subservient to fiscal policy. Since monetary policy remained subservient to fiscal policy due to the heavy reliance of the government on financing the fiscal deficit from the banking system, the direct impact of monetary policy in the short term is statistically insignificant. The impact of net devaluation on the ERER turned out to be negative as expected which indicates that nominal devaluation/depreciation of the Pak Rupee against the US $ depreciates the REER. As the coefficient of the error correction term is negative and has absolute values smaller than one, this not only indicates the stability in the long-term ERER but also reflects the gradual convergence of the exchange rate towards long-run equilibrium.
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Special Edition ISSN 1811-5438 THE
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THE LAHORE JOURNAL OF ECONOMICS Con
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Monetary, Fiscal and Financial Sect
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Reforming the Government in Pakista
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Monetary and Fiscal Policies 45 sys
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11. All references used in the text
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The Lahore School of Economics The
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