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

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  • qayyum, Abdul
  • Khan, Arshad
  • Zaman, Kair-u

Abstract

In this study we have tested the validity of purchasing power parity hypothesis and exchange rate misalignment for Pakistan over the period 1982Q2-2002Q4. From the empirical analysis we can say that nominal exchange rate is cointegrated with WPI ratio. The cointegration coefficient between nominal exchange rate and the WPI-based price ratio is close to one. Furthermore, the coefficient restrictions are tested using maximum likelihood ratio statistic, lend support for the validity of the long-run PPP. Pakistan has been pursuing trade and exchange rate liberalisation policies from the late 1980s. Through these reforms, Pakistan has successfully eliminated most price controls and liberalised trade. These trade and exchange liberalisation policies allowed the law of one price to work more efficiently as shown by the supportive evidence of PPP. Moreover, the short-run deviation from PPP has frequently occurred, but the long-run validity of absolute PPP could not be rejected. The adjustment coefficient is negative and significant. However, the size of this coefficient is small indicating that the speed of adjustment is very slow. Even though long-run PPP holds, the speed of adjustment is rather slow, implying that misalignment is eliminated in the absence of shocks but only after a substantial period of time. The exchange rate remained undervalued vis-à-vis US dollar since the adoption of managed floating exchange rate system. Finally, the predictive power of these findings implies that exchange rate misalignment relative to PPP would eventually be corrected through commensurate movements in nominal exchange rates.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 2148.

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Date of creation: 2004
Date of revision: 2004
Publication status: Published in The Pakistan Development Review 4.43(2004): pp. 721-735
Handle: RePEc:pra:mprapa:2148

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Keywords: Exchange Rate Misalignment; Purchasing Power Parity; Pakistan;

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References

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  1. John Williamson, 1994. "Estimating Equilibrium Exchange Rates," Peterson Institute Press: All Books, Peterson Institute for International Economics, number 17.
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Cited by:
  1. Khan, Muhammad Arshad & Qayyum, Abdul, 2007. "Exchange Rate Determination In Pakistan: Evidence Based On Purchasing Power Parity Theory," MPRA Paper 6754, University Library of Munich, Germany.
  2. Shehu Usman Rano, Aliyu, 2008. "Real Exchange Rate Misalignment: An Application of Behavioral Equilibrium Exchange Rate (BEER) to Nigeria," MPRA Paper 10343, University Library of Munich, Germany.

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