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Exchange Rate and Inflation Dynamics

Author

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  • Eatzaz Ahmad

    (Department of Economics, Quaid-i-Azam University, Islamabad.)

  • Saima Ahmed Ali

    (Department of Economics, Quaid-i-Azam University, Islamabad.)

Abstract

This paper studies simultaneous determination of nominal exchange rate and domestic price level in Pakistan. The estimated model contains sufficient built-in dynamics to trace the pattern and speed of adjustment in the two variables in response to temporary or permanent shocks. The two domestic shocks considered in the paper are monetary and real shocks, while the three external shocks considered are import price, export price and foreign exchange reserves shocks. The study finds that the impact period effects of temporary shock on price level and exchange rate are divergent, while the long run effects are convergent. This means that, while purchasing power parity does not hold in the short run, there is a tendency in the system to regain relative parity in the long run. Further more continuation of shocks can produce a persistent but non-accelerating divergence between inflation rate and the rate of devaluation. Therefore the parity holds in a weaker sense, that is for the marginal fluctuations in the rates of changes in price level and exchange rate over time. It is also observed that the direction of temporary disparity between the rates of inflation and devaluation depends crucially on the origin of the shock. The shocks with direct effect on price level (exchange rate) have more pronounced effects on the rate of inflation (devaluation). Finally, the relationship between price level and exchange rate is not unidirectional, though the short run effect of devaluation on inflation is smaller than the effect of inflation on devaluation. Since movements in exchange rate are mostly driven by price inflation, the practice of using exchange rate as an independent instrument is not sustainable in the presence of inflation. From policy perspective both the inflation and exchange rate could be considered as interrelated targets while focusing on the instruments that are in effective control of policy-makers, such as money supply.

Suggested Citation

  • Eatzaz Ahmad & Saima Ahmed Ali, 1999. "Exchange Rate and Inflation Dynamics," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 38(3), pages 235-251.
  • Handle: RePEc:pid:journl:v:38:y:1999:i:3:p:235-251
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    File URL: http://www.pide.org.pk/pdf/PDR/1999/Volume3/235-251.pdf
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    References listed on IDEAS

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    1. Kormendi, Roger C & Meguire, Philip G, 1984. "Cross-Regime Evidence of Macroeconomic Rationality," Journal of Political Economy, University of Chicago Press, vol. 92(5), pages 875-908, October.
    2. Faiz Bilquees, 1988. "Inflation in Pakistan: Empirical Evidence on the Monetarist and Structuralist Hypotheses," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 27(2), pages 109-129.
    3. John Cooper, 1994. "Purchasing power parity: a cointegration analysis of the Australian, New Zealand and Singaporean currencies," Applied Economics Letters, Taylor & Francis Journals, vol. 1(10), pages 167-171.
    4. Rehana Siddiqui & Usman Afridi & Zafar Mahmood, 1996. "Exchange Rate Determination in Pakistan: A Simultaneous Equation Model," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 35(4), pages 683-692.
    5. Nadeem A. Burney & Naeem Akhtar, 1992. "Government Budget Deficits and Exchange Rate Determination: Evidence from Pakistan," The Pakistan Development Review, Pakistan Institute of Development Economics, vol. 31(4), pages 871-882.
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    Citations

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    Cited by:

    1. Benhabib, Jess & Eusepi, Stefano, 2005. "The design of monetary and fiscal policy: A global perspective," Journal of Economic Theory, Elsevier, vol. 123(1), pages 40-73, July.
    2. Kiran Ijaz & Muhammad Zakaria & Bashir A. Fida, 2014. "Terms-of-Trade Volatility and Inflation in Pakistan," Lahore Journal of Economics, Department of Economics, The Lahore School of Economics, vol. 19(1), pages 111-132, Jan-June.
    3. Zulfiqar Hyder & Sardar Shah, 2004. "Exchange Rate Pass-Through to Domestic Prices in Pakistan," SBP Working Paper Series 05, State Bank of Pakistan, Research Department.
    4. Niemann, Stefan & Pichler, Paul & Sorger, Gerhard, 2013. "Public debt, discretionary policy, and inflation persistence," Journal of Economic Dynamics and Control, Elsevier, vol. 37(6), pages 1097-1109.
    5. Zulfiqar Hyder & Muhammad Mazhar Khan, 2007. "Monetary Conditions Index for Pakistan," SBP Research Bulletin, State Bank of Pakistan, Research Department, vol. 3, pages 165-190.
    6. Lu, Yang K. & King, Robert G. & Pasten, Ernesto, 2016. "Optimal reputation building in the New Keynesian model," Journal of Monetary Economics, Elsevier, vol. 84(C), pages 233-249.
    7. Khan, Imran, 2016. "Factors effecting exchange rate: a case of pakistan," MPRA Paper 75209, University Library of Munich, Germany.
    8. Khan, Safdar Ullah & Saqib, Omar Farooq, 2011. "Political instability and inflation in Pakistan," Journal of Asian Economics, Elsevier, vol. 22(6), pages 540-549.
    9. Laurent Baudry & Hervé Le Bihan & Patrick Sevestre & Sylvie Tarrieu, 2005. "La rigidité des prix en France : quelques enseignements des relevés de prix à la consommation," Économie et Statistique, Programme National Persée, vol. 386(1), pages 37-57.
    10. Bouakez, Hafedh & Cardia, Emanuela & Ruge-Murcia, Francisco, 2014. "Sectoral price rigidity and aggregate dynamics," European Economic Review, Elsevier, vol. 65(C), pages 1-22.
    11. repec:crs:ecosta:es386b is not listed on IDEAS
    12. Sikander Rahim, 2014. "What Does the Exchange Rate Do? A Status Symbol?," Lahore Journal of Economics, Department of Economics, The Lahore School of Economics, vol. 19(Special E), pages 35-60, September.
    13. S. Adnan & H.A.S. BUKHARI & Safdar Ullah KHAN, 2008. "Does Volatility In Government Borrowing Leads To Higher Inflation? Evidence From Pakistan," Journal of Applied Economic Sciences, Spiru Haret University, Faculty of Financial Management and Accounting Craiova, vol. 3(3(5)_Fall), pages 187-202.
    14. Abo-Zaid, Salem, 2015. "Optimal long-run inflation with occasionally binding financial constraints," European Economic Review, Elsevier, vol. 75(C), pages 18-42.
    15. Wang, Peng-fei & Wen, Yi, 2005. "Endogenous money or sticky prices?--comment on monetary non-neutrality and inflation dynamics," Journal of Economic Dynamics and Control, Elsevier, vol. 29(8), pages 1361-1383, August.
    16. Zhang, Fang, 2014. "Monetary policy for rationally inattentive economies with staggered price setting," Journal of Economic Dynamics and Control, Elsevier, vol. 38(C), pages 184-208.
    17. Ida, Daisuke, 2013. "The gain from commitment in a two-country economy with inflation persistence," Japan and the World Economy, Elsevier, vol. 27(C), pages 58-69.
    18. Ida, Daisuke, 2014. "Role of financial systems in a sticky price model," Journal of Economics and Business, Elsevier, vol. 72(C), pages 44-57.
    19. Garratt, Anthony & Lee, Kevin & Shields, Kalvinder, 2016. "Information rigidities and the news-adjusted output gap," Journal of Economic Dynamics and Control, Elsevier, vol. 70(C), pages 1-17.
    20. Massaro, Domenico, 2013. "Heterogeneous expectations in monetary DSGE models," Journal of Economic Dynamics and Control, Elsevier, vol. 37(3), pages 680-692.

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