Impact of real and nominal factors on long run equilibrium in Real Effective Exchange Rate (REER) in Pakistan

Waheed, Muhammad (2009): Impact of real and nominal factors on long run equilibrium in Real Effective Exchange Rate (REER) in Pakistan.

Abstract

In this paper, we focused on the hypothesis that nominal shocks such as monetary policy have only temporary impact on long run equilibrium real exchange rate and the consequent misalignment. To do so we utilized two approaches to tackle this issue. The first approach to find out long run real exchange rate is through investigation a long run relation between real exchange rate and its theoretical determinants. The variables that have a long run relationship with the real exchange rate include the terms of trade, real interest rate differential, government spending, and tradable to nontradable ratio. We found that monetary shocks have little impact in long run. Second approach used was the structural vector autoregression by imposing long run restrictions in line with the Blanchard and Quah (1989). Again, this approach has confirmed above results that only real shocks have lasting effects on long run real exchange rate. Nominal shocks only influence the equilibrium exchange rate temporarily in short run. The consequent misalignments measured through two approaches are then compared and policy implications are drawn. Although moving in the similar direction, there magnitudes are different. One important implication for this result is that policy makers’ reliance on any one measure of to judge misalignment would be give inaccurate results.

• Item Type: MPRA Paper
• Language: English
• Keywords: REER, NEER, misalignment, equilibrium, Pakistan
• Subjects: F - International Economics > F4 - Macroeconomic Aspects of International Trade and Finance; O - Economic Development, Innovation, Technological Change, and Growth > O2 - Development Planning and Policy > O24 - Trade Policy ; Factor Movement Policy ; Foreign Exchange Policy

References

Afridi U. (1995). “Determining Real Exchange Rates.” Pakistan Development Review, 34: 263-276.

Baffes, J., Elbadawi A., and O’Connell A., (1999). “Single Equation Estimation of the Equilibrium Real Exchange Rate.” In L. Hinkle and P. Montiel (eds). Exchange Rate Misalignment, Concepts and Measurements for Developing Countries. : Oxford University Press.

Blanchard, O. J. and Quah, D. (1989). The Dynamic Effects of Aggregate Demand and Supply Disturbances. American Economic Review 79, 655-73.

Chishti, S. and Hasan M. (1995). “What Determines the Behavior of Real Exchange Rate in Pakistan.” Pakistan Development Review, 34: 1015-1029

Dornbusch, R. (1976). Expectations and Exchange Rate Dynamics. Journal of Political Economy 84, 1161-76.

Edwards, S. (1989). Real Exchange Rates, Devaluation and Adjustment: Exchange Rate Policy in Developing Countries. Massachusetts: MIT Press.

Edwards, S. (1994). “Real and Monetary Determinants of Real Exchange Rate Behavior: Theory and Evidence from Developing Countries.” In J. Williamson (eds.). Estimating Equilibrium Exchange Rates. Washington, D.C.: IIE. (Chapter 3)

Edwards, S. (1988). “Real and Monetary Determinants of Real Exchange Behavior: Theory and Evidence from Developing Countries.” Journal of Development Economics, 29: 311 – 341.

Edwards, S. (1988). Real and monetary determinants of real exchange rate behavior: Theory and evidence from developing countries. Journal of Development Economics 29, 311-341.

Edwards, S., (1988). Exchange rate misalignment in developing countries. Occasional Paper Number 2, New Series. Washington, D. C: The World Bank.

Elbadawi, I. (1994). “Estimating log run equilibrium real exchange rates” In J. Williamson (eds.). Estimating Equilibrium Exchange Rates. Washington, D.C.: IIE. (Chapter 4)

Elbadawi, I. A. and Soto, R. (1994). Capital flows and long-term equilibrium real exchange rates in Chile. The World Bank.

Elbadawi, I. A. and Soto, R. (1997). Real Exchange Rates and Macroeconomic Adjustment in Sub-Saharan Africa and Other Developing Countries. Journal of African Economies 6, 74-120.

Enders, W. and Lee, B.-S. (1997). Accounting for real and nominal exchange rate movements in the post-Bretton Woods period. Journal of International Money and Finance 16, 233-254.

Frenkel, J. A. (1981). The collapse of purchasing power parities during the 1970's. European Economic Review 16, 145-165.

Hakkio, C. S. (1984). A re-examination of purchasing power parity : A multi-country and multi-period study. Journal of International Economics 17, 265-277.

Hinkle, L. and Montiel P. (1999) (eds). Exchange Rate Misalignment, Concept and Measurement for Developing Countries. London: Oxford University Press.

Hoffmann, M. and MacDonald, R. (2001). A Real Differential View of Equilibrium Real Exchange Rate. Economics Division, School of Social Sciences, University of Southampton.

Ibrahim, A. E., Raimundo, S. and inv Real Exchange Rates and Macroeconomic Adjustment in Sub-Sahara Africa and Other Developing Countries. Ilades-Georgetown University, Economics Department.

Jose De, G. and Holger, C. W. (1994). Terms of Trade, Productivity, and the Real Exchange Rate. National Bureau of Economic Research, Inc.

Kenneth, R. (1996). The Purchasing Power Parity Puzzle. Journal of Economic Literature 34, 647-668.

Lastrapes, W. D. (1992). Sources of Fluctuations in Real and Nominal Exchange Rates. The Review of Economics and Statistics 74, 530-39.

Luca Antonio, R. and Ronald, M. PPP and the Balassa Samuelson Effect: The Role of the Distribution Sector. International Monetary Fund.

Mark, N. C. (1990). Real and nominal exchange rates in the long run: An empirical investigation. Journal of International Economics 28, 115-136.

Montiel, P. (1999). “Determinants of the Long-Run Equilibrium Real Exchange Rate: An Analytical Model.” In L.

Hinkle and P. Montiel (eds.). Exchange Rate Misalignment, Concepts and Measurements for Developing Countries. London: Oxford University Press.

Montiel, P. (2003). Macroeconomics in Emerging Markets. Cambridge: Cambridge University Press.

Montiel, P. (1997). “Exchange Rate Policy and Macroeconomic Management in ASEAN Countries.” In J. Hicklin et al. (eds.). Macroeconomic Issues Facing ASEAN Countries. Washington, D.C.: IMF.

Nilsson, K (2004), “Do Fundamentals Explain the Behaviour of the Swedish Real Effective Exchange Rate?” The Scandinavian Journal of Economics, Volume 106 (4), pp 603-622.

Peter, B. C. and Ronald, M. (1998). Exchange Rates and Economic Fundamentals - A Methodological Comparison of BEERs and FEERs. International Monetary Fund.

Richard, C. and Jordi, G. (1994). Sources of Real Exchange Rate Fluctuations: How Important are Nominal Shocks? : National Bureau of Economic Research, Inc.

Ronald, M. (1997). What Determines Real Exchange Rates? The Long and Short of It. International Monetary Fund.

Serven, L. and Solimano A. (1991). An empirical Macroeconomic model for Policy Design: The case of Chile. Research Policy Series No. 709, Washington DC, World Bank.

Siddiqui, R., Afridi U., and Mahmood Z. (1996). “Exchange Rate Determination in Pakistan: A Simultaneous Equation Model.” Pakistan Development Review, 35: 683-692

Tatsuyoshi, M. (2003). Real exchange rate determination: Empirical observations from East-Asian countries. Empirical Economics 28, 173-180.

Williamson, J. (1994) (eds.). Estimating Equilibrium Exchange Rates. Washington, D.C.: IIE.