AN EMPIRICAL ANALYSIS OF THE MACROECONOMIC DETERMINANTS OF EXCHANGE RATE IN PAKISTAN

By Muzaffar Ali Roll No. MC101 !0"0 S#$$io%& 010!1 Registration No. 2006-hc-246 Thesis Submitted to the Hail#' Coll#(# of Co))#r*#+ ,%i-#r$i.' of ./# Pu%0a1 La/or# In partial ul illment o the Re!uirements or the degree o Ma$.#r of Co))#r*# 213 Y#ar$4 "ppro#ed By$

5555555555555555555555555 Prof. Dr. Lia6a. Ali %ean

5555555555555555555555555 Mr. 0!0!0!0!0!0!0!0!0!0!0 &'ternal &'aminer

5555555555555555555555555 Mr. 0!0!0!0!0!0!0!0!0 Internal &'aminer

5555555555555555555555555 Prof. Mu/a))a7 A8ra) Research Super#isor i

5555555555555555555555555 Prof. Dr. Lia6a. Ali (rincipal

Hail#' Coll#(# of Co))#r*# ,%i-#r$i.' of ./# Pu%0a1+ La/or#+ Pa8i$.a% DECLARATION TO 9E FILLED 9Y THE ST,DENT AT THE TIME OF S,9MISSION OF THESIS TO THE S,PER:ISOR AND;OR FOR EXTERNAL E:AL,ATION
Section )$ (articular o the Student
).) ).2 )./ ).4 *ull Name *ather-s Name Roll. Number (rogram +u,a ar "li Shau.at "li +0)0)2-040 +.0om- )1 2ears

Section 2$ (articular o the Thesis

2.) 2.2 2./ Title Super#isor-s Name %ate o 0ompletion A% E)<iri*al A%al'$i$ of ./# Ma*ro#*o%o)i* D#.#r)i%a%.$ of E=*/a%(# Ra.# I% Pa8i$.a% +uhammad ".ram +ay3 20)/

I do hereby solemnly declare that the abo#e titled thesis submitted by me in partial ul illment o degree program enumerated abo#e$ a4 is my original 5or.3 e'cept 5here other5ise ac.no5ledged in the te't b4 has not been published earlier and c4 shall not be submitted by me in uture or obtaining any degree rom this or other uni#ersity or institution d4 has been incorporated 6&0 (lagiarism (olicy

/.) 2./
No.#$$

Student-s *ull signature %ate

+ay3 20)/

Three copies o this %eclaration must be pro#ided by the student 7ne copy 5ill stay 5ith the 0ontroller o &'amination3 Second 5ith rele#ant 67% and third 5ill be sent 5ith thesis to &'ternal &#aluator. ii

Hail#' Coll#(# of Co))#r*# ,%i-#r$i.' of ./# Pu%0a1+ La/or#+ Pa8i$.a%

S,PER:ISOR>S CERTIFICATE ON THESIS S,9MITTED 9Y A ST,DENT S#*.io% 1& Par.i*ular$ of ./# Su<#r-i$or
).) ).2 *ull Name "ddress (ro . +uhammad ".ram 6ailey 0ollege o 0ommerce3 8ni#ersity o the (un9ab3 :ahore.

S#*.io% & Par.i*ular$ of ./# S.u7#%.

2.) 2.2 2./ 2.4 *ull Name *ather-s Name Registration Number (rogram +u,a ar "li Shau.at "li 2006-hc-246 +.0om- )1 2ears

S#*.io% ?& Par.i*ular$ of ./# T/#$i$

2.) 2./ I *#r.if' ./a.& a. T/# a1o-# %a)#7 $.u7#%. /a$ *o)<l#.#7 ./# *i.#7 ./#$i$ u%7#r )' (ui7a%*# a%7 $u<#r-i$io%. 1. I a) $a.i$fi#7 @i./ 6uali.' of ./# $.u7#%.>$ r#$#ar*/ @or8+ a%7 *. I *o%$i7#r i. @or./' of $u1)i$$io% for #=.#r%al #-alua.io%. ?.1 ?. No.#$& Su<#r-i$or>$ Full Si(%a.ur# Da.# Title %ate o 0ompletion

"n &mpirical "nalysis o the +acroeconomic %eterminants o &'change Rate In (a.istan

Super#isors are re!uested to complete three copies o this orm and send them3 along 5ith appro#ed thesis3 to the rele#ant 6ead o the department. 7ne copy 5ill stay 5ith the 6ead o the department. Second copy should be sent or record o the 0ontroller o &'amination. Third copy should be attached to the thesis be ore it is sent out or e'ternal e#aluation.

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DEDICATION

TO MY PARENTS & TEACHERS

ACKNOALEDGEMENT
i#

Though this thesis is an indi#idual tas.3 I could ne#er ha#e e'plored the depths o the sub9ect 5ithout the help3 support3 guidance and e orts o numerous people. *irst o all3 I than. you "llah "lmighty3 or the li e3 luc.3 health3 5isdom3 opportunity and the energy that you ha#e gi#en me to reali,e my academic and pro essional goals. Secondly3 I 5ould li.e to e'press my gratitude to my super#isor and honorable teacher (ro . +uhammad ".ram or instilling in me the !ualities o being a good researcher. 6is in ectious enthusiasm has been ma9or dri#ing orces throughout my +.0om ;)1 2ears4 career at the 6ailey 0ollege o 0ommerce3 8ni#ersity o (un9ab. Thirdly3 a #ery special than.s to my class ello5s and riends particularly +uhammad *arhan3 6a i, 6amid and "ti "slam or the support they ha#e lent me o#er the 5hole pro9ect. I 5ould li.e to o er bundle o than.s to you all or e#erything. I 5ould li.e to ac.no5ledge and than. +r. "rslan I!bal or the help he has pro#ided in this research. 6is help3 suggestions and encouragement ha#e in act made a di erence. +oreo#er3 I 5ould li.e to than. both :ibrarians and members o their groups at the :ibrary o 6ailey 0ollege o 0ommerce3 8ni#ersity o the (un9ab3 :ahore or their encouragement3 help and support. *inally3 I 5ould li.e to e'press my special gratitude to the persons 5hom I o5e e#erything I am today3 my mother and ather. Their guidance3 prayers and un5a#ering con idence in me is 5hat has shaped me to be the person I am today.

+u,a ar "li e'ecuti#e<hailian=4>yahoo.com

TA9LE OF CONTENTS

C/a<.#r No. 01 0

Co%.#%.$ A1$.ra*. I%.ro7u*.io% ).) Research 7b9ecti#es R#-i#@ of Li.#ra.ur# 2.) Theoretical *rame5or. and ?ariable Selection 2.).) &stimation Sample and %ata 0ollection 2.).2 %ata %ynamics 2.).2.) Time Trend "nalysis 2.).2.2 %escripti#e Statistics E)<iri*al M#./o7olo(' /.) "uto Regressi#e %istributi#e :ag ;"R%:4 "pproach to 0ointegration E)<iri*al R#$ul.$ a%7 A%al'$i$ 4.) 8nit Root Test 4.2 8nit Root Test Results 4.2.) "ugmented %ic.y-*uller Test 4.2.2 (hillips (erron ;((4 Test 4.2./ Ng-(erron Test 4.2.4 Summary o 8nit Root Tests 4./ :ong Run 0ointegration 4./.) Bac.5ard &limination (rocess 4.4 Robustness o Results 4.4.) %iagnostic Tests 4.4.2 Structural Tests 4.A :ong Run %ynamics o "R%: +odel 4.6 Short Run %ynamics o "R%: +odel 4.@ *orecasting Co%*lu$io%$ B.1 Li)i.a.io%$ a%7 Poli*' I)<li*a.io%$ A.).) :imitations and *uture "#enues A.).2 (olicy Implications and Recommendations 9i1lio(ra</' A<<#%7i= A A<<#%7i= 9

(age No. 0) 04 06 )= 22 22 2/ /) // /4 42 4/ 44 44 46 4@ 41 4= 4= A/ A4 A6 A1 60 62 6A 6@ 6@ 61 @0 10 1=

0? 0"

0B

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LIST OF TA9LES
Table 2.) Table 4.) Table 4.2 Table 4./ Table 4.4 Table 4.A Table 4.6 Table 4.@ Table 4.1 Table 4.= Table 4.)0 Table ") Table "2 Table "/ Table "4 Table "A Table "6 Table "@ Table "1 Table "= Table B) %escripti#e Statistics o %ata Results o "%* unit root test Results o (( unit root test Results o Ng-(erron unit root test Summary o unit root tests Bound Testing results o "R%: model o &!uation 4.4. Results o %iagnostics tests or "R%: model o &!uation 4.4. Residuals and itted #alues based on "R%: model o &!uation 4.4. Results o long run dynamics o "R%: model based on &!uation 4.A. Results o short run dynamics o "R%: model o &!uation 4.6. %ynamic *orecast o :N&R based on "R%: regression o &!uation 4.4. Bound Testing results o "R%: model o &!uation 4.). Results o long run dynamics o "R%: model o e!uation 4.). Results o short run dynamics o "R%: model o &!uation 4.). Bound Testing results o "R%: model o &!uation 4.2. Results o long run dynamics o "R%: model o &!uation 4.2. Results o short run dynamics o "R%: model o &!uation 4.2. Bound Testing results o "R%: model o &!uation 4./. Results o long run dynamics o "R%: model o &!uation 4./. Results o short run dynamics o "R%: model o &!uation 4./. :ist o %ata Sources 6/ @= 10 1) 12 1/ 14 1A 16 1@ 11 A= 62 A6 /) 4A 46 4@ 41 A/ A4

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LIST OF FIG,RES
*igure 2.) *igure 2.2 *igure 2./ *igure 2.4 *igure 2.A *igure 2.6 *igure 2.@ *igure 2.1 *igure 2.= *igure 2.)0 *igure 2.)) *igure 4.) *igure 4.2 *igure 4./ *igure 4.4 6istorical chart o (BR per 8S% &'change rate 6istorical chart o nominal C%( o (a.istan 6istorical chart o In lation rate o (a.istan 6istorical chart o interest rate o (a.istan 6istorical chart o 0apital and *inancial "ccount Balance o (a.istan 6istorical chart o net e'ports o (a.istan 6istorical chart o nominal C%( o 8S" 6istorical chart o in lation rate o 8S". 6istorical 0hart o interest rate o 8S" 6istorical chart o capital and inancial account balance o 8S". 6istorical chart o net e'ports o (a.istan (lot o residuals o "R%: model o &!uation 4.4. 6istogram o residuals o "R%: model o &!uation 4.4. (lot o 0umulati#e Sum o Recursi#e Residuals ;08S8+4 o "R%: model o &!uation 4.4 (lot o 0umulati#e Sum o S!uares o Recursi#e Residuals ;08S8+SD4 o "R%: model o &!uation 4 A@ *igure 4.A Craphical representation o orecasts o :N&R based on "R%: regression o &!uation 4.4 64 .4 A@ 26 2@ 21 21 2= /0 /0 AA AA 2/ 24 2A 2A

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LIST OF A99RE:IATIONS
(BR 8S% C%( "R%: *%I 8B I+* ((( %BB R&R N&R ?"R ?&0+ S?"R &0+ &8 0(I NE 0*B "I0 SB0 08S8+ "%* (( %*C:S SB( (a.istani Rupee 8nited States %ollar Cross %omestic (roduct "utoregressi#e %istributed :ag *oreign %irect In#estment 8nited Bingdom International +onetary *und (urchasing (o5er (arity %anish Brone Real &'change Rate Nominal &'change Rate ?ector "utoregressi#e ?ector &rror 0orrection +odel Structural ?ector "utoregressi#e &rror 0orrection +odel &uropean 8nion 0onsumer (rice Inde' Net &'ports 0apital and *inancial "ccount Balance ".ai.e In ormation 0riterion Sch5ar, Bayesian 0riterion 0umulati#e Sum o recursi#e residuals "ugmented %ic.y *uller (hillips (erron %ic.y *uller Cenerali,ed :east S!uare State Ban. o (a.istan

08S8+SD 0umulati#e Sum o S!uare o recursi#e residuals

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A9STRACT
Pur<o$#& The .no5ledge o determinants o &'change Rate is indispensible or policy ma.ers in order to conduct an e ecti#e and success ul trade and monetary policy. In this research3 5e tried to !uanti y the empirical relationship bet5een nominal (BR per 8S% e'change rate and its macroeconomic determinants. M#./o7olo('& Fe ha#e used the gap model in 5hich 5e ha#e ta.en gap bet5een (a.istan and 8nited States o "merica in di erent macroeconomic indicators li.e in lation3 net e'ports3 capital and inancial account balance3 Cross %omestic (roduct ;C%(4 and interest rate as determinants o (BR per 8S% e'change rate. Fe ha#e applied "R%: approach to cointegration in order to estimate the impacts o these #ariables on nominal e'change rate o (a.istani rupee against 8S %ollar. Fi%7i%($& Fe ound that C%( di erential and e'change rate di erential bet5een (a.istan and 8S" signi icantly impacts the nominal e'change rate o (BR per 8S% and also e'plains appro'imately all the #ariations in (BR per 8S% e'change rate in the long run. Interest rate di erential3 in lation rate di erential and capital and inancial account balance di erential ha#e no signi icant relationship 5ith nominal e'change rate o (a.istani Rupee against 8S %ollar in the long run. *urthermore3 5e ound that only C%( di erential signi icantly impact the nominal e'change rate o (a.istani Rupee against 8S %ollar in the short run. 6o5e#er nominal e'change rate beha#ior is di icult to predict in the short run. Ori(i%ali.';:alu#& 7ur study signi icantly contributes to5ards the e'isting literature and helps policy ma.ers o (a.istan as 5e remo#ed the uncertainty in e'change rate mar.et o (BR per 8S% in the long run. *urthermore3 our study established the act that the relati#e macroeconomic indicators are relati#ely better to e'plain the mo#ements o nominal e'change rate in the long run as compared to commonly used absolute #ariables.

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K#'@or7$& &'change Rate3 +onetary3 "R%:3 (a.istan.

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