A Systematic Review of Exchange Rate Studies in the Context of Pakistan

ABSTRACT

The exchange rate is a crucial indicator of a nation’s performance in the external sector and influences key macroeconomic variables. In theory, exchange rates should be determined by market forces and reflect economic fundamentals; however, developing economies such as Pakistan often experience significant deviations due to structural weaknesses and policy interventions. This paper reviews the literature on the exchange rate in Pakistan, classifying and summarising the findings on nominal exchange rates, real exchange rates, real effective exchange rates, and foreign exchange market pressures.
This review provides a comprehensive understanding of exchange rate policy in Pakistan and its economic implications. The paper concludes by identifying gaps in current research and suggesting areas of future study to address the complexities of exchange rate management in developing economies.

INTRODUCTION

The exchange rate is a key indicator of a nation’s relative success in the externalsector. In a flexible exchange rate system, an appreciation of the currency suggests better performance compared to competitors, while depreciation indicates the opposite. The exchange rate policy is central to economic policy, directly and indirectly impacting macroeconomic indicators such as export growth, resource allocation, consumption patterns, foreign investment, and employment (Edwards, 1989). Ideally, the exchange rate should be determined by market forces and reflect the actual economic conditions. However, this is often not the case due to the complex interplay of numerous factors. Central banks frequently influence exchange rate policy to align with the political motives of ruling regimes, even if the declared policy is a flexible exchange rate regime (Akthar, 2019). Developing economies, particularly vulnerable to external shocks, often struggle with overvalued currencies due to low foreign exchange reserves and structural imbalances. This overvaluation can lead to unsustainable economic conditions, culminating in exchange rate crises, capital flight, and economic instability (Boorman, et al. 2000). Pakistan’s exchange rate history reflects these challenges. It is characterised by persistent government intervention, resulting in deviations from equilibrium levels. Since the early 1980s, the country has transitioned from a fixed to a managed float and, eventually, a market-based regime (see Figure 1). However, the State Bank’s continuous intervention to maintain an overvalued exchange rate has depleted foreign exchange reserves (Figure 2), even during periods of apparently market-determined exchange rates. This overvaluation is evident in the persistent premium of the parallel market exchange rate over the official rate, particularly during periods of dual exchange rate regimes (1999, 2003-2008, and 2013-2017) as depicted in Figure 3. The parallel market rate, unaffected by government intervention, serves as a benchmark for the true value of the currency.