What Determines the Behaviour of Real Exchange Rate in Pakistan?

It is now widely acknowledged that the role of the real exchange rate is crucial in the adjustment process of the economy. While exchange rates are, generally, relative prices of national currencies under a floating rate regime, they may be viewed as being determined by the interaction of supply and demand in the foreign exchange markets. This premise, though uncontentious, renders simply a beginning for comprehending the determination of the exchange rate and its ensuing relationship to various macroeconomic variables and to policy. It has been argued rather forcefully [e.g., Edwards and Wijnbergen (1987); Edwards (1988, 1988a); Khan (1986); Khan and Lizondo (1987)] that any analysis in this regard to be labelled as comprehensive would characterise the exchange rate as being detc;:rmined by a complex process of interaction simultaneously with other variables in tbe national and international macroeconomy rather than being determined simply by ‘purchasing power parity’ (PPP) as proposed by Cassel (1918). Citing Cassel’s writings in this context, Officer (1976) noted the reasons for such a departure from a stable relationship between the real exchange rate and the PPP as being due to frequent trade restrictions, distorted tariff policies, speculations in the ‘foreign exchange market, large capital outflows, government’s heavy handed ~intervention in the foreign exchange markets, etc.

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