url
31
Oct
2013

Performance of CHEERs Based Equilibrium Exchange Rate of Pakistan:Introduction

Performance of CHEERs Based Equilibrium Exchange Rate of Pakistan:IntroductionActively trading economies in the world, because of their dynamic conditions alter the rate (i.e. Exchange Rate) that makes the price level of that particular economy with its trading economic partners. Hence a stability persuading policy maker will tend to foresee how this rate is behaving and to which economic factors it is being sensitive too.

Especially, for the economy like Pakistan where major exports are agricultural goods and major imports are Crude oil and machinery, as both group or type of commodities whose nature tends to make it price inelastic hence for Pakistan, there is no control on the prices that it receives or pays by altering the quantity it sells or buys, in this condition the fluctuations in the currency value (i.e. rising Exchange Rate) further damage the county’s balance of payments. Given historical pattern of the Exchange rate of Pakistan in figure 1, depict a rising trend throughout which kick started from early 80’s. Like any other pehnomenon in ecnonomics, Exchnage Rate behavior can also be seen as a result of demand and supply forces, and in this case it is the demand and supply of currency. And market forces or arbitrage opportunity drives the Exchange Rate up or down. Hence the rising Exchange Rate prepresent a constant pressure from the increasing demand of Foreign currency (i.e. US Dollars).

Analysing the current accout channel from where the goods market is used to interact between Pakistan and USA, the graph of the increasing price level differential from early 80’s justifies the increase in the purchasing power of the consumers to buy relatively cheaper goods from the foreign market. For this reason there will be an increas in the demand of the foriegn currency which drives the Exchnage Rate up. this relationship between the price levels and the Exchange Rate is known as the Purchasing Power Parity, such that if this Parity holds then there will be same prices all over the world converted to same currency units and chnages in the exchange will try to stabalise this equality.

In the financial market, investors tends to go towards the country, where there is higher return on the capital, this flow in and out of capital stops when the returns in the investment in both countries equate in terms of single currency unit, in other words Exchnage Rate adjusts to remove this arbitrage opportunity. In the graph of Fiancial Market and Exhange Rate, the rise in the interest rate of Pakistan relative to USA are mirrored in the peaks of the change in Exchange Rate. Except for the period of late 90’s where Financial market of Pakistan crahsed due to international secutiry conditions. This correspondence between the interest rate and the Exchange Rate is termed as Uncovered Interest Parity.

The result is that both Goods and Capital Market affects the Exchange Rate, so the Equilibrium Exchange Rate must be responsive to the changes to changes in these markets. The comparison of this Equilibrium Exchange Rate with the actual Exchange Rate will tell how far is the economy from the optimal balancing behavior?, as any imbalance will cause repercussions to any of the Current Account or Capital Account through the Goods or Capital Market respectively.

As importance of Exchange rate is described in the introduction section, this paper will address that issue by trying to fulfill following set of objectives.

1) Statistically and empirically reasonable econometric model that can give insight to how Purchasing Power Parity and Uncovered Interest Parity effects exchange rate.

2) Using in sample and out sample forecasting checking the performance of the Exchange rate model.

This study will be organized in following manner. Firstly, a review of Literature will be presented to show that importance of Exchange Rate and how it was sorted out? Secondly, the historical relationship of the PPP and UIP will be explained using a mathematical and statistical model. Thirdly, a thorough analysis of historical pattern of individual variables will be done to find preliminary connections with each other. Finally, set of data will be used to estimate the stochastic equation put forward in second section and then test the forecasting ability of this model. And in this section we will also derive conclusion from the interpretations of the model and its Implications.

Figure 1

Figure 1. Exchange rate & price level differential

Figure 2

Figure 2. Financial market and exchange rate

 

Actively trading economies in the world, because of their dynamic conditions alter the rate (i.e. Exchange Rate) that makes the price level of that particular economy with its trading economic partners. Hence a stability persuading policy maker will tend to foresee how this rate is behaving and to which economic factors it is being sensitive too. Especially, for the economy like Pakistan where major exports are agricultural goods and major imports are Crude oil and machinery, as both group or type of commodities whose nature tends to make it price inelastic hence for Pakistan, there is no control on the prices that it receives or pays by altering the quantity it sells or buys, in this condition the fluctuations in

About The Author

Kevin J. Brandon

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