Equilibrium Real Effective Exchange Rate and Exchange Rate Misalignment in Pakistan

Zulfiqar Hyder () and Adil Mahboob ()
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Adil Mahboob: State Bank of Pakistan

SBP Research Bulletin, 2006, vol. 2, 237-263.

Abstract: This paper estimates equilibrium real effective exchange rate (EREER) and exchange rate misalignment for Pakistan. Using the annual data from FY78 to FY05, Engle Granger co-integration technique is used to estimate the EREER based on various macroeconomic fundamentals suggested in economic literature by Edwards (1988, 1989, 1994), Elbadawi (1994), and Montiel (1997). The results indicate that EREER is determined by terms of trade, trade openness, net capital inflows, relative productivity differential, government consumption, and workers’ remittances. Trade openness, the increase in government consumption and capital inflows depreciate the REER, while, the increase in workers’ remittances and the improvement in terms of trade and total factor productivity relative to trading partners appreciate REER. The coefficients of the error correction term indicate the gradual convergence of the exchange rate toward long-run equilibrium. The estimated long run EREER and degree of exchange rate misalignment reveal that exchange rate misalignment ranged between -11.1 percent to 20.1 percent with zero reversion mean from FY78 to FY05 reflecting the long-term convergence tendency of actual REER toward EREER in Pakistan. Furthermore, the actual REER of FY05 is slightly depreciated in the range of 1.8-2.4 percent on the basis of two estimated regressions while one equation reflects an appreciation of 2.0 percent relative to EREER. This suggests that the current exchange rate is not too far away from the EREER and more or less reflects the underlying macroeconomic fundamentals. The result also reflects that the exchange rate misalignment and its volatility in REER measured by standard deviation tend to be smaller in the flexible exchange rate regime as compared to others

Date: 2006
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