by: Arshad Ali Bhatti, Tauqir Ahmed, Babar Hussain
This paper assesses the growth effects of real exchange rate (RER) misalignment in Pakistan using
annual data over the period 1980-2013. Its objectives are threefold: First, to examine the long run
relationship between the real effective exchange rate (REER) and its economic fundamentals.
Second, to estimate the equilibrium real effective exchange rate (EREER) and real exchange rate
misalignment. Third, to test the hypothesis that undervaluation is associated with economic growth
as claimed by Rodrik (2008). This study employs Autoregressive Distributed-lag (ARDL) bounds
testing approach of Pesaran et al. (2001) to appraise the long-run equilibrium relationship
between REER and macroeconomic variables. Further, the “Hodrick-Prescott (HP) filter” is used
to compute the misalignment of REER. The empirical findings suggest that there is long- run
relationship among REER, Real GDP per capita, trade openness, terms of trade, government
expenditures, discount rate, FDI, and financial development. Further, Pakistani Rupee was found
to be undervalued in 1980 by 17 %. It remained overvalued from 1981-85 with a highest
misalignment of 24% in 1984. In the period thereafter (1986-1994), Pakistani Rupee remained
undervalued. We observe different episodes of appreciation and depreciation of the local currency
since 1995. However, the appreciation and depreciation was relatively smaller than the periods
of 1980s and early 1990s. It is noted that Pakistani currency remained overvalued since 2010 that
might adversely affect economic growth, while moderate undervaluation would increase the
economic activity. Finally, it is found that REER misalignment Granger causes real GDP growth,
whereas no feedback effect is observed.
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