J. Appl. Environ. Biol. Sci., 6(3)177-185, 2016 © 2016, TextRoad Publication

ISSN: 2090-4274 Journal of Applied Environmental and Biological Sciences www.textroad.com

The Impact of Exchange Rate on Gross Domestic Product, Inflation and Foreign Exchange Reserves in Pakistan A Simultaneous Equation Analysis Dr. Muhammad Tariq1, Irfan Ullah2, Dr. Shahid Jan3, Dr. Zilakat Khan Malik4 1 Assistant Professor, Department of Economics, Abdul Wali Khan University Mardan MS Scholar, Department of Economics, Abdul Wali Khan University Mardan Pakistan 3 Associate Professor, Department of Management Sciences, Abdul Wali Khan University Mardan. 4 Professor, Department of Economics, University of Peshawar, Pakistan 2

Received: June 14, 2015 Accepted: January 29, 2016

ABSTRACT The main purpose of the present study is to investigate the impact of Pak-Rupee exchange rate depreciation on the Gross Domestic Product, inflation and foreign exchange reserves. Time series annual data covering the period 1973 to 2008 has been used for the empirical analysis. Two Stage Least Squares method is used for the estimation of regression equations. Testing the contractionary hypothesis of real depreciations, it has been concluded that real exchange rate depreciations put negative impact on the Gross Domestic Product of Pakistan. Dealing with the role of the real exchange rate in the determination of inflation, it is found that real depreciations is of help to describe the evolution of prices in Pakistan. Finally, examining whether reserves holdings in Pakistan is motivated by precautionary or mercantilist motives, the results showed that reserves holdings in Pakistan is the by-product of the export led growth strategies of Pakistan through real exchange rate depreciations. On the basis of the findings, it has been recommended that instead of devaluations of rupee for increasing exports, the government is required to follow import substitution policies. Furthermore, to increase the inflow of foreign exchange reserves in the country, the development of export sector of the country can play an important role. 1. INTRODUCTION Devaluation1 is often considered a key tool for recovering the foreign sector of an economy. The traditional approaches (elasticities, absorption and Keynesian) of devaluation, states that devaluation operates through aggregate demand channel and its ultimate effects are positive. According to the elasticities approach devaluation of currency increases the prices of imports and decreases the prices of exports, causing the trade balance to improve (Pearce, 1961, Turnovsky, 1980). The absorption approach states that devaluation enhances the output level through the expenditure switching and reducing mechanism (Alexander, 1952). Whereas the Keynesian approach states that devaluation will increase level of output and employment assuming the economy at less than full employment and the level of output determined by aggregate demand (Domac, 1997). However, in contrast a number of empirical studies concluded that devaluation reduces the level of output through various aggregate demand and supply channels (Alejandro, 1963, Gylfason and Schmid, 1983). Exchange rate fluctuations also influence domestic prices through its effect on aggregate supply and aggregate demand. On the supply side, fluctuation in exchange rate affects imported goods prices both directly and indirectly. Depreciation of domestic currency in comparison to that of foreign currencies directly results in higher import prices and vice versa. On the other hand, the potentially higher cost of imported inputs associated with exchange rate depreciation increases marginal cost and indirectly leads to higher prices of domestically produced goods. On the demand side, increased foreign demand for net exports may bid up the domestic price level, causing higher inflation. Foreign exchange reserves are used as a tool for monetary policy management. Fluctuations in exchange rate can also influence the level of foreign exchange reserves in a country. A devaluation of domestic currency increases the level of foreign exchange reserves via increase demand for exports. Pakistan devalued its currency several times with the expectations that it will boost exports and divert demand towards domestic goods, improving the foreign trade sector of the economy. But due to huge dependency on importable inputs for domestic production, political instability, huge debt 1

In this study devaluation and depreciation are used interchangeably unless stated otherwise.

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Corresponding Author: Dr. Muhammad Tariq, Assistant Professor, Department of Economics, Abdul Wali Khan University Mardan 177

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burden, low level of foreign exchange reserves and weak monetary policies it could not achieve the targeted policy goals. Pakistan followed a fixed exchange rate system from 1947 to 7th January 1982. The rupee devalued from 4.9 to 10.55 per US dollar during 1971-81. On 8th January 1982, the State Bank of Pakistan adopted a managed float exchange rate system but the rupee kept its downward trend. During the period1982-99 it further depreciated from 12.71 to 51.77 per US dollars. After that the State Bank of Pakistan introduced a full float market based system on 19th May 1999, determined by the demand and supply side factors in foreign exchange market. But the value of rupee declined further and it depreciated from 58.44 to 78.49 per US dollar during the period 2000-08 (State Bank of Pakistan, 2005). Looking at the growth performance, the average GDP growth rate of Pakistan during the period 1973-89 was 5.9%. It declined to 4.48% in the period 1990-99 but again increased to 4.58% during 2000-08 (State Bank of Pakistan, 2005). On the other hand the inflation rate during the period 1970-80 was 12.3%. It decreased to 7.8% during the period 1980-91 but again increased to 9.7% in 1991-2000. However, it declined to 8.4 % during 2001-09 (Economic Survey 2008-09). Similarly, the foreign exchange reserves of Pakistan during the period 1973-79 were 615.86 million dollars on average. It increased to 1775.7 million dollars in the period 1980-89. During the periods 1990-99 and 2000-05 it was in total amount of 2071.3 and 9483.67 million dollars, respectively (SBP, 2005). The average trade deficit of the country was 979.9 million dollars from 1973-79. It increased to 2513.59 million dollars in the period 1980-89. During the period 1990-99 it decreased to 2229.78 million dollars but increased to 5734.29 million dollars in the period 2000-09 (Economic Survey, 2008-2009). In brief the above discussion makes it clear that Pakistani rupee showed a downward movement during the study period (1973-2008). The GDP growth performance and inflation rate showed both up and downward trend during the same period. The foreign reserves of the country also showed fluctuations. The trade balance except the period of 1973 remained negative. Keeping in view the facts and figures, the impact of exchange rate fluctuations on growth, inflation and foreign reserves in Pakistan needs to be explored. No study in Pakistan has so far worked out the role of exchange rate in output growth, inflation and foreign reserves in Pakistan. The present study is being conducted to cover the gap. It will be helpful in assessing the soundness of present monetary and fiscal policies of the country. It will also help in setting up these policies in the years to come. It also will provide a guideline for import based industries and banking sector in the management of their future strategies. 2. Objectives of the study The present study seeks: i. To assess the structure and pattern of exchange rate fluctuations in Pakistan. ii. To examine the impact of exchange rate fluctuations on output growth, price level and foreign exchange reserves in Pakistan. 3. Hypothesis The hypothesis of the study will be: i. Exchange rate fluctuations has significant impact on output growth, price stability and foreign reserves in Pakistan. ii. Exchange rate fluctuations has positive impact on trade balance in Pakistan. 4. Literature Review There are a number of theoretical and empirical studies available on issues relevant to the impact of exchange rate fluctuations on key macroeconomic variables. Mundell (1961) suggested in his theory of optimum currency areas that those countries which are closely integrated through international trade and factor movements fixed exchange rate system is appropriate, where for countries among which factors are immobile flexible exchange rate system is appropriate for them. Alejandro (1963) mentioned that devaluation redistribute income to that group in which marginal propensity to save is higher from the low marginal propensity to save group which decrease aggregate demand and in the end bring contraction in output. Gylfason and Schmid (1983) utilized a simultaneous model to explore the effects of exchange rate fluctuations on economic growth in 10 developing countries. It was found that devaluation affects real income on the supply side by increasing the costs of inputs imported and through imports, exports and expenditures on the demand side. Further, the demand side effects dominated the supply side effects. Kamin and Rogers (2000) examined the relationship between real exchange rate and output in

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Mexico using quarterly data from 1980-I to 1996-II. They utilized Vector Auto regression (VAR) model and found that real devaluation brings reduction in economic activity and raised inflation in Mexico. Alexius (2001) used a VAR model to find out the factors caused fluctuations in the exchange rate of four Nordic Countries i.e. Denmark, Finland, Norway and Sweden. Utilizing quarterly data ranging from 1960-I to 1998-II it was found that productivity shocks were the main determinants of exchange rate movements in these countries. Aleisa and Dibooglu (2002) examined the sources which brings movements in real exchange rate in Saudi Arabia utilizing monthly data from 1980:02 to 2000:02 using a VAR model. It was stated that as compared to nominal shocks, there was a greater role of real shocks in the movements of real exchange rate in Saudi Arabia. However, the study suggested that nominal shocks played a greater role in the movements of price level. Berument and Pasaogullari (2003) empirically examined the effects of real exchange rate on output and inflation in Turkey using quarterly data ranging from1987-I to 2001-III. Based on VAR model the study found that real exchange rate depreciations had a negative relationship with output and a positive relationship with inflation. It was also suggested that the overvaluation of currency should be controlled to tackle the unfavorable effects of devaluation. Hyder and Shah (2004) studied the impact of exchange rate fluctuations on prices in Pakistan. The study utilized a Recursive VAR model for the period Jan-1988 to Sep-2003. The results of study showed that exchange fluctuations affected both consumer prices and wholesale prices in Pakistan. It was further suggested that the pass through effect of exchange was stronger on wholesale prices in comparison to consumer prices. The pass through effects was high during the periods of high inflation. Hsing (2006) investigated short term exchange rate fluctuations in Poland using quarterly data ranging from 1996-I to 2004-I based on an open extended economy model and the interest parity condition. The results showed that real exchange was negatively correlated with real M2 (money supply), foreign interest rate and expected rate of inflation. Where government deficit/GDP ratio and the expected real exchange rate had a positive relationship with real exchange rate. De Silva and Zhu (2008) investigated the impact of exchange rate movements on trade balance and output growth for Sri Lanka using vector auto regression (VAR) and error correction model (ECM) models for the period 1971 to 1997. It was found that devaluation improved trade balance of Sri Lanka but with no impact on real output. The study further suggested that if Sri Lanka want to increase the level of output it should increase its labor productivity. Kasman and Ayhan (2008) studied the long run relationship between exchange rate and foreign reserves. Using a conventional Augmented Dickey-Fuller(ADF) and Gregory and Hansen co integration tests by utilizing monthly data from the period 1982-I to 2005-II. Although the results of conventional co integration did not find any long run relationship between the two, the Gregory and Hansen co integration test showed a long term relationship between exchange rate and foreign reserves. It was concluded that the country should properly manage its foreign exchange reserves to decrease the negative impacts of foreign exchange reserves in Turkey. Ling et al (2008) investigated the short and long term relationship between real exchange rate and balance of trade in Malaysia for the period 1955 to 2006 using Unit Root Tests, Co integration Techniques, Engle-Granger Test, Vector Error Correction Model (VECM). The results showed that real exchange rate has a significant long run positive impact on trade balance which fulfilled the MarshallLerner condition with no evidence of J-curve effects. Omotor (2008) analyzed the role of exchange rate changes in the determination of inflation in Nigeria over the period 1970 to 2003. Utilizing Vector Error Correction (VEC) model the study concluded that exchange rate and money supply has a significant positive impact on inflation in Nigeria. It was further found that a strong monetary and exchange rate policy is needed to control inflation in Nigeria. Oskooee (2008) analyzed the impact of contractionary effects of devaluation on real output in the emerging countries of Easter Europe (Belarus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Russia and Slovak Republic). The study used quarterly data ranging from 19312006-II. By using bound testing approach, the results showed that in short run depreciation increased real output in Belarus, Latvia, Poland and Slovak Republic and decreased real output in Czech, Estonia and Russia. However the study did not find any long run relationship between depreciation and real output growth for any country. The study suggested that to increase the level of output the all the Eastern European countries should properly manage their fiscal and monetary policies. After studying the available literature, it can be observed that no study in Pakistan analyzed the impact of exchange rate fluctuations on output level, price level and foreign exchange reserves. The present study is an effort to bridge the gap.

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3. Data & Methodology The following section presents information about the data and methodology of the study. First, section 3.1 shows variables definitions and proxies used in the present study. Then section 3.1 shows the data sources. After that section 3.3 shows the models of the study. 3.1 Variables Definitions The variables and proxies used in this study are given in table 3.1, which are as follows: Table. 3.1 Variables and Proxies VARIABLES Exchange Rate

DEFINITIONS Exchange rate of Pakistan rupee against US dollar

PROXIES ER

Interest Rate

Average annual money call rate of Pakistan

INT

Gross Domestic Product

Gross Domestic Product of Pakistan in millions of rupees

GDP

Inflation Rate

Average annual percentage change in CPI of Pakistan

INF

Foreign exchange reserves

Foreign Exchange Reserves in millions of Pak rupees

FER

Money Supply

Money supply (M2) of Pakistan in millions of Pak rupees

MS

Remittances

Total workers’ remittances inflow in million of Pak rupees

REM

Trade Balance

Total exports minus total imports in millions of Pak rupees

TB

Imports divided by GDP multiplied with 100 TO Trade Openness Data Sources: Economic Survey of Pakistan various issue, Fifty Years Statistics of SBP, International Financial Statistics, IMF

3.2 Data Collection and Sources The study period of this research will be 1973-08 by using annual data. Different sources will be utilized for required data. The data will be taken from the following sources. 1. International Financial Statistics (IFS), various issues. 2. Economic survey, Finance Division, Government of Pakistan various issues. 3. State Bank of Pakistan various reports. 4. Federal Bureau of Statistics. of Pakistan, various years data. 5. World Development Indicators (WDI) data. 6. Ministry of Finance Pakistan various years data. 7. Export Promotion Bureau, Government of Pakistan. 3.3 Empirical Models The major objective of the present study is to find out the impact of exchange rate fluctuations on output growth, price level and foreign exchange reserves of Pakistan. The augmented form of the following core model (Kamin & Rogers, 2000) will be used. Y = DD + NX (1) Whereas, Y = Gross Domestic Product DD = Domestic Demand NX = Net Exports For estimation, the empirical form of the model can be written as Y = f (ER, INF, FR, MS, G, TB, INT) (2) Whereas, GDP = Gross Domestic Product ER = Exchange Rate INF = Inflation MS = Money Supply G = Government Expenditures TB = Trade Balance INT = Interest Rate Now some of the variables in the model which seems explanatory can take the form of endogenous variables, so the problem of simultaneous bias can affect the estimation. In order to avoid the simultaneity bias, the following simultaneous equation models will be estimated in the present study. Similarly, the equations for other major variables Inflation and Foreign Reserves will be as follow: INF= f (ER, MS, Y, INT) (3) FR = f (ER, INT, TO, REM, FDI) (4) Whereas, REM = Remittances FDI = Foreign Direct Investment

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For estimation of regression model 2SLS (Two Stage Least Squares) has been used. E-views software has been used for the analysis of the data. 4. Results and Discussion The present section shows the results and discussion of the study. First, section 4.1 shows the structure and pattern of exchange rate fluctuations and exchange regimes of Pakistan during the study period. After that section 4.2 shows the estimation results. 4.1 Structure and Pattern of Exchange Rate during 1973 to 2008. Pakistan is a small open economy in Asia which came into being on 14 August, 1947. The small size of the economy is evident from its total GDP which stood 12084380 million rupees in which the shares of money supply, foreign exchange reserves and remittances were 45.59%, 6.97% and 3.92% respectively during 2007-2008. Whereas, the openness of the economy can be judged from the share of its exports and imports in GDP which reached to 11.63% and 24.42% during 2008 (i.e. For detail see table 4.1). Rupee is the name of Pakistan currency, the official code of which is PKR. It consists of 1, 2 and 5 rupee coins and 5, 10, 50, 100, 500, 1000 and 5000 currency notes. As USA is one of the major trade partners of Pakistan and dollar is the most trading currency in the international foreign exchange markets, the exchange rate of rupee is usually measured in terms of US dollar. Although the role of exchange rate was minimum during the fixed exchange rate era, however in the wake of speedy process of trade liberalization and financial integration of the economies, the role of exchange rate has increased significantly in the conduct of monetary policy and overall macroeconomic performance. Although fluctuations in exchange rate can be beneficial for an economy, a large number of studies showed that these positive impacts of the exchange rate become doubtful when it is studied for the developing countries like Pakistan where agriculture fulfils most of the needs of domestic and foreign sectors and looking to their heavy dependence on foreign countries for its exports and imports. The following chapter shows a detail historical overview of the major macroeconomic variables including exchange rate, output growth, inflation, trade balance and foreign exchange reserves of Pakistan during the period 1973 to 2008. The details are given as below. A strong and competitive financial system is considered as a pre requisite for the macroeconomic stability. But how to make a financial system stable, this largely depends on the conduct of the monetary policy. Whereas, monetary policy refers to the use of different instruments such as bank rate, cash reserves requirements and open market operations for the achievement of desired goals i.e. higher economic growth, price stability, trade surplus and exchange rate stability. Although, monetary policy is used for the correction of most of the macroeconomic variables, yet, among these variables, exchange rate has always remained at the core its major objectives. It is one of the key macroeconomic variables which connect the country with the rest of the world in both the goods and assets markets and have strong influences for the internal and external sectors of the economy. In contrast, a poor exchange rate policy risks misrepresenting trade opportunities and results in the misallocation of resources in an economy. In Pakistan, monetary policy is based on targeting monetary aggregates (i.e. growth of money supply). The State Bank of Pakistan (SBP) has the responsibility for maintaining monetary and economic stability in the country. In 1997, SBP and its Central Board were empowered to formulate, conduct and implement monetary policy independently in the country and a Monetary & Fiscal Coordination Board was established to ensure that fiscal policy is well coordinated with the monetary policy (Akhtar, 2007). Like other developing countries, monetary policy in Pakistan has passed through several stages during the last few decades. In 1971, the rupee was delinked from pound sterling and attached with US dollar. After a devaluation2 of 130% in nominal terms of rupee during 1972, the nominal exchange rate appreciated from 11.03 to 9.9 i.e. 10.24% in nominal terms and 13.70% in real terms. After that the exchange rate of rupee was kept fixed against US dollar for almost 9 years i.e. 1973 to 1981. However, at the beginning of 1980s the US economy faced a large budget deficit which forced the government to raise the interest rate. This increase in the US interest resulted in a massive inflow of capital from abroad and led to appreciation of dollar against rupee. Since rupee is attached with dollar, it is also overvalued because of the market pressure. This made Pakistan’s exports expensive and imports cheaper in the international market and resulted in the deterioration in the trade balance. Hence, for maintaining exports competitiveness in the international market and improving trade balance, the State Bank of Pakistan (SBP) delinked the rupee from US dollar and moved to manage float system in 1982. With this move, the nominal exchange rate of rupee increased from 9.9 to 12.84 i.e. it is devalued 29.69% in nominal terms and 24.74% in real terms. In 2000, the State Bank of Pakistan adopted a market based exchange rate system. However, the rupee continued its downward movement and the nominal exchange rate further devalued from 51.78 in 1999 to 58.03 in 2000 i.e. showing a decline of 12.07% in nominal terms and 11.87 % in real terms respectively. During 2008 the nominal exchange 2

. Whereas, it was the largest devaluation of rupee in the history of Pakistan.

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rate was 62.55 showing a depreciation of 2.17% in nominal terms. However, in real terms the rupee showed an appreciation of 6.02%. For more details see table 4.2.

40 30 20 10 0 -10 -20 -30

1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Percentage grwoth rates of both nominal and real exchange rates of Pakistan

Figure 4.1. Percentage growth rates of both Nominal & Real exchange rates of Pakistan

Year

NER(%) •

RER(%)

Source: Source: Economic Survey of Pakistan 1973-2008

Although, the trends of both the nominal and real exchange rate mostly remained downward during the study period, however, so for the real exchange rate is concerned beside nominal exchange rate, inflation was another major factor that contributed significantly to the fluctuations in it. During the period 1973-1981, when the nominal exchange rate was kept fixed against the US dollar, even than the real exchange rate showed large fluctuations. However, these fluctuations were only because of the movements in inflation. Similarly, during 1982-2008 although the nominal exchange rate showed fluctuations as the SBP was following flexible exchange rate systems, inflation remained an important factor responsible for the movements in the real exchange rate of rupee. Figure. 4.2. Nominal exchange rate, Inflation and Real exchange rate of Pakistan

60 40 20 0 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Nominal exchange rate, Inflation and Real exchange rate of pakistan

80

Year

Nominal Exchange Rate •

Inflation

Real Exchange Rate

Source: Economic Survey of Pakistan 1973-2008

Whatever the reasons for these large fluctuations in both the nominal and real exchange rate, these factors strongly pushed the rupee value downward in comparison to most of the world major currencies. Table 4.1: Exchange Rate of Pak-rupees against the world major currencies (1982-2008) Year 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991

USA (Dollar) 12.84 13.50 15.36 15.98 17.25 17.45 18.65 21.42 21.90 24.72

UK (Pound) 18.95 20.50 19.60 18.56 23.25 26.21 30.85 32.91 34.92 41.57

France (Franc) 1.72 1.79 1.65 1.61 2.10 2.70 3.02 3.05 3.58 4.18

Germany (Mark) 4.38 5.15 5.02 4.93 6.49 8.92 10.19 10.35 12.11 14.12

Canada (Dollar) 8.31 10.29 10.74 11.32 11.68 12.63 13.73 15.98 18.23 19.42

S.Arabia (Riyal) 2.88 3.69 3.84 4.23 4.41 4.58 4.69 5.10 5.72 5.99

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UAE (Dirham) 2.68 3.46 3.67 4.12 4.39 4.67 4.79 5.23 5.84 6.12

China (Yuan) 5.66 6.47 6.56 5.65 5.18 4.62 4.72 5.16 5.09 4.44

Japan (Yen) 0.04 0.05 0.05 0.06 0.08 0.11 0.13 0.14 0.14 0.16

Hong Kong (Dollar) 1.74 1.94 1.73 1.94 2.06 2.20 2.25 2.46 2.74 2.88

EMU (Euro) na na na na Na Na Na Na Na Na

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1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

25.70 30.12 30.80 34.25 40.25 44.05 45.89 51.78 58.03 60.86 58.53 57.22 59.12 59.83 60.92 61.22 62.55

43.74 42.03 45.16 48.69 51.91 63.06 71.14 76.80 82.49 84.73 88.56 92.74 100.6 110.28 106.43 117.18 125.29

4.44 4.89 5.20 5.96 6.69 7.21 7.18 7.96 7.91 7.95 8.38 Euro Euro Euro Euro Euro Euro

15.08 16.57 17.90 20.68 22.97 24.41 24.09 26.70 26.53 26.65 28.10 Euro Euro Euro Euro Euro Euro

21.38 20.79 22.55 22.37 24.65 28.54 30.48 31.04 35.16 38.44 39.17 38.82 42.85 47.55 51.49 53.57 61.97

6.64 6.94 8.06 8.24 9.06 10.44 11.51 12.48 13.81 15.58 16.37 15.59 15.34 15.80 15.96 16.16 16.69

6.78 7.09 8.24 8.42 9.23 10.66 11.76 12.75 14.09 15.91 16.72 15.92 15.67 16.15 16.29 16.51 17.03

4.57 4.59 4.33 3.68 4.03 4.69 5.21 5.65 6.24 7.06 7.41 7.06 6.94 7.16 7.41 7.75 8.61

0.18 0.21 0.28 0.32 0.32 0.33 0.34 0.37 0.48 0.51 0.48 0.48 0.52 0.55 0.52 0.51 0.57

3.20 3.35 3.90 3.99 4.33 5.03 5.57 6.04 6.65 7.49 7.87 7.49 7.39 7.61 7.71 7.77 8.02

Table 4.1 shows the Pak-rupee exchange rate against some of the world leading currencies such as US, UK, France, Germany, Canada, S. Arabia, UAE, China, Hong Kong and Japan currencies during the period 1982-2008. The data shows that except Yen, all the currencies remained strong against it. Another noted point is that rupee stood the single currency among all these currencies which showed a continuous downward trend. During 1982, the rupee exchange rate3 against US dollar, Pound, Franc, Mark, Canadian dollar, Riyal, Dirham, Yuan, Yen and Hong dollar were 12.84, 18.95, 1.72, 4.38, 8.31, 2.88, 2.68, 5.66, 0.04, and 1.74 respectively. It raised to 62.55 against US dollar, 125.29 against pound, 92.17 against France and Germany, 61.97 against Candian dollar, 16.69 against Riyal, 17.03 against Dirham, 8.61 against Yuan, 0.57 against Yen and 8.02 against Hong Kong dollar during 2008. Although, the rupee showed appreciation against some currencies except US dollar for a few years. However, that was only because of the internal factors in these countries. 4.2 Estimation Results Two Stage Least Squares method has been applied for the estimation of the results. First, table 4.2 shows the results for showing the impact of exchange rate devaluation on the Gross Domestic Product of Pakistan. The results showed that exchange rate depreciation put negative impact on the Gross Domestic Product of Pakistan. Table 4.2: Results for Exchange Rate and Gross Domestic Product Dependent Variable: Gross Domestic Product (GDP) Method: Two-Stage Least Squares White Heterosckedasticity-Consistent Standard Errors & Covariance Independent Variables Co-efficient Std. Error 0.005252 0.131680 (Constant) -0.036916 0.011673 ER 0.003246 0.003475 FER 0.006208 0.000837 MS -0.002356 0.000567 INF 0.093933 0.072516 G .015 .004 TB R-Square: .56 Adj. R-Square: .54 Durbin Watson Statistic: 1.95

t-Statistic 0.039884 -3.162510 0.934109 7.415684 -6.847632 3.501744 .006

P-Value 0.9685 0.0037 0.3582 0.0900 0.0456 0.5416 0.0543

Similarly, other variables money supply, inflation rate and trade balance showed significant relationship with the GDP. However, the signs of inflation remained negative. Whereas, the sign of trade balance and money supply turned positive. Other variables foreign exchange reserves and inflation remained insignificant. The R-square value was 0.56 showing the percentage of variation in the dependent variables explained by the explanatory variables. And Durbin Watson Statistic value was 1.95 showing that there is no auto correlation problem in the data. Similarly, for showing the impact of exchange rate on inflation results has been estimated which are in given in table 4.3.

3

In 2003 because of the agreement among the European countries, Germany and France also joined the European Union and following Euro as an official currency.

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Na Na Na Na Na Na Na Na Na Na 54.99 61.30 68.62 75.53 72.86 79.17 92.17

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Table 4.3: Results for Exchange Rate and Inflation Dependent Variable: Inflation (INF) Method: Two-Stage Least Squares White Heterosckedasticity-Consistent Standard Errors & Covariance Independent Variables Co-efficient Std. Error 0.505534 27.26138 (Constant) 0.194508 2.513092 INF (-1) 0.200479 2.807762 ER -0.505534 27.26138 GDP 0.948141 0.413799 MS 0.055452 0.038329 INT R-Square: .50 Adj. R-Square: .48 Durbin Watson Statistic: 1.98

t-Statistic 0.018544 0.9388 0.9436 -0.9853 2.291311 1.446760

P-Value 0.9853 0.027398 0.031402 0.018544 0.0291 0.1580

The results showed that lag inflation, exchange rate, GDP and money supply became significant. Whereas, only interest rate remained insignificant in the model. The R-square value remained 0.50 showing the overall goodness of fit of the model. The Durbin Watson Statistic value was 1.98 showing the absence of auto correlation problem in the data. Finally, results computed for investigating the impact of exchange rate fluctuations on the foreign exchange reserves inflows in Pakistan. Table 4.4: Results for Exchange Rate and Foreign Exchange Reserves Dependent Variable: Foreign Exchange Reserves (FER) Method: Two-Stage Least Squares White Heterosckedasticity-Consistent Standard Errors & Covariance Independent Variables Co-efficient Std. Error -2.532059 8.085133 C -0.094694 0.040826 ER 0.420115 0.156095 TO 0.082269 0.063324 REM 0.002822 0.001232 FDI R-Square: .60 Adj. R-Square: .59 Durbin Watson Statistic: 1.94

t-Statistic -2.333409 -2.319486 2.691408 1.299173 2.291689

P-Value 0.2268 0.0276 0.0117 0.2041 0.0294

The results are given in table 4.4. The results showed that exchange rate, trade openness and foreign direct investment remained significant. Whereas, remittances remained insignificant in the model. The R-square value was 0.60 which showed that there is no autocorrelation problem in the data. The Durbin Watson Statistic value remained 1.94 showing that there is no autocorrelation problem in the data. Conclusion The study examined the impact of Pak-Rupee exchange rate depreciation on the Gross Domestic Product, inflation and foreign exchange reserves. Time series annual data covering the period 1973 to 2008 has been used for the empirical analysis. Two Stage Least Squares method is used for the estimation of regression equations. Testing the contractionary hypothesis of real depreciations, it has been concluded that real exchange rate depreciations put negative impact on the Gross Domestic Product of Pakistan. Whereas, other variables inflation, trade balance and money supply also remained significant according to expectations. Dealing with the role of the real exchange rate in the determination of inflation, it is found that real depreciations is of help to describe the evolution of prices in Pakistan. Other variables Gross Domestic Product, lag inflation and money also showed the expected significant relationship with inflation. Finally, examining whether reserves holdings in Pakistan is motivated by precautionary or mercantilist motives, the results showed that reserves holdings in Pakistan is the by-product of the export led growth strategies of Pakistan through real exchange rate depreciations. Moreover, foreign direct investment and trade openness also showed a significant impact on the foreign exchange reserves. On the basis of the findings, it has been recommended that instead of devaluations of rupee for increasing exports, the government is required to follow import substitution policies. Furthermore, to increase the inflow of foreign exchange reserves in the country, the development of export sector of the country can play an important role.

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