Portfolio balance approach: An empirical testing

Exchange rate plays vital role in an economy and thus has gained much attention in the literature. The purpose of the study is to test the portfolio balance approach which proposes that money supply and bonds of a country impact its exchange rate. For this purpose, Augmented Dickey Fuller and Phillips Perron test have been applied on the quarterly data from 2001 to 2010 to test the stationarity of the data. Auto regressive distributed lag model has been used to analyze the data. Results validate the empirical evidence and reveal that long term relationship is found among the variables. Money supply of US, money supply of Pakistan and bonds for US are having an impact on the exchange rate of these countries.   Key words: Portfolio balance approach, exchange rate, money supply, bonds, balance of payments.