Exchange Rate and Inflation Dynamics

This paper studies simultaneous determination of nominalexchange rate and domestic price level in Pakistan. The estimated modelcontains sufficient built-in dynamics to trace the pattern and speed ofadjustment in the two variables in response to temporary or permanentshocks. The two domestic shocks considered in the paper are monetary andreal shocks, while the three external shocks considered are importprice, export price and foreign exchange reserves shocks. The studyfinds that the impact period effects of temporary shock on price leveland exchange rate are divergent, while the long run effects areconvergent. This means that, while purchasing power parity does not holdin the short run, there is a tendency in the system to regain relativeparity in the long run. Further more continuation of shocks can producea persistent but non-accelerating divergence between inflation rate andthe rate of devaluation. Therefore the parity holds in a weaker sensethat is for the marginal fluctuations in the rates of changes in pricelevel and exchange rate over time. It is also observed that thedirection of temporary disparity between the rates of inflation anddevaluation depends crucially on the origin of the shock. The shockswith direct effect on price level (exchange rate) have more pronouncedeffects on the rate of inflation (devaluation). Finally, therelationship between price level and exchange rate is notunidirectional, though the short run effect of devaluation on inflationis smaller than the effect of inflation on devaluation. Since movementsin exchange rate are mostly driven by price inflation, the practice ofusing exchange rate as an independent instrument is not sustainable inthe presence of inflation. From policy perspective both the inflationand exchange rate could be considered as interrelated targets whilefocusing on the instruments that are in effective control ofpolicy-makers, such as money supply.