NATIONAL COLLEGE OF BUSINESS

ADMINISTRATION & ECONOMICS

MULTAN

Determinants of Exchange Rate: A Case Study of Pakistan

BY

Arif Raza

A Project Report submitted to

School of Business Administration in partial fulfillment of the
Requirements for the degree of

MASTER OF SCIENCE
IN
ACCOUNTING AND FINANCE

AUGUST, 2020

i
 NATIONAL COLLEGE OF BUSINESS
ADMINISTRATION & ECONOMICS
MULTAN
Determinants of Foreign Exchange Rate: A Case Study of
Pakistan

BY
Arif Raza
A Project Report submitted to School of Social Sciences, in partial
fulfillment of the requirements for the degree of

MASTER OF SCIENCE
IN
ACCOUNTING AND FINANCE
Dissertation Committee:

___________________________

Chairman

___________________________

Member

___________________________

Member

___________________________

Pro-Rector
National College of Business
Administration & Economics Multan

ii
 IN THE NAME OF
ALLAH
The Most Gracious and Compassionate
The Most Merciful and Beneficent
Whose Help and Guidance Always
Solicit at Every Step
At Every Moment

iii
 DECLARATION
This is to certify that this research work has not been submitted for obtaining similar
degree from any other university/college.

Arif Raza
AUGUST-2020

iv
 National College of Business Administration & Economics
Multan Campus
11/B, Gulgasht Colony, Bosan Road Multan

COURSE COMPLETION CERTIFICATE

Ref. Date

It is certified that Course requirements of Mr. Arif Raza Registration No.

121810182 for the program MSc. Accounting and Finance has been completed and his
current CGPA is 3.65

Prof.Dr. Farkhand Shakeel Prof.Dr. G R Pasha

Director (R&D) Pro-Rector

Copy to

1. The Director NCBA&E Lahore

2. The Director NCBA&E Multan Campus.

3. Notification file.

v
 RESEARCH COMPLETION CERTIFICATE

It is certified that the research work contained in this thesis entitled

“Determinants of Foreign Exchange Rate: A Case Study of Pakistan” has been
carried out and completed by Arif Raza under my supervision during his MSc.
Accounting and Finance program.

Dr. Syed Wahid Ali

(Supervisor)

vi
 ACKNOWLEDGEMENT

Thanks to ALLAH the one and only who gave such appreciable and worthy
opportunity and enable me to complete my project and I am also in debt to Holy Prophet
Hazrat Muhammad (PBUH) whose life is a living example for every Muslim.

I would like to pay my profound thanks, gratitude and admiration to my kind

supervisor Dr. Syed Wahid Ali for his valuable support, advice, encouragement and
patience. I have no words to explain her contribution in my research work.

I am highly thankful to our respected Pro Rector Dr. GR Pasha and

Prof.Dr.Farkhand Shakeel head of Research and Quality Control, National College of
Business Administration and Economics, Multan for his valuable advices from time to
time.

I would like to express my special thanks to my loving parents whatever I am

today, it is because of my parent’s support, advice and guidance.

I want to thanks my all friends who helped and caring me a lot. Finally, I would
thank the Administration, faculty and all the staff member of NCBA&E Multan
Campus.

vii
 DEDICATION

This study is wholeheartedly dedicated to our beloved parents, who have been our
source of inspiration and gave us strength when I am thought of giving up, who
continually provide their moral, spiritual, emotional, emotional, and financial support.

I also dedicate this study to our brother, sister, mentors, and classmates who
shared their words of advice and encouragement to finish this study.

viii
 ABSTRACT

Objective of the study is to check the effect of the determinants of the exchange rate the
context of Pakistan for the 29 years (1991-2019). Data source is the World Bank (WB),
International Financial Statistics (IFS) and Pakistan Economic Survey. The Ordinary
Least Square (OLS) Method is applied to get the results of the study. Results of the OLS
show that TOT and INF have statistically significant and positive impact on the
Exchange Rate (ER) in the Pakistan. GOVD and IR have statistically significant and
negative impact on the Exchange Rate (ER) in the Pakistan.

Keywords: Exchange Rate, Terms of Trade, Ordinary Least Square, Pakistan.

ix
 SUMMARY

The main purpose of the study is to explore the determinants of foreign exchange
rate in Pakistan. Firstly, the study presents introduction related to the research work.
Further, the study reviews different literatures to investigate the relationship between
dependent variable and independent variables in different time period. According to
studies different determinants effect the foreign exchange rate. The study also threw light
on the three important theories foreign exchange rate. These major theories are Price
Specie Flow Mechanism, Purchasing Power Parity Theory and Marshall Lerner
Condition. In the next step, the study presents different sources of data collection and
description of variables. After the variables description the study set up the econometric
model. The statistical techniques also described briefly which are applied to find the
relationship between defendant variable and independent variables. The present study
briefly explains the empirical results with their tables by using annual time series data
from 1991 to 2019. First of all, the study finds the descriptive and correlation results.
After this the study applied Ordinary Least Square (OLS) to check the long run and short
run relationship between variables. The result shows that there is a positive and
significant impact of term of trade and inflation on foreign exchange rate in Pakistan.
Government debt and interest rate have negative but significant impact on foreign
exchange rate in Pakistan. Finally, the study provides conclusion and policy
recommendation.

x
 LIST OF CONTENTS

CONTENTS Page No

DECLARATION IV
COURSE COMPLETE CERTIFICATE V
RESEARCH COMPLETION CERTIFICATE Vi
ACKNOWLEDGEMENT Vii
DEDICATION Viii
ABSTRACT Ix
SUMMARY X
CHAPTER NO 1 INTRODUCTION 1
1.1 Background of the Study 1
1.2 Statement of the Problem 3
1.3 Objective of the Study 3

1.4 Organization of the Study 3

CHAPTER NO 2 LITERATURE REVIEWS 5
2.1 Introduction 5
2.2 Literature Reviews 5
2.3 Conclusion of Literature Reviews 7
CHAPTER NO 3 THEORETICAL FRAMEWORK 8
3.1 Introduction 8
3.2 Price Specie Flow Mechanism 8
3.3 Purchasing Power Parity Theory 9

3.4 Marshall Lerner Condition 12

4.1 CHAPTER NO 4 DATA & METHODOLOGICAL ISSUES 19
4.1 Introduction 19
4.2 Data Sources 19
4.3 Description of Variable 19
4.3.1 Exchange Rate 20
4.3.2 Terms of Trade 20
4.3.3 Government Debt 21

xi
4.3.4Interest Rate 21
4.3.5Inflation Rate 21
4.4 Model Specification 21
4.4.1 Time Series Data Analysis 22
4.4.2 Ordinary Least Square (OLS) Model 23
CHAPTER NO 5 EMPIRICAL ANALYSIS 24
5.1 Introduction 24
5.2 Descriptive Statistics 24
5.3 Correlation Matrix 26
5.4 Serial Correlation LM Test 27
5.5 Heteroskedasticity Test 27
5.6 Ordinary Least Square OLS Results 27
CHAPTER NO 6 CONCLUSION & POLICY RECOMMENDATION 30

6.1 Conclusion 30
6.2 Policy Recommendations 30
REFERENCES 31

LIST OF TABLES

Title Page No

4.1 Summary of Variables 20

5.1 Results of Descriptive Statistics 24
5.2 Results of Correlation Matrix 26
5.3 Auto Correlation 27
5.4 Heteroskedasticity 27
5.5 Regression Results 27

xii
 LIST OF FIGURES

Title Page No
3.1 Import Market 14
3.2 Export Market 14
3.3 Effect of Devaluations 16
3.4 Elasticity of Imports 17

xiii
 CHAPTER 1
INTRODUCTION
1.1 Background of Study
The foreign exchange rate is an important source to determine the economic
health of any country. Foreign exchange rate may be defined as “the rate at which one
currency can be converted into other currency. It may change with daily changes in
market forces of demand and supply of currency between the two countries. So while
sending or receiving money from abroad it is important to know what determines the
exchange rate or what are the determinants of the foreign exchange rate.

Determinants of foreign exchange rate:

Following are the main determinants of foreign exchange rate:

1. Inflation rate
2. Interest rate
3. Balance of payments
4. Government debt
5. Terms of trade
6. Political stability
7. Recession
8. Speculation

Exchange rate changes alter the welfare conditions of the economy. As the
exchange rate is the price of one currency in terms of other currency so the price of
anything may affect the equilibrium condition like that the price of home currency in
terms of foreign currency may also affect the equilibrium in the foreign market. In the
short run, the factors that induce changes in the exchange rate are not much clear as
compared to the long run (Kim, & Sheen, 2002). Mostly exchange rate is determined
with the country’s trading performance and what is its impact on the current account
of its balance of payments. The demand for foreign currencies to finance the imports
is to be compared with the supply made by foreigners purchasing exports.

1
 According to Chow, & Chen, (1998), the monetary approach exchange rate
determination is a process in which we equate the total demand of national currency to
the total supply of national currency in every nation. The money supply is given by the
monetary authorities while demand for money depends on some factors like price level,
real income, and the real rate of interest. Price level and real income are positively related
to the demand for money while the real interest rate is negatively related to the demand
for money. Adjei, Yu, &Nketiah, (2019), have described the long-run approach that is
purchasing power parity theory to determine the exchange rate. This approach helps to
demonstrate the behavior of currency exchange in the long run. Purchasing Power Parity
theory has mentioned that the exchange rate between two currencies is basically the ratio
of the general price level of both countries. Therefore, this theory explains that the higher
will be the prices the currency of that country will depreciate. On the other hand, the
lower will be the prices the currency of that country will appreciate.

According to Khan, & Qayyum, (2007), the literature consists of a lot of studies
regarding the determinants of the foreign exchange rate is playing an important role in the
progress of a country. Most studies use cross-section data. Panel data is more helpful to
answer the questions but there is a lack of specification in panel data. Recent research
contributed in five different ways to the literature to analyze the determinants of the
exchange rate.

Firstly, this research explains the exchange rate determination in Pakistan. In the
era ofthe floating exchange rate system, Pakistan’s home currency tends to depreciate at
the beginning which indicates the inappropriate policies.Secondly, the present study uses
the time series data that was long. It consists of 142 observations during the period 1973
to 2013. This large sample data helps in analyzing the exchange rate determination in
Pakistan.Thirdly, this research uses the autoregressive distributed lag model in the
investigation of the long-run relationship between variables.Fourthly, researchers are
against the unit root test and co-integration techniques. According to them, these
techniques mislead the results; the reason for misleading is low size.Fifth, this research is
not constrained by any econometric approach for the estimation of coefficients in a long
period.

2
1.2 Problem Statement

Due to rapidly change in Pakistani currency Pakistan faces the high exchange rate in
international market. In international market Pakistan also faces the high prices of
imports. Exports also effect by the exchange rate. The main problem is that what
determinants effect the exchange rate. In this study we see the different determinants
impact on Exchange rate of Pakistan.

1.3Objective of the Study

To know the determinants of foreign exchange rate in Pakistan

1. To know the impact of term of trade on foreign exchange rate in Pakistan.

2. To find the effect of Government Debt on foreign exchange rate in Pakistan.
3. To see the impact of inflation rate on exchange rate of Pakistan.
4. This study also finds the effect of interest rate on economic growth of Pakistan.

1.4Organization of the Study

1. First chapter of this study includes the introduction of foreign exchange rate and
its determinants of Pakistan. Further we discussed about statement of the
problems, and objectives of the study.

2. In chapter 2 review of previous literature will be presented on both developing

and non-developing countries. In the literature reviews of the present study,
different methods and techniques will also be discussed.

3. In chapter 3 we discussed about those different theories which are related to our
study. It will discuss the various concepts to examine the determinants of foreign
exchange rate.

4. Chapter 4 of present study will discuss about data and methodology. This section
of study describes the data sources, method of estimation and model specification
and finally the description of the variables also discuss to determine the link
between dependent variable and independent variables.

3
5. In chapter 5 we will present the data analysis and show the relationship between
dependent variable and independent variable. In this section we use time series
data and also use Ordinary Least Square (OLS) method and finally interpret the
finding.

6. In chapter 6 we discussed about conclusion and policy recommendations of the

study.

4
 CHAPTER 2

LITURATURE REVIEW

2.1 Introduction

There are many studies about developing and non-developing countries in which
performance of exchange rate has been discussed. These studies showed the determinants
of foreign exchange rate in Pakistan. All of these studies analysed the link between
monetary policy and economic growth and examined how the different determinants
changes the exchange rate. Some famous studies reviews are given below.

2.2 Literature Review

Saeed, Awan, Sial, &Sher, (2012), explain the impact of macroeconomic

variables that affect the exchange rate determination in seven countries using the data of
35 years from 1960 to 1994. Recently the difference between anticipated and
unanticipated fluctuations in the exchange rate and its determinant variables has been
focused (Raja, & Ullah, 2014). Frenkel and Mussa discuss the exchange rate highly
sensitive to the asset price changes and affected instantly by the new information.

Foreign exchange rate exposure cannot provide more important results in the
literature the reason is that the sensitivity of the exchange rate is identified after
restricting the company’s activities. Raza, &Afshan, (2017), explain that the companies
usually adopt three types of hedging: financial hedging, operational hedging, and pass-
through of input costs to the customers. Fuchs, (2019), used the non-parametric method
while they know that the non-parametric method is not much clear as compared to the
random walk model to forecast the exchange rate.

Faff and Marshall (2005), Highlighted worldwide proof on the determinants of

foreign exchange rate presentation of global enterprises. The study shows that foreign
exchange threat control of many corporations is defensive, in a try to minimize foreign
exchange losses. The finding shows that UK MNCs will in general have negative foreign

5
exchange exposures and the Asia Pacific subsample tend to have positive outside trade
exposures.

Saeed, Awan, sial, and sher (2012) lead an econometric examination of

determinants of conversion scale in Pakistan. The examination utilized Stock of cash,
remote trade saves, and all-out obligation of Pakistan comparative with the United States
Alongside Political flimsiness in Pakistan as a spurious variable. ARDL ways to deal
with co-coordination and blunder remedy model are applied. Results show that Relative
outside trade hold is adversely and essentially identified with remote trade save. Political
precariousness adversely influences the estimation of monetary forms in the event of
Pakistan. The investigation inferred that supply of cash, obligation, and remote trade hold
balance all in relative terms are noteworthy determinants of conversion standard.

Kim and sheen (2002) analyze the determinants of foreign exchange intervention
by the national bank of Australia. Utilizing probit and friction models it is concluded that
swapping scale pattern correction, Australian interest rate differentials, exchange rate
volatility smoothing, profitability, and remote money saves have a huge impact on
intercession behavior. Intervention conduct is being affected by the development of the
exchange rate. We conclude that the reserve bank of Australia has reacted to showcase
scattering just when it is at a reasonable level. The RBA smoothed the market’s tumult by
interceding.

Chow and Chen (1998) give detail about the exchange rate exposures of Japanese
firms and their determinants. This paper controls the impact of supporting on exposure.
Conversion standard presentation is the relationship between changes in firm worth and
swapping scale changes. Results show that Japanese firms are overwhelmingly contrarily
uncovered, for example, their value returns decline as yen depreciates. The finding shows
that organizations with high influence, low liquidity, and high money profits have high
exposures. For the short return horizon, littler firms have littler exposures, while for the
longer-return horizons bigger firms have smaller exposures.

Bodnar and wong (2003) using the data of a large sample of US firms over the
time of 1977-1996 this paper investigates the significance of highlights of model

6
structure on the resulting assessments of exchange rate exposure. stock return regression
is being utilized in this paper. Results show that large firms, which are normally more
globally situated, will in general have more negative exposures to the value of the US
dollar. conversely, small firms tend to have more positive exposure to the value of the US
dollar.

Khan and Qayyum (2007) utilizing Johansen multivariate cointegration and a

bound testing way to deal with cointegration investigate that there is a high level of
outside trade and merchandise market combination. By examining the validity of the
purchasing power parity result shows that the validity of PPP demonstrates a higher level
of products and foreign exchange markets integration. Financial changes assisted with
expanding the adaptability of costs and nominal exchange rates in altering the monetary
deviations. The short-run deviation from PPP has often occurred, yet since quite a while
ago run legitimacy of purchasing power parity could not be dismissed.

2.3 Conclusion

All the above-mentioned factors determine the fluctuations in the exchange rate of
any country so while transferring money from abroad remains updated with these factors.
From a monetary perspective, the price level and exchange rate are not independent.

7
 CHAPTER 3
THEORETICAL FRAMEWORK
3.1 Introduction

In research study it is very necessary to use those theories which are closely related
to study. Now, in present study we use three different theories price specie flow
mechanism, Purchasing power parity theory, and Marshall Lerner condition. These
theories are related to our study. The theories described the concept of exchange rate and
balance of trade and showed that how exchange rate changes improve the balance of
trade.

3.2 Price Specie Flow Mechanism

David Hume was a classical economist who introduced the concept of price species flow
mechanism to shows how an increase in exports would lead to an increase in imports.
Through this price specie flow mechanism, the disequilibrium between the export and
import automatically correct. Hume was a first economist who suggest a connection
between exports and imports. The concept of price specie flow mechanism used with
gold standard. Changes in the price level of a countries completely adjust by an inflow
and outflow of a gold or specie.
 Level of price Inflate by an inflow of gold or specie tends.
 Level of price Deflate by an outflow of gold or specie tends.

For this purpose, we take an example of two countries, country A and country B.

Suppose country A exports exceed than its imports and country B imports exceed than its
exports. In country A gold or specie is flow with in a country because exports of country
A exceed than its imports. Following is the rule of gold standard when gold flow with in
a country. In this situation country A lower the interest rate. According to marginal
efficiency of capital, the activities of investment increase, when Interest Rate decreases.
Now country A move under a situation of inflation. Country A became a good market in

8
selling activities but a very bad market in purchasing activities. Thus, exports of country
A decrease but its imports increase.

On the other hand in case of country B. Imports of country B exceed than its exports. In
this situation Gold or Specie flow out of the country. According to the rule of gold
standard country B rise their Rate of Interest when gold or specie flow out of the country.
And according to marginal efficiency of capital, the activities of investment decrease due
to increase the rate of interest. Now a Country B move under a situation of deflation.
Country B became a good market in purchasing activities but a very bad market in selling
activities. Thus exports of country B increase but its imports decrease.

According to the above analysis, through a changing in the level of price between country
A and B, the initial exceed of imports than exports in country B and exceed of exports
than its imports in country Aare automatically correct. The movement of short term
Capital also play an important role in the adjustment of trade balance under the gold
standard. With the help of following we easily understand how the rate of interest in
country A is lower than the rate of interest in country B. This will encourage the
movement of short term capital from country A to Country B.

3.3 Purchasing Power Parity Theory

Gustav Cassel was a Swedish economist who presented a purchasing power parity theory
in 1920. This theory states that exchange rate between two countries’ currencies are in
equilibrium when the purchasing power parity in each of the two countries same. This
means that between two countries the exchange rate and the price level of a fixed basket
of products should be equal. This theory also states the effect of un-stability in balance of
trade on the stable exchange rate.

In order to return purchasing power parity, the country exchange rate must have
depreciated when the country local price level increase. The country local price level
increase when a country experiences inflation. The connection between exchange rate
and inflation is known as purchasing power parity.

9
Purchasing power parity theory based on the “law of one price” which states that in the
absence of transaction cost, tariffs and other transportation cost (shipping cost),
competitive market will equalize the price of identical goods in two countries when the
price are expressed in the same currency. This connection between exchange rate and
commodities prices is known as the law of one price. Due to arbitrage opportunities, the
law of one price exists. If the price of a goods different in two different markets than an
arbitrageur will purchasing these goods in the cheaper market and sell it where the prices
of goods are higher.

Forms of purchasing power parity theory:

There are two form of purchasing power parity theory

 Absolute Purchasing power parity theory

 Relative Purchasing power parity theory

Absolute purchasing power parity theory:

The absolute purchasing power parity theory states that exchange rate between currencies
determined on the basis of purchasing power of the currencies in their respective
countries. In other word the absolute purchasing power parity theory also states that in
both of two counties the equilibrium exchange rate equal to the level of prices.
The absolute Purchasing power parity relation is:

Pd /P f =ER df

This equation show the relationship between domestic and foreign countries
Pd : Domestic price index
Pf : Foreign price index
ER df : Exchange rate of domestic and foreign countries (domestic currency units per unit
of the foreign currency).

For Example:
10
Take an example of two countries America and Britain. America country is donated by
“1’’ and the Britain country is denoted by “2’’. According to Absolute Purchasing Power
Parity theory exchange Rate of these two countries equal to the level of prices in America
and Britain.

The relationship between exchange rate and price level of both countries is

ER 12=P1 / P2

ER 12 : Exchange rate of America and British

P1 : Price of American goods
P2 : Price of Britain goods

This equation shows that exchange rate between US and UK equal to the price of
American goods to the price of Britain goods. If the Price of Goods in US Double to that
of the price in UK, then the exchange rate between both countries will be

12 P 1 2 dollar
ER = =
P 2 1 pound

This shows that if the price of one table is 2 dollars in America, the same product
available in British at the price of 1 pound. Then the exchange rate between US dollar
and UK pound will be 1pound=2$.

 When the foreign market exchange rate is greater than purchasing power parity,
then the domestic currency is undervaluing.
 When the foreign markets exchange rate is less than purchasing power parity,
then the domestic currency is overvaluing.

Relative purchasing power parity theory:

11
The relative purchasing power parity theory states that changes in the exchange rate equal
to the changes in price level between two countries

P1 s
( )
P1 c
ER = 2 s (ER 12 c )
12 s

P
( 2c )
P

Er 12 s : Exchange rate in the succeeding year (succeeding year donated by S)

ER 12 c: Exchange rate in the current year (current year donated by C)

Suppose, if the price of basket of goods in country 2 does not change from the current
year to the succeeding year, whereas the price increase by 50% in country 1. Then,
according to the relative purchasing power parity theory the exchange rates between
Country1 and Country 2 currency increase by 50%. It also means that value of country 1
currency falls by 50% in the succeeding year as compared to the currents year.

Relative purchasing power parity refers to rates of changes of price levels, that is,
inflation rates. This proposition states that the rate of appreciation of a currency is equal
to the differences in inflation rates between the foreign and the home country. For
example, if a Canada has an inflation rate of 1% and the US has an inflation rate of 3%,
the US dollar will depreciate against the Canadian dollar by 2% per year. This
proposition holds well empirically especially when the inflation differences are large.

3.4 Marshall Lerner Condition

Alfred Marshall and Abba Lerner is the two most popular economist of the
economic world. Who discovered the concept of Marshall Lerner Condition? In MLC
theory, both economists showed the effects of the changes in exchange rate on Balance of
trade independently. MLC is a heart of the elasticity approach to the balance of trade.

MLC states that devaluation in the exchange rate improved the trade balance, if the
sum of price elasticity of demand for import and export is greater than 1. The balance of
trade is worsening, if the sum of price elasticity of demand for import and export is less

12
than 1. And, if the sum of price elasticity of demand for import and export is equal to 1,
then the balance of trade unchanged not improved further.

In Mathematical way, the condition of changes can be written in the following way:

PED X + PED M >1

PED X + PED M <1
PED X + PED M =1

In short run period of analysis, level of output does not affect the price level. In
short run, the producer of the firm set the unchanged price of their goods and meets the
demand of the customers at that price. In this situation the supply curve is horizontal
when the output level does not affect the level of price. The firm set the unchanged level
of price of their product.

The local firm set the level of price Ṕof their products which is exported to the
other countries and the international firms set a price Ṕ*of their products in their
international currency. This means that the real exchange rate, E Ṕ*/ Ṕcan vary only when
there is a change in the nominal exchange rate, (E).

The Import market:

Resident of a country who is imported goods will be concerned with the price of
that imported goods in term of local currency even through the price has been set by
international producers at Ṕ*, the price the local economy experiences when the goods is
imported at E Ṕ*. Then the imported goods supply curve is infinite elastic at level E Ṕ*.

Explain with the help of diagram:

13
 Figure 3.1 Import Market

In figure 3.1 horizontal axis shows the quantity of import and vertical axis shows
the price of import in local currency. In import market, at E Ṕ*which is a fixed supply
price and supplier are willing to sell imported good at this price. The import demand
decreases due to the fixed price of supply in comparison to local goods E Ṕ*/ Ṕ.

The export market:

The producer of the local country set the export supply at ṔThe export goods supply
curve is infinite at Ṕ. The price of the exportable goods for a person abroad is in
international currency, P. By converting the price into the currency units of a person
abroad gives the prices of exportable good P/E.

Explain with the help of diagram:

Figure 3.2 Export Market

14
 In figure 3.2 horizontal axis shows the quantity of exports and vertical axis shows
the exportable good price. In export market due to menu cost price of supply goods fixed,
producers of the supply goods willing to export goods at the price Ṕ. The export demand
curve negatively slopes downward related to the relative price of the international goods
to the local goods. Demand of export in export market can be written in the following
way X =X ( Ṕ/E) / Ṕ*

Shifting of the Demand Curve:

In the figure 3.2, vertical axis shows the price of export goods in the currency of
exporting country. The demand curve of export changes the position due to change in the
nominal exchange rate. A demand curve shows the relation between the demands of
quantities of goods at different price level represented on the vertical axis. The demand
curve also shifts due to any changes of the other factors that affects demand.

Explanation with the help of example, the price of local country exportable goods is
P=100 and exchange rate is E=40 per USD then the export in international currency unit
is USD P/E=100/40=2.5 USD. Now we see what will happen when there is depreciation
of exchange rate. In case of demand curve for exports, suppose price of export is P=100
and exchange rate has depreciated to E’=50 per USD instead E=40 per USD. Now due to
depreciation export in international currency units is USD P/E’=100/50=2 USD. The
international price of the export has declined from USD 2.5 to 2. Thus, export become
cheaper and the demand of exportable items increase and the curve of export demand
shift rightward. And if the nominal exchange rate appreciated in foreign currency unit
exportable items become expensive and the curve of export demand shift leftward.

Now, we see how changes in exchange rate affects the balance of trade when
devaluation occur nominal exchange rate changes from E’ > E. The local currency price
of importable items rise E’ Ṕ*> E Ṕ*and the curve of import supply shift upward in figure
3.3A. The demand curve shift to the right side when devaluation makes exportable items
cheaper for those who want these items of export in term of their currency in figure 3.3B.

15
 Figure 3.3 Effect of a Devaluation

Effects of devaluation:
16
  In figure 3.3B, the Balance of trade improves because depreciation makes
products cheaper in the country and this rise the real export volume from X 0 ¿ X 1
 In the figures 3.3A, reduction in imports improves the balance of trade because
devaluation reduce the import quantity from Q 0m ¿ Q1m
 In the figure 3.3A, imported price in local currency rise fromE Ṕ* to E’ Ṕ*.Price
of international goods rise as compared to local country goods. Thus, the changes
in the valuation ofimports worsen the balance of trade.

Elasticity of imports:

Figure 3.4 Elasticity of Imports

Figures 3.4 shows two type of import demand curves - the Elastic import demand
curve and the inelastic import demand curve. At point E Ṕ*the both import demand
curves meet and the quantity of import is same atQ 0m. Due to devaluation local currency

cost rise E Ṕ*to E’ Ṕ*. And the import quantity decline Q 0m ¿ Q 1me along the elastic demand

curve of import and the imports changes smaller at Q 1m . along inelastic demand curve of
imports. Depreciation increase the price of import and increase import valuation for the

17
inelastic import demand curve that is given by the sum of area A and B which was given
in figure 3.4. Area A in figure show more elastic import demand curve.

When demand of import is inelastic than the 3 rd effect is larger and the 2nd effect is
smaller. This shows that demand curve of import and the demand curve of export are
more elastic and it improve the balance of trade. This theory confirmed that devaluation
in exchange rate improve the balance of trade, if the sum of both price elasticity of
demand for export and import is greater than 1.

PED X + PED M >1

18
 CHAPTER 4

DATA AND METHODOLOGY

4.1 Introduction

It is very important to use Data and Methodology in research study. It is also very
important to use reliable data sources and techniques to estimate the results. After the
literature review of different articles and theories on economic growth and on exchange
rate, it was investigated that there exists relationship between exchange rate and different
macroeconomics variables.

The present chapter will describe the different and their sources. It will also
describe different methodologies to describe different economic variables and their
relationship between them.

In short, the chapter will explain the different types of data, sources of data,
techniques econometric strategies and the description of variables to describe the
relationship between exchange rate and other microeconomic indicators, the case study of
Pakistan.

4.2 Data Source

This study uses the time series data for the years 1991-2019 for Pakistan and data
is collected from the World Bank (WB), International Financial Statistics (IFS) and
Pakistan Economic Survey.

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4.3 Description of Variables
Summary of variables which are used in present study, their abbreviation and
their measurement unit are given below in table 4.1

Table: 4.1Summary of Variables

Variables Explanation Units

ER Exchange Rate Percentage %
TOT Terms of Trade Percentage %
GOVD Government Debt Percentage %
IR Interest Rate Percentage %
INF Inflation Rate Percentage %

Trend of Dependent and Independent variables in Pakistan

4.3.1 Exchange Rate

Exchange rate is the rate of two currencies in which currency of one country is
exchanged for other country currency. In other words, it is the value or price of one
country currency in term of other country currency. For-example US 1$ is exchanged
with Pakistani 60RS, its mean 1 dollar = 60 rupee.

Types of exchange rate:

Three main type of exchange rate

 Fixed exchange rate: It is an exchange rate that is fixed by the government

through its agent, the central bank.
 Flexible / Floating exchange rate: It is an exchange rate determined by the
market forces of demand for and supply of the currency in the foreign exchange
market, it is also known as Clean Floating.

20
  Managed exchange rate:It is an exchange rate determined by the market forces
of demand for and supply of the currency in the foreign exchange market, but
managed by the central bank of the country, it is also known as Dirty Floating.

4.3.2 Terms of Trade

The terms of trade (TOT) is the relative price of exports in terms of imports and is

defined as the ratio of export prices to import prices. It can be interpreted as the amount
of import goods an economy can purchase per unit of export goods.

4.3.3 Government Debt

Debt is the entire stock of direct government fixed-term contractual obligations to

others outstanding on a particular date. It includes domestic and foreign liabilities such as
currency and money deposits, securities other than shares, and loans. It is the gross
amount of government liabilities reduced by the amount of equity and financial
derivatives held by the government. Because debt is a stock rather than a flow, it is
measured as of a given date, usually the last day of the fiscal year.

4.3.4 Interest Rate

Interest rate spread is the interest rate charged by banks on loans to private sector
customers minus the interest rate paid by commercial or similar banks for demand, time,
or savings deposits. The terms and conditions attached to these rates differ by country,
however, limiting their comparability.

4.3.5 Inflation Rate

Inflation as measured by the consumer price index reflects the annual percentage
change in the cost to the average consumer of acquiring a basket of goods and services
that may be fixed or changed at specified intervals, such as yearly.

21
4.4 Model Specification

To see the impact of exchange rate on balance of trade in case of Pakistan, we use the
following regression equation.

ER=f (TOT, GOVD, IR, INF)

The econometric model is as,

ERt = α0 + α1 TOTt + α2 GOVDt+ α3 IRt+ α4 INFt + ɛ

Where;

ER= Exchange Rate

TOT= Terms of Trade

GOVD= Government Debt

IR= Interest Rate

INF= Inflation

ɛ= Error Term

t= Time Series

This equation shows the relationship between dependent variable (ER) and
independent variables (TOT, GOVD, IR, INF). Exchange Rate is a function of terms of
trade, government debt, interest rate and inflation rate. Changes in independent variables
change the ER on Pakistan.

4.4.1 Time Series Data Analysis

Any variable that is measured overtime in sequential order is called a time series or
data recorded at regular intervals of time is called time series. Time series data analysis is
a statistical method which is used to make an inference about the pattern of the time
series data is known as the time series analysis. This analysis is used to detect patterns of

22
changes in statistical information over regular intervals of time. Time series data is used
to analyze the relationship between dependent and independent variables over a specific
time period. Time series data analysis is very useful to understand how variables change
with time. In present study time series analysis is used to determine the relationship
between dependent variable exchange rate and independent variable and examine the
effects.

4.4.2 Ordinary Least Square Method

In statistics, ordinary least squares (OLS) is a type of linear least squares method
for estimating the unknown parameters in a linear regression model. OLS chooses the
parameters of a linear function of a set of explanatory variables by the principle of least
squares: minimizing the sum of the squares of the differences between the observed
dependent variable (values of the variable being observed) in the given dataset and those
predicted by the linear function.

23
 CHAPTER 5

EMPIRICAL RESULTS

5.1 Introduction

The present chapter consists of various statistical techniques which is used to

perform the empirical results of dependent variable and independent variables by using
time series data. Firstly, we find descriptive statistics results to see the mean, median,
skewness and kurtosis value etc of collected data of dependent variable and independent
variables. In this chapter, we also present the correlation results, to measure the strength
between the variables. In the last of this chapter, we use Ordinary Least Squares (OLS)
Method to measure the long run and short run results of dependent and independent
variables.

5.2 Descriptive Statistics

Descriptive statistics define the data’s basic features. Central tendency uses the
three measures, mean median and mode for the measurement of a random variables
(Gujarati,2004).

Table: 5.1 Descriptive Statistics

ER TOT GOVD IR INF

Mean 67.10604 76.40543 41.16121 11.87069 8.18865

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 Median 60.27134 65.01 57.8 12 7.692156
Maximum 121.8241 123.5 79.8 20 20.28612
Minimum 23.80077 53.81 5.2 6.25 2.529328
Std. Dev. 29.03732 22.09233 27.99361 3.808836 4.243012
Skewness 0.190805 0.611813 -0.39258 0.265109 0.687163
Kurtosis 1.83985 2.02998 1.326054 2.122084 3.320367
Observations 29 29 29 29 29
Source: Software E-Views 9.0

Table 1 present the basic features of the data of every variable. Dependent
variable is Exchange Rate (ER) but the Terms of Trade (TOT), Government Debt
(GOVD), Interest Rate (IR), and Inflation (INF) are the independent variables of the
model. Numbers of the observations are 29 years from 1991 to 2019. The mean, median,
maximum and minimum values of the Exchange Rate (ER) are 67.10604, 60.27134,
121.8241 and 23.80077 respectively. Dispersion of data of every variable is measured by
the standard deviation in descriptive statistics. Highest value of standard deviation is
29.03732 of Exchange Rate (ER) in this model of the study. The values of the standard
deviation of other variables like Terms of Trade (TOT), Government Debt (GOVD),
Interest Rate (IR), and Inflation (INF) are 22.09233, 27.99361, 3.808836 and 4.243012
respectively. The skewness value indicates about data distribution whether it is positively
skewed or negatively. The value of skewness is 0.190805 of the Exchange Rate (ER) that
show data distribution of the ER is positively skewed and progressive. The kurtosis value
of Exchange Rate (ER) is 1.83985 that show Platykurtic distribution. Goodness of fit
checked by the Jarque-Bera test. Jarque-Bera test based on residuals of OLS. Jarque-Bera
test for Exchange Rate (ER) is 1.80232which is greater than 0.5 and forecast that data is
not normally distributed. If probability of data is less then o.o5 means rejected null
hypotheses. Probability (P) value of Exchange Rate (ER) is 0.406098,shows that it is
statistically insignificant.
Terms of Trade (TOT) is first independent variable in this study. The mean,
median, maximum and minimum values of the Terms of Trade (TOT) are 76.40543,
65.01, 123.5 and 53.81 respectively. The value of skewness is 0.611813 of the Terms of
Trade (TOT) that show data distribution of the Terms of Trade (TOT) is positively
skewed. The kurtosis value of Terms of Trade (TOT) is 2.02998 that show Platykurtic

25
distribution. The value of Jarque-Bera is 2.946159 and probability value is 0.229218.
Probability value show that that Terms of Trade (TOT) is statistically insignificant.
Government Debt (GOVD) is second independent variable in this study. The mean,
median, maximum and minimum values of the Government Debt (GOVD) are 41.16121,
57.8, 79.8 and 5.2 respectively. The value of skewness is -0.39258 of the Government
Debt (GOVD) that show data distribution of the Government Debt (GOVD) is negatively
skewed. The kurtosis value of Government Debt (GOVD) is 1.326054 that show
Platykurtic distribution. The value of Jarque-Bera is 4.130758 and probability value is
0.12677. Probability value show that that Government Debt (GOVD) is statistically
insignificant.
Interest Rate (IR) is third independent variable in this study. The mean, median,
maximum and minimum values of the Interest Rate (IR) are 11.87069, 12, 20 and 6.25
respectively. The value of skewness is 0.265109 of the Interest Rate (IR) that show data
distribution of the Interest Rate (IR) is positively skewed. The kurtosis value of Interest
Rate (IR) is 2.122084 that show Platykurtic distribution. The value of Jarque-Bera is
1.271007 and probability value is 0.529669. Probability value show thatInterest Rate (IR)
is statistically insignificant.
Inflation (INF) is fourth independent variable in this study. The mean, median,
maximum and minimum values of the Inflation (INF) are 8.18865, 7.692156, 20.28612
and 2.529328 respectively. The value of skewness is 0.687163 of the Inflation (INF) that
show data distribution of the Inflation (INF) is positively skewed. The kurtosis value of
Inflation (INF) is 3.320367 that show Platykurtic distribution. The value of Jarque-Bera
is 2.406283 and probability value is 0.300249. Probability value show thatInflation (INF)
is statistically insignificant.

5.3 Correlation Matrix

Correlation Matrix is used to check the statistical association among the variables.
The relationship will be shown positive or negative between the variables if the working
variables are increasing or decreasing together. However, if one variable is increasing and
other is decreasing then the correlation between the variables is negative. Nature of the
correlation is shown through the signs of the coefficient. Correlation Matrix is used to
check the multi-collinearity in the data, the value of the variables is not more than 0.9.

26
Table: 5.2 Correlation Matrix
TOT GOVD IR INF
TOT 1
GOVD -0.8821 1
IR 0.60725 -0.732688 1
INF 0.046082 -0.17228 0.564772 1
Source: Software E-Views 9.0

Consequences of the table represents the links of the sequence between each
other. Terms of Trade (TOT) is positively correlated with the Interest Rate (IR), and
Inflation (INF) while it is negatively correlated with Government Debt (GOVD).
Government Debt (GOVD) is negatively correlated with Interest Rate (IR), and Inflation
(INF). Moreover, Interest Rate (IR) is positively correlated with the Inflation (INF).
Moreover, the value of every variable is less than 0.9 in the table that predicts the absence
of the multi-collinearity in the data and we can further proceed to the Ordinary Least
Square (OLS) analysis.

5.4 Serial Correlation LM Test:

Table: 5.3 Auto-Correlation

Breusch-Godfrey Serial Correlation LM Test:

F-statistic 7.001571 Prob. Value 0.0042
Source: Software E-Views 9.0

To check the auto-correlation in the data, Breusch-Godfrey Serial Correlation LM

Test is applied. The value of the F-Statistic is 7.001571 and probability value is 0.0042 which
is greater than 5%. and outcomes predicts that auto-correlation exist in the data of the
current study.

5.5 Heteroskedasticity Test: Breusch-Pagan-Godfrey:

Table: 5.4 Heteroskedasticity Test

Breusch-Pagan-Godfrey
F-statistic 9.459798 Prob.Value 0.0001
Source: Software E-Views 9.0

27
 To check the heteroskedasticity in the data,Breusch-Pagan-Godfrey Test is applied.
The value of the F-Statistic is 9.459798 and probability value is 0.0001 which is greater than
5% and outcomes predicts that hetro exist in the data of the current study.

5.6 Ordinary Least Square (OLS) Method:

Table: 5.5 Regression Results
Variable Coefficient Std. Error t-Statistic Prob.
TOT 0.031837 0.012585 2.529758 0.0187
GD -0.08468 0.016455 -5.14622 0.0000
IR 0.50189 0.068925 -7.28168 0.0000
INF -0.739343 0.045541 16.23457 0.0000
R-squared 0.971297 F-statistic 160.1975
Adjusted R-squared 0.966305 Prob(F-stat) 0.0000
Durbin-Watson stat 2.376632
Source: Software E-Views 9.0

This table of the study shows the regression results of the Terms of Trade (TOT)
on the Exchange Rate (ER) in the context of Pakistan. Dependent variable is Exchange
Rate (ER) but the Terms of Trade (TOT), Government Debt (GOVD), Interest Rate (IR),
and Inflation (INF) are the independent variables of the model. Coefficients of the
variables show the strength of the variables, but positive and negative signs of the
coefficients show the direction of the variables either they are working in the same
direction or opposite.

Results of the table show that the coefficient and probability values of the Terms
of Trade (TOT) are0.031837 and 0.0187 respectively. Its mean that when TOT will
increase by 1 unit then the rise in the Exchange Rate (ER) will be 0.031837 unit. TOT
has statistically significant and positive impact on the Exchange Rate (ER) in the
Pakistan. As the exchange rate will increase, it would become the cause to enhance the
terms of trade because prices of exports will increase, and prices of imports will become
cheaper. The coefficient and probability values of the Government Debt (GOVD) are-
0.08468 and 0.0000 respectively. Its mean that when GOVD will increase by 1 unit then
the decrease in the Exchange Rate (ER) will be 0.08468 units. GOVD has statistically
significant and negative impact on the Exchange Rate (ER) in the Pakistan. When the
exchange rate increase, value of the currency will decrease, then the government have to

28
pay more amount against the principal amount and its services. That is why increased
government debt will negatively affect the high exchange rate. The coefficient and
probability values of the Interest Rate (IR) are-0.50189 and 0.0000 respectively. Its mean
that when IR will increase by 1 unit then the decrease in the Exchange Rate (ER) will be
0.08468 units. IR has statistically significant and negative impact on the Exchange Rate
(ER) in the Pakistan. Low interest rate will not attract the foreign capital, when the
foreign direct investment will not come in the country then it not become the cause to
increase the exchange rate. The coefficient and probability values of the Inflation (INF)
are0.739343 and 0.0000 respectively. Its mean that when INF will increase by 1 unit then
the increase in the Exchange Rate (ER) will be 0.08468 units. INF has statistically
significant and positive impact on the Exchange Rate (ER) in the Pakistan.

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 CHAPTER 6

CONCLUSION AND RECOMMENDATION POLICY

6.1 Conclusion

Objective of the study is to check the effect of the determinants of the exchange rate in
the context of Pakistan for the 29 years (1991-2019). Data source is the World Bank
(WB), International Financial Statistics (IFS) and Pakistan Economic Survey. The
Ordinary Least Square (OLS) Method is applied to get the results of the study. Results of
the OLS show that TOT has statistically significant and positive impact on the Exchange
Rate (ER) in the Pakistan. As the exchange rate will increase, it would become the cause
to enhance the terms of trade because prices of exports will increase, and prices of
imports will become cheaper. GOVD has statistically significant and negative impact on
the Exchange Rate (ER) in the Pakistan. When the exchange rate increase, value of the
currency will decrease, then the government has to pay more amounts against the
principal amount and its services. That is why increased government debt will negatively
affect the high exchange rate.IR has statistically significant and negative impact on the
Exchange Rate (ER) in the Pakistan. Low interest rate will not attract the foreign capital,
when the foreign direct investment will not come in the country then it not become the
cause to increase the exchange rate. INF has statistically significant and positive impact
on the Exchange Rate (ER) in the Pakistan.

6.2 Recommendation Policy

The results of the study suggest that TOT has positive impact on exchange rate it means
when our export increases our currency value increases and exchange rate goes upwards.
The positive impact of TOT on exchange rate shows that our fiscal policy is going in
right direction. Government should increase its exports to make exchange rate better. The

30
results also show that increasing government debt has negative impact on exchange rate
so government must keep a balance between its debts and exchange rates. Further results
of study show that inflation has positive impact on our exchange rate in Pakistan which
clearly means that our monetary policy is going in wrong direction. State Bank of
Pakistan must review its monetary policy.

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