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Inflation & exchange rate are two main factors of macro-economics. Inflation is a rise in the general level of prices of goods & services in an economy by the passage of time. Exchange rate is very important factor in economic which impact imports & exports of country.
A country does not always want the exchange rate to fluctuate because an exchange rate influences the levels of its imports & exports, which are the component of fiscal policy. Policy makers want to hold rate at a particular level or within a certain range in order to achieve given domestic policy goals related to the level of growth of GDP.
In the perfect mobility the exchange rate movements and an adjustment of goods market is relative to asset market and consistent expectations. The extends that output responds to a monetary expansion in the short run, this acts as an effect on exchange depreciation which lead to an increase in interest rates (Dornbusch, 1976).
There are three types of ways which gives stickiness in prices, the prices set by the firms in that currencies, the firms set the prices for currencies of consumers, or firms set the prices in the currencies of producers (Engel, 2001). When the exchange rates changes, the changes appear in the relative prices and make to generate additional uncertainty for equilibrium in markets. However, there is also defining that the changes in terms of trade play the larger role of changes in the exchange rates which affect the variability of exchange rates (Stockman, 1980).
Inflation is one of the key indicators of the country and provides important information on the state of the economy and sound macroeconomic policies that govern it. Inflation is the production of the expenses of manner of things arise which leads to the advancement of the last in the price of meals.
For example, if the matter is hardy and this leads to the increment of the price of the production of the costs of increasing, and in turn this leads to increasing prices to keep the crowd his profits. The discretionary nature of the existing monetary policy in Pakistan is inflation, and it is targeting to hit on the Pakistani economy by focusing attention on the monetary policy.
So the government of Pakistan is to make monetary policy more transparent for achieving the explicit goal, and decreasing the inflation. Therefore, it is increasing the public understanding of the strategy of central bank to deliver the target, so the State Bank of Pakistan helps to provide an anchor for inflation expectations in the economy.
The State Bank of Pakistan (SBP) has achieving a low rate of inflation in a high priority, and also aims to support the national country objectives of Pakistan to meet the economic diversification and competitiveness in the form of export from the world.
1.2 Problem statement
This study is to examine the impact of exchange rate on inflation in Pakistan economy.
H1: The Exchange rate explains the inflation.
1.4 Outline of the Study
The variability of industrial production output higher in the regime of fixed exchange rates instead of regime of flexible exchange rates (Flood & Hodrick, 1986). The effect of consumption goods purchases by the government is not the private utility, but per capita real government expenditure are the composite of individual consumption of goods. So notice that the demand of money depends on consumption of goods rather than income and that is the important distinction of closed economies (Obstfeld & Rogoff, 1995).
Pakistan major import is crude oil which is purchased in dollars. If foreign exchange rate increases, it has increased the cost of oil that has adverse impact on the economy of Pakistan. Inflation is also caused by international loans and the national debt.
As nations borrow money, have to deal with the interest that the final prices increase as a way to keep up with debts. The main problem of Pakistan is external debt, which has altered the economic balance. The most immediate effect of inflation is the declining purchasing power of the rupee and its depreciation.
This study has been helpful for economic policy makers, foreign investors, economic analysts, business students who are interested in macro-economics studies. This study identifies how two macro-economic factors are related with each other.
For this study the following variables have utilized:-
Exchange Rates - Independent Variable:
The exchange rates are foreign exchange rate between two currencies. Every country has a foreign exchange market and is one of the largest markets in all countries of the world. It converts 3.2 trillion USD currency conversion. It has two types i.e. fixed and floating exchange rates. Meese and Rogoff (1988), it depends on fundamentals such as money supplies, real incomes, interest rates and inflation.
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Inflation - Dependent Variable:
Inflation has increased the general level of prices of goods and services in an economy by the passage of time. Price inflation measure is the rate of inflation, the annual percentage change in general price index (usually the Consumer Price Index) over time.
Effects of inflation on the economy have manifold and simultaneously positive and negative. Negative effects of inflation include a decrease in the real value of money and other monetary items over time, uncertainty over future inflation which discourages investment and savings, and high inflation leads to shortages of goods if consumers begin hoarding out of concern that prices increase in the future.
Positive effects include a development of economic recessions, and debt assistance by reducing the real level of debt.
CHAPTER 2: LITERATURE REVIEW
The analysis of the monetary determinants of inflation is of obvious interest for the nations that pursue a policy of inflation targeting. This study focuses on Pakistani economy that is currently following an Inflation targeting approach or did so in the recent past. Currency stability plays an important role for the monetary authorities in this economy.
Exception of real money growth rule is included in the estimation of Phillips curves for the four economies Bayesian model averaging (McCallum, 1999). Entrepreneurs seek stability in the course says that keeps the price of imported items from growth due to rupee depreciation, which is not only support the economy in general, but also exporters who use large amounts of imported cases in the production of exportable surplus.
Since the beginning of this fiscal year, while the rupee has lost about 2.5 percent of its value against the dollar and its depreciation rate is unlikely to accelerate in the coming months due to continued inflow of foreign capital and funds.
Also include the support of IMF, partial release of the fund, a coalition of U.S., which is part of its payment obligations by the Friends of Democratic Pakistan, extremely strong inflow of return of foreign workers of portfolio investments and possible pick-up in exports and foreign direct investment in the second half of fiscal year. Current rupee stability has helped in containing imported inflation and weakening inflation expectations.
Bankers expect that trend continues throughout this financial year, a national unit is depreciated more than 7.0-7.5 percent during the entire fiscal year, against 19.5 percent last year. Businesses verify that the bankers are the forward currency cover in accordance with this expectation.
What Pakistan needs today is not a platform to launch an "economic revival program" but what people need is an actual 'economic revival.' The main problem of Pakistan is the foreign debt which has risen to unmanageable proportions in the last decade and the repayment of which has created turbulence in external balance of Pakistan to such an extent that it does not meet its minimum necessary development requirements. At present Pakistan cannot survive without fresh borrowings from foreign donor agencies.
As emphasized by Choudhri and Hakura (2006), an important policy debate for the contemporaneous monetary and exchange rate policy implementations is to reveal the degree to which changes in exchange rates or import prices impact or pass-through into domestic consumer prices.
Presently there are three rates of exchange i.e. the bank rate, the inter bank rate and the open market rate. The overall effect on the foreign exchange rates should not be more than 5 to 6 per cent as the increased inflow of foreign exchange have neutralize the effect of the increased demand of private imports.
If the foreign exchange earners and remitters keep on getting a fair exchange rate for earnings, it is visualized that in the next few years exports can touch the $15 billion mark and overseas Pakistani remittances can fetch $5 billion.
It was concluded that the exchange rate feed shock on domestic inflation, first at the level of prices of the manufacturer and then the level of consumer prices and the impact of shocks on the variables of price the various stages of the supply is different.
The purchasing power parity theory doctrine means different things to different people. There are two versions of this theory that is called the 'absolute' and the 'relative' interpretation. The first version of purchasing power theory calculated as a ratio of consumer goods prices for any country that has tended to the equilibrium rates of exchange.
In the second version of relative interpretation the rate of exchange rate have been determined between the two countries and quoted with general levels of prices of two countries. This version amend the international trade theory which have been the part of PPP, in which the non-traded goods (services) has been introduced, but the advantage is greater in regards of traded goods than non-traded goods, because of the assumptions of marginal rates of transformation.
The relationship between purchasing power parity and exchange rates provides the international comparison of national incomes and living standards (Balassa, 1964). Lawrence (1976) gave another review of this purchasing power parity theory. It has define two applications in economics, the first application use of the conversion factor to transfer the data in one national way to another.
The use of PPP is mainly the body of (index number theory) and applications of GDP that have improved over the years and path breaking studies in the area continue to appear. The second application of PPP did not have the widespread acceptance, which has remained the unsophisticated applications.
Stockman (1980) develops the model of determination of prices of goods and exchange rates. The changes in commodity prices due to supply and demand affect the change in exchange rates by purchasing power parity deviations.The changes in exchange rates have failed to resemble the changes in prices of goods, because exchange rates more volatile than prices levels and inflation rates.
The study proposes the equilibrium of exchange rates behavior and different international goods that have been traded. This relationship cannot exploited by the government, because greater the changes in terms of trade the larger the changes in exchange rates variability.
The deviations from PPP persists that variation of exchange rates more than ratios of price indexes. The results found the two interpretation of the relationship between exchange rates and terms of trade. In the first, the causes that affect the changes in exchange rates also affect the change in terms of trade because prices of goods do not adjust to clear the markets.
This interpretation also found in the research of Dornbusch (1976), and Isard (1977), the analysis formally differentiates the system with respect to exchange rates and allow prices to change but not the changing in asset stocks. The interpretation presented the elasticity approach of the foreign exchange market and the relation between the trade and exchange rates.
Real supply and demand shocks affect prices and the derived demand of exchange rates. These changes in demand for foreign exchange result the supply and demand shocks and that should affect the equilibrium of exchange rates. In second interpretation the expected rate of change of exchange rates revealed on the forward foreign exchange market.
This should be related the anticipated change in the terms of trade and the inflation differentials. A persuasive argument about the level of exchange rates is only associated with not causes of the relative prices changes.
Bilson (1985) gives the empirical findings about macroeconomic and flexible exchange rate of the U.S dollar related to PPP theory. From the perspective of this research, the sluggish price adjustment in the commodity markets resulted in increased variability in exchange rates.
For the demonstration of result it is important because the instability of floating exchange rate is due to the inherent differences between commodity and foreign exchange markets. The determination of the expected future rate is impossible, because it is more difficult to reject the forward parity condition.
The major part of the forward parity is the variation in the premium is due to the forecast. The object of this study is to determine that if the forward parity failed is the cause of instability in the same way that the failure of purchasing power parity. The findings develop that currency risk premium is the important factor relative to floating rate system, and movement in the exchange rate are dominated by the non speculative activity and it has the adverse effect on world economy.
Meese and Rogoff (1983) analyzed the outcome of sample forecasting accuracy on various models. The study estimated the horizons of the dollar with different country currencies, like Dutch mark, Japanese yen, and Britain pound that traded to weight the dollar exchange rates.
It has also studied the flexible exchange rates with the monetary models of sticky price, so the model of sticky price, which incorporates the current account. The first model is structural models in which it requires to generate the forecasts of exchange rates and explanatory variables. It contains the explanatory power, but it is predicted badly because the explanatory variables are difficult to predict.
The second is the univariate time series model in which it identifies a variety of prefiltering techniques involves differencing, de-seasonalizing and removing time trends. The relative performance of these techniques is of interest in itself. The third model use is the random walk model. It is also linked with this univariate time series model.
It is used as the predictor of the current spot rate with the entire future spot rate, and it requires no estimation. In this study the performance of estimated univariate time series models or candidate structural model is no good instead it is worst. From a methodological stand point the view that the outcome of sample model fit is an important criterion when evaluating exchange rate, but the estimation of out of sample is failure with time series models that are well approximated the major country exchange rates.
Feinberg and Kaplan (1992) evaluated and interact the real exchange rates index expectations is developed and used to explore the role of determination on domestic producer prices. The fact that time path of the exchange rate has directly affected the input costs, and the price of substitutes strongly.
To examine the links between both actual and anticipated movements in the dollar and relative domestic producer prices, it chooses to analyze price responses to real exchange rate changes. The effect is dependent on the nature of substitutability between imports and domestic goods.
The major finding is that the period of appreciation and depreciation over the past 10 years to inhibit the pass through in to domestic prices. In depreciation the market share to enjoy the continued good times kept prices other than expected.
The theory of optimum currency areas, which is usually presented by the other name called flexible exchange rate system, but it is proponent as a device of depreciation that takes place of unemployment when the balance of payment is deficit and appreciation when it replaces inflation when it is surplus.
The problem can be exposed and more revealed by defining a currency area within when exchange rates are fixed. Three answers can be given, first certain parts of the world are going through the process of economic integration, so new experience can be made and what constitutes the optimum currency area can be given the meaning of these experiments.
Second those countries that have flexible exchange rates are likely to face problems with the theory of optimum currency areas, so these do not coincide the optimum currency areas with the national currency. Third the idea that illustrates the functions of currencies which have been treated in economic literature, and sometimes neglected in the problems of economic policy.
In the currency area, countries with different currencies including national country currencies interact pace of employment in deficit, because there is the presence of inflation in the surplus countries. The argument for flexible exchange rate system is based on national currencies, and is valid about mobility of factor, so if it is high in the country and low in the foreign countries, the flexible exchange rates system on home country currencies has to work effectively.
The concept of optimum currency area has practically applicable only in those areas, where the state has the political organization in the country. The factor mobility is most considered and is more relative rather than absolute concept, with both industrial and geographical factors.
It is likely to change the alterations with time over time in conditions, with the conditions of political and economic stability. Money is the convenience that restricts the optimum number of currencies, so in terms of this argument the optimum currency area which is composed in number of countries (Mundell, 1961).
In another review, the author defines the stabilization of capital mobility policy under the exchange rates which is fixed and flexible in the currencies markets. It concerns the theoretical and practical approach of the increased mobility of capital.
Obstfeld and Rogoff (1995) analyses the global macroeconomic dynamics to supply framework based on competition and nominal prices. This study incorporates the prices rigidities that explain exchange rate behavior without insights of the intertemporal approach to the current account. The effects of macroeconomic policies on output and exchange rates have not been yet persuaded to abandon.
The framework which integrated exchange rates dynamics and current account yields is a new perspective, it realize that when prices are sticky the government should spend on shock raises short run output and long run output.
The assumption is that home and foreign government purchases the consumption goods that do not directly affect the private utility, but the per capita real government consumption expenditure is a composite consumption of individual goods.
It explains that the composite consumption for the services is to balance the opportunity cost and notice that the money depends on consumption rather than income, that distinction is more important in closed economies. The results of this study develop framework that give new foundations about some of the fundamentals problems in international finance.
It realizes that the existing Keynesian model is incomplete to offer a satisfactory treatment of exchange rates, output and the current account, but the model which is used in this study is more complex, because it yields simple and intuitive insights of monetary and fiscal policies.
It can be extended in a number of dimensions, including non traded goods, market behavior, government spending, and labor market distortions and so on. It goes beyond the essentially statistical approach that handles the current account and exchange rates issues, most importantly this approach allows to analyze the welfare implications of policies.
Melvin (1985) has regarded and focused that how the choice of an exchange rate system can affect the stability of the economy. The appropriate nature of the exchange rate system has differed of the disturbance to the economy. It presented the evidence that indicate that the approach is more consistent according to practice by actual country.
The other approach is to reach the desirable price stability, in which some mechanism tells the floating rates superiority has become less in the face of monetary shocks. It finds that the flexibility in exchange rates depends not on openness and less important in the mobility of capital, but its positive effects were found for the economic development.
The purpose of this study is to consider the determinants of exchange rates system choice, which indicates the theoretical approach with the country choices. The result found that the choice of an exchange rate system has the role of the disturbance to the economy.
It suggests that the money shocks are the key of exchange rate system choice in an economy, in which it seeks to minimize the fluctuations in the country price levels. It also suggests that the greater the price shocks the more is a float, so it affects greatly domestic money shocks.
Lothian and Taylor (1996) examines the real exchange rate behavior, and explains the variations in sample of stationary univariate equations in real exchange rates. The study investigates the additional insight in the exchange rates behavior that can be gained by considering the floating rate from the perspective of the data.
These issues can be best understood on the subject of real exchange rates stability between the currencies of the major industrialized countries. Some of the pre-float studies support the fairly stable exchange rates in the long run. Subsequently, Dornbusch (1976), and Frenkel (1981), gave largely as the result of studies published, and reject the hypothesis of random walk behavior of real exchange rates.
The PPP shows the empirical movements in real exchange rates were highly persistent and effective. Although the PPP is reject the hypothesis of non-stationary behavior of real exchange rates in the long run. The result of this study shows that the longest span of two countries exchange rates are significantly mean reverting.
The first model result indicates the 80 percent of the variation in the exchange rates of the history data of two countries. By using of another model, the results explaining the performance of remarkably well in the floating, so that this model produce better forecasts of the actual exchange rates.
In line with recent studies, it fined that this process of mean reverting is quit slow, with estimated adjustment of data. In the long run the PPP equilibrium is remaining a useful empirical approximation.
Gerlach (1988) examine the dynamic interrelationship between innovations in monthly industrial production in a set of economies, specifically this study attempt the output fluctuations that have been correlated during the periods of fixed and flexible exchange rates.
The current has to manage exchange rates flexibility that has reduces the interdependence across countries. It should follow the recent article of Flood and Hodrick (1986) in which it is argued that the variability have been higher during a regime of fixed exchange rates instead of flexible exchange rates, but the conclusion of author is striking so sharply.
The results of this study of multiple country output movements under fixed and flexible exchange rates are clear. The variances of growth rates should be higher in the flexible exchange rates and in the fixed exchange rates periods. These variances are statistically significant related to the degree of openness and national income.
Thirdly the output movements are correlated across countries under exchange rate regime, particularly the co movements in output are more important in the business cycle frequently during the recent years of managed exchange rates flexibility.
CHAPTER 3: RESEARCH METHODS
3.1 Method of Data Collection
The Data of Consumer price index (Inflation) has been collected from federal bureau of statistics while the data of exchange rate has been collected from Pacific Exchange Rate Service, both are the secondary, published source of data.
3.2 Sampling Technique
The sampling technique that has been applicable is "convenience sampling" as it is easily accessible to collect the relevant information from the source and it is inexpensive and hence, gets a gross estimate of the results. (What is The Advantage of Convenience Sampling, 2007-2010).
3.3 Sample size
The sample size is selected on the basis of limitations and scope of the research therefore, Last 54 years i.e., 1947 - 2010, data of inflation and exchange rate is decided to be examined.
3.4 Research Model developed
From the above defined and explanations of both the dependent i.e. inflation and independent i.e. exchange rates variables and also discussing the effects of exchange rate on inflation and how it have affects on economic of a country. In this study first analysis is the correlation between these two variables, and identifies the significant relationship. Then it analyzes and evaluates the empirical investigation in regression model as a statistical tool. The simple regression model which can be defined in the equation that represented below:
Inflation = Î²Ð¾ + Î²(exchange rate) + Îµ
Î²Ð¾ = the intercept of the equation.
Î² (exchange rate) = the changing coefficient of exchange rate.
Îµ = the error term of the equation.
From the above explained model, the study develop the following estimation and used for the establishment of the model. Therefore, all the compatible data has entered in to SPSS for statistical analysis.
3.5 Statistical Technique
The statistical test that has been applied is single linear regression. This is because only one independent variable and one dependent variable to be used in this research.
Frankel (1979) defined that most of the recent work on floating exchange rate goes under the name of the monetary or asset view. The exchange rate is moving to equilibrate the international demand for assets, rather than the international demand for the flow of goods.
But with the asset view there is 'Chicago Theory' in which assumes that prices are perfectly flexible. As the consequences when nominal interest rate changes, it has also reflect the changes in expected inflation rate, so as the domestic currency expected to lose value through inflation and depreciation. This is the rise in the exchange rates and gets the positive relationship between positive exchange rate and inflation.
CHAPTER 4: RESULTS
4.1 Findings and Interpretation of the result
The simple linear regression technique is used to determine the explanation of dependent variable i.e. inflation due to independent variable i.e. exchange rate. The analysis of the result is defined below:
The hypothesis of this study is that exchange rate explains the inflation, which is being accepted and exchange rate is explaining inflation by 17.3%.
These findings support to recent theories that suggested the foreign exchange market efficiency with the existence of risk at equilibrium. Wihlborg (1982) examined the relation of interest rates, exchange rate and currency risks in this study. It identifies the test which empirically shows the impact of currency on interest rates and exchange rates. In this study there are three different ways in which the importance of currency risks for interest rate and exchange rate determination. The results presented here that substantiate the changes in the level of currency risk have a non-negligible impact on the changes of exchange rates and on rates of interest of relative between currencies.
CHAPTER 5: CONCLUSION, DISCUSSIONS, IMPLICATIONS AND FUTURE RESEARCH
This study is concluded to examine the dependency of exchange rate on inflation by using the data of consumer price index (CPI) as inflation and the data of exchange rate on yearly basis.
The result of this study is highly significant so that the hypothesis of this study is not rejected. The result shows that 17.3% variation in inflation is due to the exchange rate in Pakistan. The analysis of this study also shows that if exchange rate becomes zero, the inflation exist to some extent. For example, if one unit of exchange rate increases, the inflation increases only by 0.693 times.
This study has applied exchange rate as independent variable and consumer price index (CPI) as dependent variable. For the availability of data, all the data should be available on daily monthly and yearly basis, but the data is used in order to consistent as yearly basis. The regression model has been formulated for these variable relationship investigations. The study developed the hypothesis that the exchange rate explains the inflation in Pakistan, and the findings are supported by the analysis done by Balassa (1964), Meese & Rogoff (1983), Frankel (1979), and Mc Callum (1999) etc.
5.3 Implications and Future Research
The result also accompanies that the exchange rates are the strength of character of foreign exchange market in Pakistan, and it should effect on each of the related variables as an inflationary basis. Therefore the State Bank of Pakistan and Government officials should realize the role of exchange rates in the economy and try to maintain exchange rates to stop or decrease the consumer price index in Pakistan, so that the price range of every thing should be in range of common men.
Also government should address the issues that why exchange rates increasing, and why the consumer price increases due to foreign exchange volatility. If the Government takes effective actions against these issues so it can also facilitate the investors to gain confidence in the foreign exchange market and local currency value is strong from other foreign currencies. This has turned Pakistani currency to be stronger, and which has boost the economic growth.
In this study, only exchange rate is taken to predict inflation in Pakistan. But in the country like Pakistan inflation is predict by the various variables like interest rate, money supply, foreign trade and so on. So in the future research other variables should be included.