Exchange rate misalignment in Pakistan: Evidence from purchasing power parity theory

Abstract

This paper examines the validity of the purchasing power parity to evaluate whether the Pakrupee vis-à-vis the US-dollar has been overvalued since the introduction of managed floating exchange rate. The Johansen multivariate cointegration technique is applied for the period 1982Q2-2002Q4. A single cointegrating vector is identified whose coefficients conform in broad terms to the restriction implied by the PPP theory, lending support to the interpretation of the model as describing a long-run relationship. This support is reinforced by the results derived from the adjustment coefficient, which is identifies clear short-run tendency for the exchange rate to revert to the equilibrium value defined by the estimated long-run model. Furthermore, exchange rate misalignment is also calculated using the estimated long-run relationship to evaluate whether the Pak-rupee vis-à-vis the US-dollar was undervalued or overvalued since the inception of managed floating exchange rate system. Calculated misalignment shows a substantial undervaluation of the Pak-rupee vis-à-vis the US dollar.