Nexus Between Real Exchange Rate Misalignment and Economic Growth: A Case of Pakistan

Abstract

This study investigates the nexus between real effective exchange rate (REER) misalignment and the economic growth of Pakistan. It relies on a single equation model for estimating equilibrium exchange rate using the autoregressive distributive lags (ARDL) approach. The study further uses the growth equation to explore the effects of misalignment of RER on growth proxies. The data were obtained from the official websites of the World development indicator, IMF, Penn World Table, Pakistan Bureau of Statistics, and Ministry of Finance Pakistan. In terms of trade, the data was available on three different bases in different editions of the economic survey of Pakistan. All unit values of imports and exports were changed as per new base 1991 so that the data from editions of survey becomes uniform. The study takes data from 1970 to 2020. The study findings show that gross capital formation, trade openness, and government spending have a substantial role in defining the equilibrium REER. The findings also identify a positive and significant effect of REER misalignment on the economic growth of Pakistan. This paper contributes by measuring the degree of misalignment of real exchange rates using the single equation approach which is rare in the case of Pakistani literature. The single equation approach not only measures the misalignment by PPP factor but also considers basic economic fundamentals such as trade openness, terms of trade, productivity differentials etc. The study further provides evidence of misalignment with economic growth over a longer period (1970-2020). The findings suggest the effective use of exchange rate policy to control exchange rate misalignment to get higher and more sustainable economic growth. The study is useful for policymakers in the long-term economic planning of Pakistan. The results can be generalized for other economies with similar features.