Do real exchange rate misalignments have threshold effects on economic growth? Asymmetric evidence from Pakistan

Abstract

This study investigates the impact of real exchange rate misalignment on Pakistan’s economic growth across different identified threshold levels. The research makes three significant contributions to the applied macroeconomics literature. First, it employs a dynamic regression model to assess the primary factors determining the equilibrium real exchange rate (ERER). Second, it examines the asymmetric impact of real exchange rate misalignment on Pakistan’s economic growth using the nonlinear autoregressive distributed lag (NARDL) model. Third, through a threshold regression model inspired by Hansen (Hansen, Econometrica 68:575–603, 2000), it identifies the threshold values of the Pakistani rupee that can either promote or hinder economic growth. The study concludes that the Pakistani rupee experienced significant periods of both undervaluation and overvaluation between 1982 and 2022. Moreover, the analysis establishes that overvaluation impedes Pakistan's economic growth, while undervaluation stimulates it. Our findings suggest that the undervaluation of the Pakistani rupee promotes economic growth up to an estimated threshold of a 10.025% deviation from ERER is reached. In contrast, an overvalued Pakistani rupee can stimulate economic growth up to a 9.346% threshold. The study implies that Pakistan should avoid both overvaluation and undervaluation beyond these identified thresholds to sustainably enhance economic growth. Additionally, it recommends that appropriate fiscal and monetary policies be pursued to maintain the exchange rate close to the equilibrium rate.