Exchange rate behaviour after recent float: The experience of Pakistan

Abstract

The paper analyses different models to check the behaviour of exchange rate after the recent floating period in July 2000. It is found that the gap between the nominal and real exchange rate has widened after 9/11. Changes in the nominal exchange rate and real exchange rate are highly correlated and relative prices are not significantly correlated with the nominal exchange rate. Moreover, the exchange rate did not capture frequent changes in relative prices, which implies that PPP does not hold for the recent floating period. Real exchange rate always overshoots in response to exogenous shocks and then adjusts back to restore the equilibrium, although the adjustment process varies by country. The real exchange rate is not completely a random walk model and the movements are also explained by other fundamentals. It is safer to keep reserves in dollar and yen than in any other currency.