Estimation of Keynesian Exchange Rate Model of Pakistan by Considering Critical Events and Multiple Cointegrating Vectors

This study employs the Mundell and Fleming (1963) traditional flow model of exchange rate to examine the long run behavior of rupee/US $ for Pakistan economy over the period 1982:Q1 to 2010:Q2.This study investigates the effect of output levels, interest rates and prices and different shocks on exchange rate. Hylleberg, Engle, Granger, and Yoo (HEGY) (1990) unit root test confirms the presence of non-seasonal unit root and finds no evidence of biannual and annual frequency unit root on the level of series. Johansen and Juselious (1988,1992) likelihood ratio test indicates three long-run cointegrating vectors. Cointegrating vectors are uniquely identified by imposing structural economic restrictions of purchasing power parity (PPP), uncovered interest parity (UIP) and current account balance. Finally, the short-run dynamic error correction model is estimated on the bases of identified cointegrated vectors. The speed of adjustment coefficient indicates that 17 percent of divergence from long-run equilibrium exchange rate path is being corrected in each quarter. US war on Afghanistan has significant impact on rupee in short run because of high inflows of US aid to Pakistan after 9/11.