Exchange Rate Misalignment in Pakistan: Evidence from Purchasing Power Parity Theory

In this study we have tested the validity of purchasing power parity hypothesis and exchange rate misalignment for Pakistan over the period 1982Q2-2002Q4. From the empirical analysis we can say that nominal exchange rate is cointegrated with WPI ratio. The cointegration coefficient between nominal exchange rate and the WPI-based price ratio is close to one. Furthermore, the coefficient restrictions are tested using maximum likelihood ratio statistic, lend support for the validity of the long-run PPP. Pakistan has been pursuing trade and exchange rate liberalisation policies from the late 1980s. Through these reforms, Pakistan has successfully eliminated most price controls and liberalised trade. These trade and exchange liberalisation policies allowed the law of one price to work more efficiently as shown by the supportive evidence of PPP. Moreover, the short-run deviation from PPP has frequently occurred, but the long-run validity of absolute PPP could not be rejected. The adjustment coefficient is negative and significant. However, the size of this coefficient is small indicating that the speed of adjustment is very slow. Even though long-run PPP holds, the speed of adjustment is rather slow, implying that misalignment is eliminated in the absence of shocks but only after a substantial period of time. The exchange rate remained undervalued vis-à-vis US dollar since the adoption of managed floating exchange rate system. Finally, the predictive power of these findings implies that exchange rate misalignment relative to PPP would eventually be corrected through commensurate movements in nominal exchange rates.