On Nominal and Real Devaluations Relation: An Econometric Evidence for Pakistan

The economy can be affected, either positively or negatively, by the process of devaluation of local currency. An improvement in trade balance is considered as one of the most significant and beneficial impacts of devaluation. However, higher inflation would lead to expensive imports that offset the growth of economy resulting from an increase in exports. This reduces the effectiveness of devaluation to reduce the trade deficit. The benefits of devaluation are restricted where inflation severely hits the economy. Moreover, nominal devaluation of exchange rate improves the trade balance when it leads to real devaluation of exchange rate. The present study is also an attempt to explore the long run and short run relationship between nominal and real effective exchange rates. The study is one of the a unique attempt in the case of Pakistan as devaluation has always been a politically sensitive issue. The order of integration has been found through Ng-Perron (2001), whereas ARDL and DOLS are employed for long run correlations. The findings clearly indicate that nominal devaluation not only leads to real devaluation in long run but also in short run. This scenario provides directions for policy-makers to take into consideration both positive and negative implications of devaluation in Pakistan.