On the exchange rate expectations: Does UIP really beat PPP and random walks?

In this paper, the purchasing power parity, uncovered interest rate parity and random walk component are nested in a single equation and tested for Pakistan. The autoregressive distributed lag framework is used to recover the underlying parameters of exchange rate expectations formation. The estimates of unit-root tests indicate that all the variables have same order of integration. The long-run estimates show that the interest rate differential is the most significant determinant of exchange rate expectations. Besides, I find that the present stance of the exchange rate has also a critical role to play in exchange rate expectations. These findings are of significance in process of financial reforms and to design an effective exchange rate policy alike.