Testing for explosivity in US-Pak Exchange Rate via Sequential ADF Procedures

Global Financial Crises (GFC) of 2007-08 has disclosed the fact that economists and policymakers were unable to foresee bubble in housing prices in the US and other countries that consequently triggered the economic downturn. However, serious attempts have been made afterwards by researchers towards early identification of asset price bubbles, so that necessary policy measures could be taken to avoid any future mishap. Current study is conducted in similar vein to identify bubbles in nominal Dollar to Pakistani Rs exchange rate, from January 1982 to May 2020. Whether any identified bubble in nominal exchange rate is a rational bubble or otherwise generated by fundamentals, nominal exchange rate is adjusted for traded goods price differential and non-traded goods price differential in two countries as there is growing trend to take underlying fundamentals into account while studying asset prices to get accurate results on bubble detection (Bettendorf and Chen, 2013; Jiang et al., 2015 and Hu & Oxley, 2017). Further to explore whether nature of bubble changes with regime switching from managed floating to flexible floating in Pakistan is an addition of the study. Results of Generalized sup Augmented Dicky-Fuller (GSADF) test show that traded goods fundamental fully explain the movements in exchange rates even when non-traded goods are taken into account. Exchange rates were volatile both in managed floating and flexible floating regimes. However, volatility in only managed floating regime can be attributed to traded goods price difference. Various explosive episodes have been observed during flexible floating regime, which are either collapse or collapse and recovery phases.