Master of Science in Economics
Faculty / School
Faculty of Business Administration (FBA)
Department of Economics
Date of Submission
Dr. Mohammad Nishat, Institute of Business Administration, Karachi
MSECO Research Project
Exchange rate is considered an important channel in the transmission mechanism of monetary policy in Pakistan in both short run and long run given the high dependence of the country on trade. Given the vital role of exchange rate in affecting inflation, it can be proposed that monetary policy in Pakistan can use exchange rate as a tool. Targeting exchange rate as part of monetary policy can help not only in controlling the imported inflation but also in promoting exports by allowing its depreciation through market mechanism. However, before proposing the exchange rate-targeting approach of monetary policy, it is needed imperative to empirically test if exchange rates respond to monetary policy and if the prevalence of a particular exchange rate matters to an effective transmission mechanism of monetary policy. In this regard, this study attempts to find the direction of causality between money supply (as an indicator of monetary policy) and exchange rate in both managed and pure floating exchange rate regimes. The causality has been found through Granger causality Wald tests using VAR approach. The model also incorporates change in price level, other than including money supply and exchange rate, to identify the effect of inflation on exchange rate. This has been done to make the model theoretically robust. The study finds that in the flexible regime, exchange rates significantly respond to inflation and inflation significantly responds to money supply but in the managed floating regime neither exchange rates respond to inflation nor does inflation respond to money supply. Meanwhile, exchange rates also respond to money supply in the flexible regime but not in the managed floating regime. This underlines the important role of flexible exchange rate regime in the transmission mechanism of monetary policy. Second finding is that money supply doesn’t respond to inflation and nor does the inflation respond to exchange rate in any of the regimes. Meanwhile, money supply also doesn’t respond to exchange rates in any of the regimes. This indicates the monetary-targeting approach of our monetary policies and emphasizes the importance of adopting exchange rate targeting approach of monetary policy in Pakistan.
Jabeen, F. (2014). Exchange rate regimes and the relationship between money supply and exchange rate: the case of Pakistan (Unpublished graduate research project). Institute of Business Administration, Pakistan. Retrieved from https://ir.iba.edu.pk/research-projects-mseco/4
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