Do Monetary Models Really Matter to Determine the Exchange Rate Behavior: A Case for Pakistan

Abstract

This study attempts to investigate whether monetary models of exchange rates are contributing at the same pace to determine the exchange rates across countries, or whether their role has been changed through the development process. Since the ‘money demand’ and ‘purchasing power parity are two major elements of these models suggesting a linear association of monetary models with exchange rate fundamentals, therefore, to capture the expected long-run relationship across these models is assessed by applying the cointegration technique. Three main currencies based exchange rates of Pakistan are evaluated within the context of monetary models including the US dollar, Euro, and Chinese Yuan. A sample of monthly data for the period 1957 to 2020 has been analyzed. The results show a weak long run relationship in the case of the Chinese Yuan-based exchange rate; however, in the short-run monetary models are significantly contributing to determining the real (nominal) exchange rate in the case of all three based currencies. Whereas in the case of both Euro and US dollar-based exchange rates the relationship is strongly evident both in the long and short runs. Chinese Yuan appears to be preferred over both US Dollar and Euro for international payments and a major share in foreign exchange reserves.