Modeling Exchange Rate Volatility in Pakistani Context The Application of Ardl Bounds Test Approach

Abstract

This study documents determinants of exchange rate fluctuations in Pakistan using an ARDL Bounds testing approach over the period of 1981-2015. The study explored the short and long-run factors of exchange rate fluctuations in Pakistan. Dependent variable was exchange rate while explanatory variables were Gross Domestic Product, Interest rate, Inflation Rate, Current Account and Foreign Direct Investment. Empirical results confirmed that Gross Domestic Product, Current Account and Foreign Direct Investment are significant determinants of exchange rate in Pakistan while Interest rate and Inflation Rate are not significant determinants. The ARDL bounds test approach confirmed lung run relationship between exchange rate and the explanatory variables. The error correction term was strongly significant and having the right sign (negative); this means that the estimated speed of adjustment to the long run equilibrium in response to the disequilibrium caused by the short run shocks of the previous period was 16 percent per year. Both ARDL long and error correction model were found to be robust because they passed all diagnostic tests such as Breusch-Godfrey Serial Correlation LM test, heteroskedasticity and normality test. Moreover, the CUSUM test confirmed the stability of both estimated models.