DETERMINATION OF EXCHANGE RATE IN PAKISTAN: EVIDENCE BASED ON PURCHASING POWER PARITY THEORY by

MUHAMMAD ARSHAD KHAN and ABDUL QAYYUM

Presented by Yousuf Razzak

Purchasing Power Parity

PPP theory was originally advanced by Cassel (1916, 1918), asserts that under the conditions of free trade the nominal exchange rate between two countries is equal to the ratio of the two countries price level. PPP theory assumes that equilibrium real exchange rates remain constant over time and therefore, movement in nominal exchange rates tends to offset relative price movements.

Purchasing Power Parity

The basic concept underlying the PPP theory is that goods market arbitrage equalizes prices internationally once the prices of goods are measured in the same currency. PPP continuously serves as an equilibrium condition in the theory of exchange rate determination and in exchange rate policy and frequently used to determine the link between exchange rate and relative prices

The building block of PPP is the law of one price (LOP) which simply states that in the absence of a competitive market structure and the absence of transport costs, quotas, tariffs and other trade impediments, trade and effective arbitrage in goods markets should ensure identical price across countries.

The LOP is based on the idea of perfect goods arbitrage. Arbitrage occurs where economic agents exploit price differences to provide a risk less profit.

Absolute Purchasing Power Parity

APPP is BASED on the law of one price. Law of Once Price States if two ore more countries produce an identical product, the price of the product should be the same no matter which country produces. If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices or the exchange rate between the countries is the ratio of prices. By comparing the prices of identical products denominated in different currencies, we could determine the real or PPP exchange rate that should exist if markets were efficient

Absolute Purchasing Power Parity

APPP is not very dynamic, it a static concept as it does not reveal changes in exchange rate or how the currency will behave in future.

Absolute purchasing power parity

The Relationship Between PPP and the Law of One Price
The law of one price applies to individual commodities, while PPP applies to the general price level. If the law of one price holds true for every commodity, PPP must hold automatically for the same reference baskets across countries. Proponents of the PPP theory argue that its validity does not require the law of one price to hold exactly.

Relative purchasing power parity (RPPP)

Relative purchasing power parity relates to the changes in the national price level or inflation rate and exchange rate. To put it as briefly as possible, If inflation rises in an economy it would put a downward pressure on its currency or there is an inverse relationship between the rate of inflation and currency value. Now this should not let you to the simplistic belief that whenever inflation rises currency value depreciates. Your approach must be holistic in the sense that the price level changes one among many other factors that determine exchange rate.

Purchasing power parity

Empirical testing of PPP and the law of one price has been done, but has not proved PPP to be accurate in predicting future exchange rates. Two general conclusions can be made from these tests:
PPP holds up well over the very long run but poorly for shorter time periods The theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets

Problems with Purchasing Power Parity in short run

Unidentical products between countries. Non Tradability of product and services No free flow of goods and capital between the countries.

Purchasing Power Parity and the Long Run

Purchasing-power parity theory tells us that price differentials between countries are not sustainable in the long run as market forces will equalize prices between countries and change exchange rates in doing so. In the long run having different prices in the United States and Mexico is not sustainable because an individual or company will be able to gain an arbitrage profit by buying the good cheaply in one market and selling it for a higher price in the other market.

Conti
The economic rationale behind the PPP is given by arbitrage on goods and asset markets. Specifically, if goods are perfectly mobile across countries, then arbitrage ensures that their prices after accounting for expected changes in the value of the various currencies are ultimately equalized, which is reflected in the PPP condition.

Purchasing Power Parity

Even if PPP theory may not hold in reality, it can still play a useful role in economic analysis. For instance one can use the PPP determine exchange rate as a benchmark in deciding whether a nations exchange rate is overvalued or undervalued in terms of PPP. Further a PPP determined exchange rate can be more useful than a market determined exchange rate for meaningful comparison of economic conditions of different countries.

Hypothesis Testing
This paper examines the empirical evidence on purchasing power parity (PPP) for Pak-rupee vis--vis US-dollar exchange rate.

The PPP Hypothesis states that the exchange rate between US and PAK currencies equals the ratio of the currencies purchasing power, as measured by national price levels (WPI) or Does Purchasing power parity hold true in Long run in case of Pakistan. OR HO: Purchasing Power Parity is consistent in Long run. H1: Purchasing Power Parity is inconsistent in Long run.

Data Methodology
The data set used in this study consists of quarterly observations covering the time series data from 1982Q2 to 2005Q4. We apply using Johansen (1988) and Johansen and Juselius (1990) multivariate cointegration and bound testing approach to cointegration over the period 1982Q22005Q4.

Data Methodology
Criteria for Inclusion: The exchange rate (st) is the average market rate measured in terms of unit of Pak-rupee per USdollar. Relative prices (p p*)t were calculated on the basis of wholesale price index.18 All the data were obtained from the International Financial Statistics (IFS) CD-ROM (2006).

 The variables used for the analysis are taken at log level so that their first difference signifies a percentage change between periods. Autocorrelation occurs in time-series studies when the errors associated with a given time period carry over into future time periods. Conditional Heteroskedasticity identifies non-constant volatility.

Durbin-Watson Statistic
Test for Autocorrelation
2 ( e e ) t t 1 t 2 2 e t t 1 n n

If d=2, In this Case is 1.93 autocorrelation is absent.

Model

The Testable version of APPP is given above Where s, p and p* are the natural log of nominal exchange rate, domestic and foreign price indices respectively while ut is the error term. 0 is the logarithm of the exchange rate observed in the base period. The absolute PPP in equation (1) shows comparative prices in different currencies in a given location and common basket of identical goods. Due to the fact that the PPP hypothesis is regarded as a theory of exchange rate determination, hence, its validity may be depends on the degree of the exchange rate flexibility. The absolute PPP cannot be tested empirically due to the non-availability of comparable data, particularly, on the price levels across countries

Model

The testable version of relative PPP is given above. Where is the first difference operator. For the relative PPP to hold the coefficient restrictions 0 = 0 and 1 = 1 must not be rejected. If these restrictions hold then relative PPP argues that the rate of change in exchange rate is equal to the inflation differential among two countries.

The next step is to estimate errorcorrection model based on long-run relationship between nominal exchange rate and relative prices to examine the short-run dynamics. The theory underlying the error-correction model is that a proportion of the deviations from PPP in the initial period are corrected in the subsequent periods. The error-correction model takes the following form

Where is the speed at which the deviations from the PPP are corrected. < 0 would indicate a reduction in the exchange rate in the current period. A negative and significant error-correction coefficient indicates the tendency for the exchange rate to revert to its long-run equilibrium path. = 0 shows no statistical relationship between the exchange rate and the deviation from PPP. In this case there is no tendency for the exchange rate to revert back to its long-run equilibrium. While > 0 would mean that the exchange rate is greater than its long-run equilibrium path. Under such situation one would expect that adjustments in exchange rate will take place in the next period and the movements in the price level will produce tendency in restoring long-run equilibrium. Sie Zie Roe

Results of Deviation from Longrun PPP

PPP may have deviations from its long-run equilibrium in either structural or transitory. First, the structural changes may have been a trend deviation from PPP. For instance, a productivity growth differential between countries leads to trend changes in the real exchange rate. A rise in the domestic productivity would give real appreciation of domestic currency against foreign currency. Shifts in technology, tastes, commercial policies and labour force growth will bring changes in the national productivity and hence real exchange rate.

The Transitory deviations from PPP occur as a result of disturbance through which the economy adjusts with differential speeds in goods and asset markets. This may be due to the price stickiness and imperfect competition in the product market. In addition, capital flows and divergent fiscal-monetary policies also generate significant deviations from the PPP.

Results
The mean reversion hypothesis is examined by testing the stationarity of the real exchange rate. Stationarity test of real exchange rate show that PPP does not holds. However, using Johansen-Juselius multivariate cointegration test we find one significant cointegrating vector, which indicates the presence of PPP in Pakistan. The robustness of the Johansen results is confirmed by implementing ARDL cointegration technique.

 An important finding of the study includes: first, the nominal exchange rate Is cointegrated with WPI-based relative price level. The cointegration coefficient between nominal exchange rate and the WPI-based price ratio is close to unity, confirming the proportionality proposition. These results lend strong support for the validity of WPI-based PPP.

 The reason for the presence of PPP in the traded sector could be: (i) the economic development of Pakistan is heavy dependent on the developed countries, and (ii) the government is pursuing trade, finance and exchange rate liberalization policies since 1990. To this end, various price controls were lifted and significant efforts were made in liberalizing the trade and payment systems. These liberalization policies allowed the LOP to work more efficiently as shown by the supportive evidence of PPP. The results further implies that high inflation rate due to monetary shocks have been neutralized over the long-run.

Second, the validity of PPP indicates a higher degree of goods and foreign exchange markets integration.