Government Budget Deficits and Exchange Rate Determination: Evidence from Pakistan

Abstract

It is now generally accepted that the real exchange rate is a key relative price in an econom/ Changes in the real exchange rate influence foreign trade flows, balance of payments, the structure and level of production, allocation of resources, etc. While the real exchange rate is an endogenous variable that responds to both exogenous as well as policy-induced shocks, the nominal exchange rate is usually taken as a policy instrument. The two rates, however, are found to be related to each other. 2 For effective policy-making, it is imperative to have some idea about different factors that influence the real exchange rate. Equally important is the knowledge of the manner in which the real exchange rate responds to changes in the exogenous variables. While there is a general consensus that the impact of various exogenous shocks on the exchange rate is transmitted through four broad channels, namely, (i) absolute prices, (ii) relative prices, (iii) income, and (iv) interest rates, the relative importance of each of these channels is found to vary across countries. In general, it depends on the degree of openness of the economy and the relative effectiveness of the fiscal and the monetary sectors within a country.

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