This study has examined the impact of external debt and the volatility of exchange rate on domestic consumption in Pakistan by using the yearly data (1980–2014). We apply the bounds testing approach to cointegration and error-correction modeling to check their short run and long-run impact on the domestic consumption. The findings of this study has contributed to the existing literature in two ways: bound test results show that income, interest rate, exchange rate, volatility of exchange rate, and external debt have long-term relationship with domestic consumption and income, interest rate and exchange rate have positive impact whereas exchange rate volatility and external debt have negative impact on domestic consumption in the short run as well as in long run. Moreover, the coefficient of ECMt-1 is significantly negative and it shows that adjustment toward equilibrium from short run to long run takes more than half a year. Consumption is the major component of GDP so policymakers use its determinants to fine-tune the economy. This study proposes that policymakers should consider external debt and exchange rate volatility in devising the monetary policy of Pakistan.
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