Impact of exchange rate and its volatility on domestic consumption in India and Pakistan

Abstract

Consumption accounts for more than 70% of GDP in both Pakistan and India and both countries face high debt to GDP ratio as well as current account deficit. Consequently, exchange rates are usually volatile and they directly affect major economic indicators in the respective countries. Therefore, this study examines the impact of the exchange rate and its volatility on consumption in Pakistan and India using the time series data from 1980 to 2018. The empirical models differentiate between real and nominal variables to isolate the impact of inflation pass-through. The long-run and short-run relationships are identified using the autoregressive distributive lag cointegration method. The results show that real and nominal exchange rates do not have a significant relationship with consumption in Pakistan. Whereas, in India, an increase in real exchange rate increases consumption while an increase in the nominal exchange rate reduces consumption, indicating inflation pass-through. The volatility of the real exchange rate has a positive relationship with consumption in Pakistan. In India, the volatility of the nominal exchange rate has a negative relationship with consumption; showing the presence of inflation pass-through effect in India. Our results show that domestic consumption in India is more prone to external shocks as compared to Pakistan, most probably due to a relatively higher degree of openness. Our results suggest that there is a long-run relationship between exchange rate volatility and consumption in both countries and the stabilization of the exchange rate can improve the sustainability of consumption in both India and Pakistan.

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