analyze the relationship between Exchange rate and inflation based on time series data, using can affect domestic price makers and increase domestic prices. Relationship Between Exchange Rate and Inflation in Pakistan As a matter of fact, rise in general price level can be mapped on growth of money supply. prove a significant long-run relationship between exchange rate and inflation in Ghana. The results Ghana's real GDP growth rate averaged % during the.
Also, UK consumers will find it more attractive to buy European imports.
What effect do exchange rates have on inflation?
Therefore they will supply pounds to be able to buy Euros and the Euro imports. This increase in the supply of pounds decreases the value of Pound Sterling. Therefore, in the long run, changes in relative inflation rates should lead to a change in the exchange rates. In the post-war period, the UK experience a higher inflation rate than Germany. This caused the Pound Sterling to depreciate against the German Mark.
It was a reflection that German industry was becoming more competitive than UK industry. Also, markets anticipate future inflation.
If they see a policy likely to cause inflation e. Of course, this would happen mechanically if prices did not adjust.
But, importantly, it also holds for goods for which prices change after an exchange rate shock. Gopinath argues that the strong effects of currency denomination arise because it is costly for firms to adjust prices.
Relationship Between Exchange Rate and Inflation in Pakistan - Economics
She shows that if it were costless to adjust prices, currency denomination would be irrelevant. When there are costs to renegotiating prices, however, exporting firms' choice of currency denomination will depend on their own cost composition and on the currency choices of other exporters.
If most other exporters price in dollars, then a firm will be better able to control its relative price in the market if it also prices in dollars. The findings suggest that absent coordinated international action, the dollar is likely to remain the dominant currency of international trade for the foreseeable future.
The causing factors of inflation in Pakistan remained inconclusive in both fiscal and monetary aspects.
Heavily dependent on specifications, the varying econometric results have yet to resolve the debate. Some of the empirical studies see for instance, Bilquees ; Hassan et al. Information plays an important role to change the business scenario and it also change the expectation of the people regarding market.
Therefore foreign investors require more return if risk is more to relative country. Such information is perceived from different macroeconomic variables. For example, information related uncovered interest rate can change the exchange rate and risk premium between two countries Duartea and Stockman, Macroeconomic variables can change the economic phenomenon as well as it leads to change the exchange rate at domestic level.
Nominal or real change in the interest rate is the main important feature of the monetary policy and it reason to change the exchange rate. In addition, the positive change in real or nominal interest at domestic level can appreciate the exchange rate at domestic level and vice verse Kim and Roubini, However, information regarding macroeconomic variables can be divided into two types whether it is strong or weak.
But strong announcement of macro-economic variables reason to appreciate the exchange rate. Although in long run there is a co movement in interest and exchange rate and this movement also leads to require the risk premium Fausta et.
Moreover, daily intervention by central economic authority also set the exchange rate but the benefit can be achieved for short term not for long term Dominguez, Subsequently, economic news related macroeconomic variables like interest; inflation and monetary policy increase or decrease the value of the currency.
In addition, positive change in fundamental of the economy can appreciate the value of currency while unexpected negative change in the economic variable leads to decrease the value the domestic currency Ehrmann and Fratzscher, Consequently, variation in inflation also changes the spot and forward exchange rate while it depends upon direction of the inflation of one country to other country.
- The Relationship Between Exchange Rate and Inflation in Pakistan
In addition, it is observed positive change in exchange rate if direction of inflation in two countries is same but domestic inflation remains low as compare to other country Simpson et. However, macroeconomic variable and exchange rate are positively correlated but it depends upon the time duration Ray, Accordingly, inflation and interest rate both have negative relation with nominal exchange rate.
However, expectation regarding real exchange rate has positive relation with nominal exchange rate Hsing, On the other hand, thereis a co movement between interest rate and exchange rate and sensitivity depends upon the monetary structure of the relative country.
The country having strong monetary structure has low co movement between exchange rate and interest rate Holtemoller, The above literature denotes the importance of interest rate and inflation in the determining the exchange rate. The existing work also investigates the relation of inflation and interest with exchange rate.
However, less work is done on this issue related to Pakistani scenario and the robust work enhances the knowledge at academic level as well as domestic level.
Inflation and Exchange Rates | Economics Help
The monetary policy in Pakistan aims at stabilizing the domestic and external value of the currency and to foster economic growth.
Therefore, the exchange rate pass-through to domestic wholesale and consumer prices is an important link in the process of monetary policy transmission. Any appreciation or depreciation of the exchange rate will not only result in significant changes in the prices of imported finished goods but also imported inputs that affect the cost of the finished goods and services.
Specifically, exchange rate movements can influence domestic prices through direct and indirect channels see Chart 1. In case of direct channel, exchange rate movements can affect domestic prices through changes in the price of imported finished goods and imported inputs. In general, when a currency depreciates it will result in higher import prices while lower import prices result from appreciation in price taker countries like Pakistan.