Exchange rate is a price of traded goods in the world market.
To maintain the commodities competitive in the market, exchange rate
should be adjusted according to the change in prices. If it is adjusted
accordingly, then we say that purchasing power parity (PPP) holds in
that country. However, phenomenon of PPP is completely kicked out under
floating exchange rate regime in the short run [see for example, Rogoff
(1999); Mark and Choi (1997); MacDonald (1999); Obstfeld and Taylor
(1997); Coleman (1995); O’Connel (1998) and Michael, et al. (1997)].
Recent statement by the President of the National Bank of Pakistan, that
the exchange rate and the interest rate are two faces of the same coin
[Bokhari (2004)], shows that the changes in the exchange rate is
strongly associated with the changes in the interest rate differential.1
It is also argued that under free float the value of currency is
determined by demand and supply of foreign exchange and to control the
value of currency using open market operations interest rate is used as
the key monetary policy tool. Moreover, deterioration of trade balance
leads to deprecation in exchange to make the exports competitive in the
market and vice versa.