In Search of Exchange Rate Undershooting in Pakistan

Exchange rate behaviour does not follow very obvious and predicted pattern. Many attempts have been made to predict its behaviour as much as possible. This research re-examines the Dornbusch’s model of exchange rate overshooting caused by price rigidities. Dornbusch’s assumption of full employment in economy has been violated in this research which creates the possibility of exchange rate undershooting. In response to positive monetary shock, interest rate decreases and exchange rate undershoots its long run equilibrium. This research explains the dynamics of anti-intuitive exchange rate undershooting. Apart from theoretical formations of exchange rate undershooting, this research also analyses Pakistani data for exchange rate undershooting or overshooting in response to increase in money supply. Quarterly data of twenty three years for exchange rate, nominal interest rate, price, real output and money have been taken and vector autoregressive technique has been used. Evidence of exchange rate undershooting in response to positive money supply shock was found. It also gives an important insight into policy making by identifying some probable behaviour of exchange rate.

Real Exchange Rate Overshooting in Large Depreciations

The consequences of large depreciations on economic activity depend on the relative strength of the contractionary balance sheet and expansionary expenditure switching effects. However, the two operate over different time horizons: the balance sheet effect hits almost immediately, while expenditure switching is delayed by nominal rigidities and other frictions. The paper hypothesizes that the overshooting phase—observed early in the depreciation episode and driven by the balance sheet effect—is largely irrelevant for expenditure switching, which is more closely aligned with ex-post equilibrium depreciation. Given this, larger real exchange rate overshooting should signal a relatively stronger balance sheet effect. Empirical findings support this hypothesis: (i) overshooting is driven by factors associated with the balance sheet effect (high external debt, low reserves, low trade openness), (ii) overshooting-based measures of the balance sheet effect foreshadow post-depreciation output losses, and (iii) the balance sheet effect is strongest early on, while expenditure switching strengthens over the medium term.

Does Uncovered Interest Rate Parity Hold After All?

This paper tests Uncovered Interest Rate Parity (UIP) using LIBOR rates for six major international currencies for the period January 2001 to December 2008. We find that UIP generally holds over a short-term (above 5-months) horizon for individual as well as groups of currencies. Our results suggest that it is important to consider the cross-correlation between currencies. We also find that “state dependence” plays an important role for currencies with a negative interest rate differential vis-à-vis the US dollar. This state dependence could also be instrumental in explaining exchange rate overshooting.

A re-examination of the exchange rate overshooting hypothesis: Evidence from Zambia

2Dornbusch’s exchange rate overshooting hypothesis has guided monetary policy conduct for many years, despite the fact that empirical evidence on its validity is mixed. This study re-examines the validity of the overshooting hypothesis by using the autoregressive distributed lag (ARDL) procedure. Specifically, the study investigates whether the overshooting hypothesis holds for the United States dollar/Zambian kwacha (USD-ZMK) exchange rate. In addition, the study tests whether there is a long-run equilibrium relationship between the USD-ZMK exchange rate and relevant macroeconomic fundamentals. Using monthly nominal USD/ZMK exchange rates and monetary fundamentals data from January 2000 to December 2012, the study finds no evidence of exchange rate overshooting. The results also show that there is no long-run equilibrium relationship between the exchange rate and the differentials of macroeconomic fundamentals. The implication is that macroeconomic fundamentals are insignificant in determining the exchange rate fluctuations in the long run. This finding is inconsistent with the monetary model of exchange rate determination, which asserts that there is a long-run relationship between the exchange rate and macroeconomic fundamentals.