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http://dx.doi.org/10.13106/jafeb.2021.vol8.no12.0063

Real Exchange Rate Misalignment in Pakistan: An Application of Regime Switching Model  

FIAZ, Asma (School of Economics, Quaid-e-Azam University)
KHURSHID, Nabila (Department of Economics, COMSATS University)
SATTI, Ahsan (Pakistan Institute of Development Economics)
MALIK, Muhammad Shuaib (Economic Adviser Wing, Finance Division, Ministry of Finance)
MALIK, Wasim shahid (School of Economics, Quaid-e-Azam University)
Publication Information
The Journal of Asian Finance, Economics and Business / v.8, no.12, 2021 , pp. 63-73 More about this Journal
Abstract
This study investigates the key determinants of exchange rate (RER) misalignment for the period 1991 to 2020. The BEER technique has been used to estimate the degree of the equilibrium exchange rate. To explore the actual exchange rate misalignment and to assess the behavior of variables that are different in different regimes of undervaluation and overvaluation, the nonlinear technique of Markov regime-switching (MSM) was applied. The mean and variance of each regime are highly significant and show that undervaluation episodes have a low mean (116.139) and more volatility (1.229) while overvaluation episodes have a high mean (126.732) with less volatility (0.871). The findings show that MSM accurately identifies exchange rate misalignment in both regimes as separate incidents of overvaluation and undervaluation. Results further depict that misalignment of the RER is affected by terms of trade, net foreign assets, interest differential, government investment, and consumption decision. Results recommend that if policymakers want to use the exchange rate as a policy tool, they must first consider the drivers of the equilibrium exchange rate. As a result, any deliberate actions to address exchange rate misalignment must focus on the underlying fundamentals that drive the exchange rate.
Keywords
Exchange Rate; Misalignment; Markov Regime-Switching; Non-Linearity; Pakistan;
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