Impact of Real Effective Exchange Rate on Balance of Trade: A Case Study of Pakistan

Abstract

Primary aim of this paper is to indicate the impact of the real effective exchange rate (REER) on balance of trade (BOT) in Pakistan by applying time-series analysis from 1981 to 2015. The literature of independent variables suggests correlation and co-integration between these variables. The first step is to proceed to the ARDL model established on directing a unit-root test for the variables one by one deciding their level of alliance or integration. The outcomes of unit root test indicate that each variable in this analysis is integrated of order “0” and “1” which shows that few of the variables are stationary at level while some are stationary at the 1st difference. Such results suggest us to apply Autoregressive Distributed Lags (ARDL) model & Error Correction Mechanism (ECM). The outcomes of bound testing indicate that the model has a long-run and the short-run affiliation of dependent variable with independent and control variables. The investigation indicates the significant and positive relation among BOT and REER in long run with control variables e.g. gross domestic product (GDP), foreign direct investment (FDI) and foreign exchange reserves (FER). It means that misalignment in the real effective exchange rate (REER) is the cause of deficit in the balance of trade (BOT) in short run and long run. Near about 75% exports of Pakistan depends upon agricultural goods i.e. raw cotton, textile items, leather and sports equipment etc. Pakistan should diversify its trade to consumer goods, chemical items, electrical & electronic items and capital goods. This investigation also reveals that in Long Run a significant relationship between real effective exchange rate (REER), deterioration in terms of trade (TOT) and foreign debt by applying in which a channel “trade to exchange rate” found having uni-directional causality and running actively, by indicating the significant positive relationship between balance of trade and the real effective exchange rate (REER) in long run. The increase in the volume of global trade gets changes day to day with new dimensions.