Government Budget Deficits and Exchange Rate Determination:Evidence from Pakistan

It is now generally accepted that the real exchange rate is akey relative price in an econom/ Changes in the real exchange rateinfluence foreign trade flows, balance of payments, the structure andlevel of production, allocation of resources, etc. While the realexchange rate is an endogenous variable that responds to both exogenousas well as policy-induced shocks, the nominal exchange rate is usuallytaken as a policy instrument. The two rates, however, are found to berelated to each other. 2 For effective policy-making, it is imperativeto have some idea about different factors that influence the realexchange rate. Equally important is the knowledge of the manner in whichthe real exchange rate responds to changes in the exogenous variables.While there is a general consensus that the impact of various exogenousshocks on the exchange rate is transmitted through four broad channels,namely, (i) absolute prices, (ii) relative prices, (iii) income, and(iv) interest rates, the relative importance of each of these channelsis found to vary across countries. In general, it depends on the degreeof openness of the economy and the relative effectiveness of the fiscaland the monetary sectors within a country.