Inflation Differential Pass-Through to Exchange Rate: Some Evidence From Pakistan

Using regression and wavelet coherence techniques this paper tries to probe the validity of purchasing power parity (PPP) in Pakistan. For this purpose, monthly data is collected for nominal exchange rate and consumer prices of Pakistan and its 23 major trading partners for the flexible exchange rate period 1982M1 to 2020M12. The regression results show that in 12 countries inflation differential significantly positively affect exchange rate. Similarly, Granger causality results reveal that inflation differential causes exchange rates in 12 countries. Wavelet coherency results indicate that there is significant co-movements between inflation differentials and exchange rates in varying time and frequency domains in all countries. These results indicate the partial validity of PPP in Pakistan. These results suggest that by reducing its inflation Pakistan can stabilize its exchange rates.JEL Classifications: C14, E31, F31 Inflation Differential Pass-Through to Exchange Rate in PakistanSeveral factors affect the exchange rates including domestic and foreign inflation rates. This study examines the effect of inflation differentials on exchange rates in Pakistan using purchasing power parity (PPP). For this purpose, monthly data of exchange rates of Pakistan against its 23 major trading partners is used for the period 1982M1 to 2020M12. The results depict that co-movements exist between inflation differentials and exchange rates in varying time and frequency domains. This finding shows that PPP partially holds in Pakistan. These results suggest that Pakistan can stabilize its exchange rate by reducing its inflation.