The impact of symmetric and asymmetric exchange rate fluctuations on demand for money in Pakistan

Abstract

A growing body of recent literature identifies the exchange rate as an important determinant of demand for money along with income and interest rate, but these studies assume the symmetric effect of exchange rate on demand for money. In contrast, this study argues that the exchange rate can have an asymmetric effect on money demand. Therefore, we estimate the symmetric and asymmetric impact of real effective exchange rate on demand for money from 1974 to 2019 for Pakistan using the symmetric and asymmetric autoregressive distributed lag model (ARDL). The estimated symmetric ARDL model shows insignificant impact of the real effective exchange rate on demand for money while the asymmetric ARDL results show that the impact of currency depreciation on money demand is positive and significant, suggesting substitution effect. Moreover, the stability of the money demand function highlights the role of monetary aggregates in the conduct of monetary policy.

Keywords:

• Asymmetric ARDL
• money demand function
• exchange rate
• monetary policy

SUBJECT CLASSIFICATION CODES:

• C22
• E41
• E42
• F31
• F33
• F41

Acknowledgments

The authors would like to thank two anonymous referees and the editor of this journal for their constructive comments and suggestions that improved the quality of this paper. They also thank Rafat Mahmood and Alex Acheampong for reading the initial draft and making suggestions for improvement.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1 In an open economy, the importance of the exchange rate in money demand function is well established in literature (Cuddington and Cuddington 1983; McKenzie 1992; McNown and Wallace 1992; Leventakis 1993).

2 For instance, Bahmani-Oskooee (1996) and Baharumshah et al. (2009) estimated the money demand function for China, Chowdhury (1997) for Thailand, Anwar and Asghar (2012), Iftekhar et al. (2016) for Pakistan.

3 Pakistan adopted monetary aggregates as policy target for conduct of monetary policy in 1995 but due to rising inflation over the period, the monetary aggregate targeting received criticism.

4 Current monetary policy approach is close to inflation targeting regime in which inflation implicitly serve as nominal anchor (State Bank of Pakistan 2020).

5 Without the inclusion of the exchange rate, money demand equation may not form co-integrated system with income and interest rate or can lead to the instability of money demand function (McNown and Wallace 1992; Chowdhury 1997)

6 Post-Keynesian economists also indicate that the speculative motive for holding money is income elastic (Baumol 1952; Tobin 1956).

7 The Nobel laureate Mundell (1963) is among the pioneer economists who suggested exchange rate should be included in the money demand equation in addition to interest rate and income. In an open economy, the importance of the exchange rate in money demand function is well established in contemporary literature (Cuddington and Cuddington 1983; McKenzie 1992; McNown and Wallace 1992; Leventakis 1993)

8 Arize and Shwiff (1998) used broad money (M2) for estimation of money demand function for 25 developing countries including Pakistan.

9 Avouyi‐Dovi et al. (2012) estimated the money demand function using nominal interest rate in level form.

Additional information

Notes on contributors

Abdul Hannan

Mr. Abdul Hannan is final year PhD student in Newcastle Business School at University of Newcastle. His research focus is on monetary policy issues, migration, remittances, international trade, industrial economics and crime.

Tahira Ishaq

Tahira Ishaq is final year PhD student in Newcastle Business School at University of Newcastle and working as Staff Economist at Pakistan Institute of Development Economics (PIDE). Her research interest includes monetary and fiscal policy issues, regional development, fiscal decentralization, spatial inequalities and crime.