The Impact of Exchange Rate Volatility on Inflation in Pakistan

Abstract

This study aims to investigate the impact of exchange rate volatility on inflation in Pakistan. Yearly time series data spanning from 1980 to 2021 are utilized. The study employs the Generalized Auto-Regressive Conditional Heteroskedasticity (GARCH) model to examine exchange rate volatility and its impact on inflation. Furthermore, the Auto-Regressive Distributed Lag (ARDL) model is used to investigate the short-run and long-run relationships among the variables. The study analyzes the consumer price index (CPI) as a representative measure of inflation, serving as the dependent variable. Meanwhile, the nominal exchange rate (NER), money supply (MS), imports (IMP), and exports (EXP) are treated as independent variables. The results of the stationarity tests indicate varying orders of integration among the variables, while the ARDL bounds test confirms the existence of a long-run relationship among them. The GARCH model results indicate the presence of exchange rate volatility, as well as a positive and statistically significant relationship between exchange rate volatility and inflation. Overall, the findings reveal that inflation in Pakistan is significantly influenced by exchange rate fluctuations and an increase in the money supply, as both variables exert a positive and statistically significant long-run effect on the consumer price index.