An Empirical Investigation of Purchasing Power Parity and Uncovered Interest Parity in Pakistan

Abstract

This paper examines the empirical validity of purchasing power parity (PPP) and uncovered interest parity (UIP) conditions for the Pakistan rupee–US dollar exchange rate using monthly data from January 2009 to July 2023. Employing unit root tests, Johansen cointegration analysis, vector error correction modeling, and ordinary least squares regression, we investigate whether macroeconomic fundamentals—specifically inflation differentials, interest rate differentials, money supply differentials, and output differentials—systematically explain exchange rate movements in Pakistan. Our findings indicate that neither strict PPP nor UIP holds in the short run for Pakistan, consistent with the broader empirical literature on emerging market economies. However, Johansen cointegration tests reveal the existence of five cointegrating relationships among the exchange rate level and its fundamental determinants, suggesting a valid long-run equilibrium relationship. The vector error correction model estimates indicate that deviations from long-run equilibrium are corrected at a moderate speed, with the exchange rate adjusting by approximately 3.3 percent per month. Augmented specifications incorporating global factors—including the US Dollar Index, economic policy uncertainty, and commodity prices—significantly improve explanatory power, with the current account balance and foreign exchange reserves emerging as statistically significant determinants. The results underscore the importance of structural factors, policy credibility, and external sector vulnerabilities in understanding exchange rate dynamics in emerging markets such as Pakistan.

Keywords: Exchange rate determination, purchasing power parity, uncovered interest parity, Pakistan, cointegration, vector error correction model, emerging markets