Role of External Shocks in the Movements of Real Exchange Rate: A Dynamic Analysis for Pakistan

The study investigates the role of external occurred in Pakistan's economy during 1981 to 2012 with the following supporting variables (in literature known as fundamentals of exchange rate) including capital inflows (KI), trade openness (TOP) in the movements of Real Exchange Rate (RER) in Pakistan. In order to examine the role of external shocks, Error correction model (ECM), Johnson Cointeregation Technique and Impulse Response Function (IRF) have been applied to capture the short -run and long-run dynamics of the impact of external on the RER. Econometrics analysis supports the results of Cointegration, ECM and IRF analyses. Role of external shocks in the movements as well as determination of RER in Pakistan has also been analyzed. Exchange rate would be appreciated due to external shocks & improvement in the fundamentals like KI, where as deviation of RER significantly from its equilibrium level require immediate measures to correct it in order to maintain the external competitiveness of the economy. The results also reveal that external shock (D1) has lager influence on RER in short run as well as in the long run.