EFFECTS OF EXCHANGE RATE AND MONETARY POLICY ON THE TRADE BALANCE OF PAKISTAN

Abstract

This study has been conducted to investigate the effects of exchange rate and monetary policy on Pakistan's trade balance. Trade Balance is the difference between exports and imports. It is a significant element of the balance of payment. Trade balance may be surplus or deficit. In that case, when a nation's exports exceed imports, it is such a favorable situation that it may rarely occur. A deficit in trade balance transpires when a country’s imports are more significant than its exports. The secondary data of a time series nature spanning the range from 1971 to 2018 has been used for the analysis. The GDP, Interest rate, Exchange rate, Inflation, Foreign Direct Investment and Trade Balance data are collected from world development indicators and International financial statistics. The Johansen cointegration technique and Vector Error Correction method have been used to find the results. Monetary policy associated with the variations in interest rates may be contractionary or expansionary. This study has revealed that contractionary monetary policy, with the rise in the exchange rate, has worsened Pakistan's trade balance. The contractionary monetary policy caused a rise in interest rates, which decreased capital investment in the economy and resulted in a rise in the exchange rate, and this upward movement of the exchange rate worsened the trade balance of Pakistan. GDP has a positive and significant effect on the trade balance. The relationship between exchange rate and trade balance is negative, and the impact of ER on trade balance is significant. Inflation and foreign direct investment have a positive relationship, with trade balance having an insignificant effect. Interest rates negatively correlated with trade balance but significantly influenced the dependent variable. This study suggests that deterioration in the exchange rate improves Pakistan's trade balance mainly through increased exports and a cut in imports. It is exposed that the trade balance of Pakistan is highly sensitive to changes in exchange rate rather than interest rate, so it is considered that the trade balance of Pakistan is mainly and explicitly determined by the exchange rate.