Currency Devaluation and its impact on the Economy

1.

with respect to Pakistan.

INTRODUCTION & ABSTRACT

The purpose of this paper is to determine and analyze the relationship

between devaluation of countrys currency and its impact on the economy.
Devaluation is a reduction in the value of a currency with respect to other
monetary units. OR Devaluation means decreasing the value of nations
currency relative to gold or the currencies of other nations. Devaluation
occurs in terms of all other currencies, but it is best illustrated in the case of
only one other currency, it specifically implies an official lowering of the
value of a country's currency within a fixed exchange rate system, by which
the monetary authority formally sets a new fixed rate with respect to a
foreign reference currency. The question arise here is why government
devalue their currency, and the reason behind is to encourage export and
discourage import. A devaluation means that more local currency is needed
to purchase import and exporter get more local currency when they convert
the export proceeds, in this way import becomes more expensive and
exporter will earn more money hence reduce trade deficit. In this paper we
will compare Pakistani Rupee against the US dollar and analyze impact of the
changing exchange rate on some economic factors of Pakistan.
This is very important to know that whether devaluation of currency could
affect the some particular economic factor of a nation, if yes then to what
extent. In this paper I have considered three dependent variables which are
Trade Balance, GDP and Inflation, on the other hand one independent
variable which is Pak Rupee exchange rate against dollar. The data is
gathered from State Bank of Pakistan & Federal Bureau of Statistics for the
fiscal year 1980-1981 to 2009-2010. To determine and analyze the
relationship between independent and dependent variables I have used
Linear Regression Analysis and found that there is a significant relationship
between exchange rate & trade balance hence we reject the null hypothesis

Currency Devaluation and its impact on the Economy

with respect to Pakistan.

and accept the alternate hypothesis, although the value of adjusted R-Square
is only 0.365 means the exchange rate predict trade balance with only 36.5
% accuracy which is moderate. The scatter plot does not follow any pattern
which shows the adequacy of the fitted model. The other two dependant
variables have found insignificant relationship with exchange rate.

2. LITRETURE REVIEW
A few numbers of studies have reviewed to determine and analyze the
relationship between the independent & dependent variables.
Waliullah, Mehmood Khan Kakar, Rehmatullah Kakar & Wakeel Khan (2010).
This article is an attempt to examine the short and long-run relationship
between the trade balance, income, money supply, and real exchange rate in
the case of Pakistans economy. Income and money variables are included in
the model in order to examine the monetary and absorption approaches to
the balance of payments, while the real exchange rate is used to evaluate
the conventional approach of elasticity (Marshall Lerner condition). The
bounds testing approach to co-integration and error correction models,
developed within an autoregressive distributed lag (ARDL) framework is
applied to annual data for the period 1970 to 2005 in order to investigate
whether a long-run equilibrium relationship exists between the trade balance
and its determinants. The result of the bounds test indicates that there is a
stable long-run relationship between the trade balance and income, money
supply, and exchange rate variables. The estimated results show that
exchange rate depreciation is positively related to the trade balance in the
long and short run. The results provide strong evidence that money supply
and income play a strong role in determining the behavior of the trade
balance.

Currency Devaluation and its impact on the Economy

with respect to Pakistan.

Sulaiman D. Mohammad & Adnan Hussain (2010). Objective of this study is

to estimate the impact of real exchange rate depreciation on balance of
trade in Pakistan. The study examines validity of the Marshall Lerner
condition in Pakistan data (1970-2008) by using impulse response function
which fulfills the J- curve idea. To evaluate long run association among the
variables by employing Johansson Co integration test. The end consequence
of test shows that there is long run relationship among the variables at
vector two.
Huseyin Kalyoncu, et all. (2008). This article studies the effect of currency
devaluation on output level of 23 OECD countries. All data are quarterly and
gathered from the International Monetary Funds International Financial
Statistics (IMF-IFS) database. The author uses unit root and co integration
test, to develop a simple model to test the devaluation-output growth
relationship. In order to test devaluation output growth relationship two
variables are constructed. These variables are real exchange rate (rer) and
real GDP (Y). Real exchange rate is defined as nominal exchange rate times
the ratio of US price index to the domestic consumer price index. The
nominal exchange rate is defined as the price of the domestic country in
terms of the US dollar (domestic currency/US dollar). The empirical evidence
suggests that, in the long run, output growth is affected by currency
devaluations in 9 out of 23 countries. In six out of nine countries,
depreciation

exerts

negative

impact

on

output

growth;

however

depreciation improves output in three countries

Munir A. S. Choudhary & Muhammad Aslam Chaudhry (2006). This paper
studies that whether devaluation of currency effect the output & price level
in Pakistan from the period 1975 to 1985 and to analyze the impact the
authors used VEC model and suggest that both increase in import price and
devaluation has short term effect on output and adverse effect on the price
level for Pakistan economy.
3

Currency Devaluation and its impact on the Economy

with respect to Pakistan.

Ehsan U. Choudhri and Mohsin S. Khan (2002). This paper challenges the
popular view that devaluation of the rupee is inflationary and re-examine the
evidence for Pakistan and present new results, which demonstrated that
rupee devaluations have had little impact on inflation. The data gathered
from Pakistan during the period 1982 to 2001 to examine whether inflation is
systematically related to changes in the exchange rate. The empirical tests
are conducted to find out whether or not devaluation leads to an increase in
prices and finds no association between rupee devaluations and inflation in
Pakistan. The paper finds no evidence of a significant pass-through of rupee
depreciations to consumer prices in the short run. It would appear, therefore,
that concerns about the inflationary consequences of devaluation in Pakistan
are somewhat misplaced. It appears, therefore, that concerns about the
inflationary consequences of rupee devaluation are unsupported by the
facts.
Eduardo Borensztein & Jos De Gregorio (1999). This paper has examined
the response of inflation after currency crisis for Asian countries and
construct a sample of currency crises that ended with a large depreciation of
the domestic currency in the 1970-1996 period. This paper does not address
the devaluations, and its effects on inflation.

3. METHODOLOGY
To test the relationship between independent variable which is Pakistani
Rupee against the US dollar and dependents variable that are Trade balance,
GDP & Inflation I have used Linear Regression Analysis by the help of 30
observation for each variable.

4. ANALYSIS

Currency Devaluation and its impact on the Economy

with respect to Pakistan.

First of all I have taken Exchange rate as a Independent variable and Trade
Balance as dependent variable and run regression test and found that there
is significant relationship between them and that is why I have reject the
Null hypothesis and accept the Alternative hypothesis. The R-value,
which represents the correlation between the observed values and predicted
values of the dependent variable. R-Square is called the coefficient of
determination and it gives the adequacy of the model. Here the value of RSquare is 0.365 that means the independent variable in the model can
predict 36.5% of the variance in dependent variable because there are also
many other factors which can affect the values of Trade Balance. Adjusted RSquare gives the more accurate information about the model fitness. The
histogram of standardized residuals shows the value of mean and standard
deviation of the residual in the model. The mean and standard deviation is
approximately 0 and 1 respectively, which shows that the fitted model is best
and the chances of error is minimum. The Normal probability plot of
regression standardized residual shows the regression line which touches
maximum number of points presents in the model and it also shows the
accuracy of the fitted model and the scatter plot also shows the adequacy of
the fitted model as we can see that the data is scattered and it does not
follow any particular pattern, so we can say that the fitted model has
minimum chances of error. The other two independent variables have found
insignificant relationship.
Model Summary(b)
Adjusted R
Model
R
R Square
Square
1
.622(a)
.387
.365
a Predictors: (Constant), Dollor Rate
b Dependent Variable: Trade Balance

Std. Error of
the Estimate
4.06069

ANOVA(b)
Sum of
Squares
df
Regression 291.598
1
Residual
461.697
28
Total
753.294
29
a Predictors: (Constant), Dollor Rate
b Dependent Variable: Trade Balance.
Model
1

Mean
Square
291.598
16.489

F
17.684

Sig.
.000(a)

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4. CONCLUSION
Devaluing currency is not the way to improve the economy for developing
countries like Pakistan whose imports are very crucial to run the country and
whos exports are inelastic. Devaluation is not a stable way to improve the
economy, unless the Government revises its method of economic planning
and execution of plans, no amount of devaluation will stabilize the external
value of our currency. We must give highest priority to the consolidation of
our economy via expansion. A strong discipline should be exercised over all
the unproductive expenditure whether it is in public or private sector.
The devaluation may also hurt the many companies that have heavy debts
denominated in foreign money. It can make the economy slower, with growth
falling and people may become worried. Exports may go down sharply and
the nation may face budget deficit. The stock market may dip to low, the
trade deficit may rise and bad property loans may bring crises to financial
institution. Accompanying the currency devaluation, the bank has to raise a
key lending rate by some percentage to guard against a surge in inflation

Currency Devaluation and its impact on the Economy

with respect to Pakistan.

which can be a threat for the economy. By requiring more currency to buy a
dollar, a weaker currency could raise the cost of imports. Devaluing currency
means devaluing the price of labor and talent in the international market
that send foreign exchange through home remittance. Devaluation will make
lose Pakistan heavily both as seller and as a buyer and will make no good
substitute for remedial changes in economic policies and developmental
planning.

5. RECOMMENDATIONS.
Developing Countries including Pakistan should first find out the factors that
jeopardize its economy. Some factors can easily identifiable in case of our
country Pakistan we should improve our tax collection system and imposes
taxes on landlords rather that general public. Electricity is also the major
bottleneck which prevents our economy to flourish, due to shortage of
electricity our industries are facing production problem we can not produce
export quality goods which result in negative balance of payment and lower
GDP. Encourage people to

get education and prevent brain drain and used

our human talent in most effective and efficient way.

By reducing import we can have positive balance of payment which really
boosts our economy. We are still using outdated farming mechanism with
modernization, growth could be doubled and export earnings could make a
big leap. Almost half of the fruits and vegetables go bad by the time they
reach consumers. Warehouses, refrigeration and storage facilities should be
the first priority to increase export of these items. The potential of fish
farming remains unexploited. Funds should be made available for fish
farming & foreign experts should be hired to groom the locals.

6. REFERENCES.
7

Currency Devaluation and its impact on the Economy

with respect to Pakistan.

Huseyin Kalyoncu, et all. (2008) Currency Devaluation and output

Growth:

empirical

evidence

from

OECD

countries,

International

Research Journal of Finance and Economics.

Ehsan U. Choudhri and Mohsin S. Khan (2002). The exchange rate and
consumer price in Pakistan: Is rupee devaluation inflationary. The
Pakistan Development Review.