Wednesday, 21 May 2008

Recent Depreciation in Exchange Rate: Its Implications

In few weeks Rs/$ exchange rate has shot up to above Rs.69/$ from Rs.62/$, which has some serious implications. Though people might say that these are only short term but as argued by Eichner (1979) that problems in short periods give rise to all the serious problems of the economy thus we cannot ignore the implications which could be very serious in the long run, e.g., with a high debt in dollars, increase in exchange rate means our debt in rupee terms has increased as well.
Increase in exchange rate directly affects prices through increase in prices of imported products, which may include food products. Indirectly it affects through increase in the bill (in Rs.) for oil. Prices of oil are creping up to $127/barrel, which is increasing cost of production and depreciation in exchange rate creates a double impact on the cost of production. Increase in cost of production thus increases the domestic prices. However, how much it will increase prices is a major question.
Increase in cost of production will decrease profitability and investment, which directly affects GDP. Decrease in investment affects employment generation as well, which decrease the wage rate because the unemployment will be involuntary.
Moreover, increase in prices lead to decrease in real wages, and decrease in the welfare level of the people. Decrease in purchasing power leads to decrease in consumption, which has the major share in GDP.
On the other hand, it is good to let exchange rate float in the market which was overvalued for the last three years at least. Because foreign exchange intervention in the open market has its on drawbacks. Theoretically, free float removes the imbalances in balance of payment but it can only be done if there are no market discrepancies but in a country like Pakistan we need to think it twice whether it is true or not given the current circumstances. There are certain other advantages of floating exchange rate, e.g., we can use monetary policy effectively, we do not need to change our trade policy very often etc.
However we need to think whether there is a need to stabilize exchange rate at some par value or within some range or let it float wherever it goes. Does stability in exchange rate in Pakistan has fruitful affects on economy or we need to know some threshold level of stability in exchange rate. In the presence of supply shock, e.g. oil price shock, can we keep exchange rate at some par value or within some range. Above all, Is there any pass – through effect of exchange rate on prices because Hyder and Shah (2004) concluded that there is a moderate effect of exchange rate on CPI but stronger in case of WPI.

Comments are always welcome
Eichner, A. S. (1979), “A Guide to Post Keynesian Economics”, Edited by A. S. Eichner, M. E. Sharper, INC, New York
Hyder, Z. and S. Shah (2004), “Exchange Rate Pass – Through to Domestic Prices in Pakistan, Working Paper #5, State Bank of Pakistan.