Abstract:
The question of whether devaluation of the currency affects output
positively or negatively has received considerable attention both from
academic and empirical researchers. A number of empirical studies have
supported the contractionary devaluation hypothesis using pooled time
series data from a large number of heterogeneous countries. Since the
effects of devaluation on output and the price level may not be uniform
across all developing countries, the empirical results can not be
generalized for all countries. In addition, almost none of the empirical
studies used to test the contractionary devaluation hypothesis separate the
effects of devaluation from import prices. Thus, a country specific study is
needed that separate the effects of devaluation from the import price
effects. This paper uses a VEC model to analyze the effects of the exchange
rate on output and the price level in Pakistan for the period 1975-2005.
Our analysis shows that devaluation has a positive effect on output but a
negative effect on the price level. Thus, the evidence presented in this
paper does not support the contractionary devaluation hypothesis for the
Pakistani economy.
