1 Exchange Rate Misalignment in Pakistan: Evidence from Purchasing Power Parity Theory

This paper examines the validity of the purchasing power parity to evaluate whether the Pak rupee was overvalued since the introduction of managed floating exchange rate. The Johansen multivariate cointegration technique is applied for the period 1982Q2-2002Q4. A single cointegrating vector is identified whose coefficients conform in broad terms to the restriction implied by the PPP theory, lending support to the interpretation of the model as describing a long-run relationship. This support is reinforced by the results derived from the adjustment coefficient, which identify as clear short-run tendency for the exchange rate to revert to the equilibrium value defined by the estimated long-run model. Furthermore, exchange rate misalignment is also calculated from the estimated long-run relationship to evaluate whether Pak rupee was overvalued since the inception of managed floating exchange rate system. Calculated misalignment shows substantial overvaluation of Pak rupee vis-à-vis US dollar