Understanding the exchange rate responses: a focus on monetary and output shocks in the context of Pakistan

This study examines the response of the real effective exchange rate (REER) to monetary and output shocks in Pakistan using quarterly data from 1980 to 2022 and employs the vector autoregressive (VAR) model. The impulse response shows that positive shocks appreciate the home currency, while negative shocks depreciate it, except for the money supply, where positive shocks depreciate it. Variance decomposition emphasizes that monetary policy variables, specifically the supply of money and interest rates, are the key contributors to exchange rates. VECM findings show that the money supply and inflation depreciate the currency, interest rates appreciate it, and output is negatively linked to REER due to high imports. The results of the structural vector autoregressive (SVAR) model support the robustness of the empirical findings. This study suggests that sound monetary policy and other tools are essential for economic stability.