Structural Decomposition of Exchange Rate Shocks in Pakistan: An Empirical Investigation using SVAR Methodology

This study is an attempt to decompose nominal and real exchange rate movements in Pakistan into components induced by real and nominal shocks. Using the Blanchard and Quah (1989), famously known as B-Q, methodology for the period 2000:1–2009:12, the study finds that real shocks affect both nominal and real exchange rate. Similarly, the nominal shocks have a permanent effect on nominal exchange rate but have temporary effect on real exchange rate. Moreover, speed of convergence is different between the two rates affected by the same shock. These results put forward that nominal devaluation is not followed by real devaluation and resultantly will not improve trade balance situation. The policy makers, therefore, need to be careful while taking any decision regarding nominal devaluation as it may also lead to worsening of, instead of improvement in, trade balance.