Real Exchange Rate and Trade Balance in Pakistan: An ARDL Co-integration Approach

The paper aims to find the long run and the short run relationships between trade balance, income, money supply, and real effective exchange rate for the period 1980 to 2011 in the case of Pakistan. The analysis is based on bounds testing approach to co-integration and error correction models, developed within an autoregressive distributed lag (ARDL) framework. The results of the bounds test indicate a stable long-run relationship between the trade balance, income, money supply, and real effective exchange rate variables. The estimated results show that increase in the level of income and depreciation in the real effective exchange rate are negatively associated with trade balance in the long and short run. Our results show that the money supply determines the behaviour of the trade balance in the long run but not in the short run. We also use innovation accounting by simulating variance decompositions (VDC) and impulse response functions (IRF) for additional inferences and find long-run relationship between trade balance and real effective exchange rate and income variables. However, we do not find long-run relationship between trade balance and money supply (M2). Our findings also suggest that Marshal-Lerner Condition for trade balance does not hold.