Impact of Foreign Exchange Rate Volatility on Money Demand in Pakistan: An Empirical Analysis

Abstract

The primary objective of this study is to examine the impact of foreign exchange rate volatility on money demand in Pakistan. To achieve this, the study employs the disaggregate expenditure approach to construct the money demand function. Empirical estimation is conducted using the autoregressive distributed lag (ARDL) approach to investigate the cointegration among key variables, including money demand, exchange rate volatility, investment expenditure, consumption expenditure, government expenditure, and inflation. The findings from the long-run analysis reveal several significant relationships. Household consumption expenditures, investment expenditures, and inflation exhibit a positive and significant association with money demand in Pakistan. This indicates that as household consumption and investment spending increase, alongside rising inflation, the overall demand for money in the economy also grows. Conversely, the long-run results indicate that government expenditures and exchange rate volatility have a negative and significant impact on money demand. This suggests that higher government spending and increased foreign exchange rate fluctuations contribute to a decline in money demand. These findings highlight the intricate interplay between economic variables and their influence on money demand dynamics in Pakistan. Understanding these relationships is essential for policymakers and economists in designing effective monetary policies and financial strategies aimed at ensuring economic stability. By addressing exchange rate volatility and optimizing fiscal policies, economic planners can enhance monetary stability and strengthen financial resilience in Pakistan. The study provides valuable insights that can guide policymakers in managing money demand more effectively within the broader macroeconomic framework.