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Are Real Devaluations Contractionary? Theoretical Framework of the Model

Are Real Devaluations Contractionary? Theoretical Framework of the ModelHowever, despite these abundant studies on the relationship between real exchange rate and the output, works for Pakistan are still limited. There is only one study of the Choudhary and Chaudhry who examine the impact of the nominal effective exchange rate on output and inflation for Pakistan in the framework of a VAR model by using quarterly data over the period 1975-Q1-1985-Q4. Their main findings were that devaluation declined output and increased the price level in Pakistan. The study covers this gap for Pakistan by focusing on two objectives. First, it has been examined whether real devaluations are expansionary or contractionary in Pakistan. Second, the impact of the two regime switches (i.e. occurred during 1982 and 2000) on the output gap has also been investigated.
The key results of the study are that real exchange rate depreciation put expansionary effects on the output gap in Pakistan a result well in line with the contractionary hypothesis of the new structuralist economists. It has also been found that the historical exchange rate systems are related to the output gap. After a brief introduction about the impacts of real depreciation on the output gap the study proceeds in the following manner. In section-2 the theoretical frameworks of the model used in this study are given. In section-3., the empirical results are discussed. In section-4, the study has been concluded.
The models used in this study are derived on the basis of the standard IS curve backward looking models of Ball. Ball developed a closed economy model by taking output gap is a function of the lagged real interest rate, lagged output gap and an error term. Whereas, for designing his open economy model Ball added an additional variable lagged real exchange rate to his closed economy model. Based on the Ball closed and open economy IS curve models a three version IS curve approach will be used in the present study for analyzing the contractionary hypothesis in the context of Pakistan economy. First, for constructing the closed economy model, Ball model has been calibrated and nominal interest rate and inflation rate instead of the real interest rate have been included into it. However, the nominal interest rate is used contemporaneously and inflation rate in lagged form. Moreover, lags of the output gap have also been incorporated in the model. Equation shows the closed economy IS curve macroeconomic model of the study. In the model, output gap (Угг) is taken as a function of the interest rate gap (i3t}- inflation gap ( Tist-j ) and lags of output gap (ysrt_.). my payday loan

Whereas, stands for the random term. For simplicity and identification of the closed economy model, the constraints i.e. have been placed below the model for showing that regime shifts and the real exchange rate are not included in the model. Whereas, aLs, а.п5 j and C/.J, are the relevant parameters in the model and is the constant term. The main purpose here is to test the hypothesis that output gap (y^t) in Pakistan is determined only by the domestic factors. Second, for testing the contractionary hypothesis of devaluation and for showing that output gap (YBt) is an open economy issue in Pakistan Ball open economy IS curve model has been caliberated. Ball augmented his closed economy model with the lagged real exchange rate. However, deviating from Ball model in this study in addition to the real exchange rate some additional variables i.e. trade balance and foreign exchange reserves are included in the open economy model.

This post was written by , posted on May 4, 2014 Sunday at 11:22 am