Examining the Complex Role of Fiscal and Monetary Policy Shocks in Shaping Exchange Rate Dynamics: A Case Study of Pakistan's Currency Behavior

Abstract

This study departs from conventional literature by using quarterly data instead of annual data, enabling a more detailed exploration of short-term and long-term exchange rate fluctuations. It introduces an innovative analysis of the asymmetric effects of fiscal and monetary shocks on the Real Effective Exchange Rate (REER), a dimension often overlooked in prior research. The impulse response analysis reveals a clear pattern: negative shocks cause currency depreciation, while positive shocks lead to appreciation, except for money supply, where positive shocks result in unexpected depreciation. Variance decomposition emphasizes the dominant role of monetary policy tools—money supply and interest rates—over fiscal measures like government spending and taxes in influencing REER. The study recommends focusing on investment-driven fiscal policy to prevent excessive currency appreciation while supporting economic growth. Additionally, policies such as export promotion, import substitution, tight monetary regulation, and strong foreign reserves are essential for long-term exchange rate stability.