Impact of exchange rate and its volatility on domestic consumption in India and Pakistan

• Published date: 01 May 2022
• Author: Seher Mumtaz,Muhammad Ali
• Date: 01 May 2022
• DOI: http://doi.org/10.1002/pa.2479

ACADEMIC PAPER

Impact of exchange rate and its volatility on domestic

consumption in India and Pakistan

Seher Mumtaz | Muhammad Ali

Department of Economics, National University

of Sciences and Technology, Islamabad,

Pakistan

Correspondence

Muhammad Ali, Department of Economics,

National University of Sciences and

Technology, H12, Islamabad, Pakistan.

Email: alishuja@s3h.nust.edu.pk

Consumption accounts for more than 70% of GDP in both Pakistan and India and

both countries face high debt to GDP ratio as well as current account deficit. Conse-

quently, exchange rates are usually volatile and they directly affect major economic

indicators in the respective countries. Therefore, this study examines the impact of

the exchange rate and its volatility on consumption in Pakistan and India using the

time series data from 1980 to 2018. The empirical models differentiate between real

and nominal variables to isolate the impact of inflation pass-through. The long-run

and short-run relationships are identified using the autoregressive distributive lag

cointegration method. The results show that real and nominal exchange rates do not

have a significant relationship with consumption in Pakistan. Whereas, in India, an

increase in real exchange rate increases consumption while an increase in the nomi-

nal exchange rate reduces consumption, indicating inflation pass-through. The volatil-

ity of the real exchange rate has a positive relationship with consumption in Pakistan.

In India, the volatility of the nominal exchange rate has a negative relationship with

consumption; showing the presence of inflation pass-through effect in India. Our

results show that domestic consumption in India is more prone to external shocks as

compared to Pakistan, most probably due to a relatively higher degree of openness.

Our results suggest that there is a long-run relationship between exchange rate vola-

tility and consumption in both countries and the stabilization of the exchange rate

can improve the sustainability of consumption in both India and Pakistan.

1|INTRODUCTION

Globalization includes all types of economic and non-economic trans-

fers among countries such as the trade of goods and services, capital,

culture, technologies,and labor (Ali, Mahmood, & Bashir, 2015).Due to

globalization and economic integration, most countries today have

open borders for internationaltrade and investment. In foreign transac-

tions, the exchange rate plays a vital role, as it not only has an impact

on trade flows but also macro-economic variables like employment,

inflation, growth, and foreign direct investment (FDI). Therefore, the

stability of the exchange rate can influence macroeconomic decisions,

especially the ones witha long-time horizon andwith the focus on sus-

tainability (Joyce& Kamas, 2003).

Due to globalization, nations are exposed to external shocks. High

volatility in exchange rates causes uncertainty about prices in the

market and alters the consumption decisions of the households as

well as the government. Exchange rate fluctuations are especially

problematic for countries with high trade openness and a high share

of consumption to GDP (Pistaferri, 2015). Alexander (1952) was the

pioneering study on the relationship between exchange rate and

domestic consumption in which the effect of the exchange rate on

domestic consumption is explained through the inflationary effects

caused by devaluation or depreciation of the currency. Moreover,

exchange rate fluctuations can also affect local prices through

changes in the price of imported raw material and finished goods. The

higher costs of imported raw material and capital goods accompanied

by a depreciation of the exchange rate increases marginal costs

(MC) and lead to higher price of locally manufactured goods

(Obstfeld & Rogoff, 1998). The consequences of the fluctuations in

the exchange rate can be favorable or unfavorable on macroeconomic

Received: 13 July 2020 Revised: 31 August 2020 Accepted: 9 September 2020

DOI: 10.1002/pa.2479

J Public Affairs. 2022;22:e2479. wileyonlinelibrary.com/journal/pa © 2020 John Wiley & Sons Ltd 1of11

https://doi.org/10.1002/pa.2479