EMPIRICALLY EXPLORING THE IMPACT OF INTEREST RATE AND ANNUAL CPI DIFFERENCE ON EXCHANGE RATE

This paper examines the relationship and the impact of interest rate and CPI difference from one year to another on the exchange rate of the home country. This particular study has been conducted in the context of Pakistan which serves to be the home country, and the empirical findings are made in relation to China, Japan, UK and USA. The study uses the panel data concerning the exchange rate, interest rate and CPI difference for all the five countries ranging from the first quarter of 1991(Q1) to the last quarter of 2011(Q4). The results of the study validate the conjecture of the literature that in the long-run, inflation affects the exchange rate in a positive way, while interest rate prevailing in a country has a negative impact on the exchange rate. The results of the panel data regression on the cumulative data of all the countries, with fixed-effect and random-effect shows that the relationship prevails but both the CPI difference and interest rate affects the exchange rate to a very insignificant level. Comparatively, the results of LSDV, which involved evaluating the coefficients on the country-specific level, shows that interest rate and CPI change has significant impact on the exchange rate.