The Impact of Foreign Direct Investment, Inflation, and Total Reserves on Exchange Rate Volatility in Pakistan

This study investigates the intricate relationships between foreign direct investment (FDI), inflation, and total reserves on the volatility of the exchange rate in Pakistan from 1982 to 2019. Utilizing annual data sourced from the World Bank’s World Development Indicators, we employ the Autoregressive Distributed Lag (ARDL) bounds testing approach to analyze both long-run and short-run dynamics among the variables. Our findings reveal a significant long-run relationship where total reserves positively influence the exchange rate, indicating that higher reserves correlate with currency depreciation. In contrast, inflation and FDI, while theoretically expected to stabilize the currency, show statistical insignificance in the long run. The Granger causality tests suggest that fluctuations in FDI and total reserves are predictive of exchange rate movements, underscoring their critical role in driving exchange rate volatility. Additionally, CUSUM and CUSUMSQ tests confirm the stability of the model parameters over the study period. These results highlight the importance of macroeconomic policies aimed at enhancing external stability and managing inflation to mitigate exchange rate fluctuations, thereby contributing to sustainable economic growth in Pakistan