The Dynamic Effect of Exchange Rate Volatility on Pakistan’s Imports: Application of VDC and IRF

Purpose: The objective of the present study is to investigate empirically the dynamic effect of exchange rate volatility along with other fundamental determinants of import demand functions for Pakistan on the basis of quarterly time series data by employing VAR (vector auto regression) approach. Methodology: The study also generates variance decomposition (VDCS) and impulse response functions (IRFS) to investigate the dynamic interactions among the variables in the VAR system. The study builds an understanding of the nature and dynamic relationship between real imports demand and its determinants. The study uses forecast error variance decomposition based on a vector autoregressive (VAR) model to estimate real income of home country, relative price of import, real effective exchange rate and real effective exchange rate volatility. Findings: The forecast error variance decomposition and impulse response function result clearly shows that the innovations of exchange rate volatility have a minor impact on import demand for Pakistan with partner economies under concern, whereas the innovations of gross domestic product of Pakistan have significant effect on import demand. Recommendations: The policy guidelines are suggested following empirical analysis.