Pride and Prejudice : Links between the Nominal Exchange Rates of Indian and Pakistani Currencies During 1957-1997

In theory, the exchange rate is assumed to respond to a number of economic factors such as the inflation rate differential, interest rate differential, and a number of other factors affecting expectations about the future. In practice, models of exchange rate that include economic variables tend to perform poorly against naiuml;ve random walk models. In the case of developing countries, their nominal exchange rate against powerful currencies such as the US dollar is sometimes seen as a symbol of pride and used as a source of political leverage. In this paper, we test this theory using the exchange rate data for two rival countries with a shared history: India and Pakistan. These two countries have no trade between them and their import and export patterns are completely different. Hence one would not expect any influence of one currency. But we find that Indian exchange rate influences Pakistan's and vice-versa, supporting the pride theory