Testing the Harrod Balassa Sameulson Hypothesis: The Case of Pakistan

For a small open economy of Pakistan, exchange rate is determined through the two alternative theories; the nominal theory of exchange rate named by Purchasing Power Parity (PPP) and the real theory known as Harrod Balassa Sameulson (HBS). According to the requirements of theories, two kinds of real exchange rate have been employed for the yearly data of 1972-2008. As, both of the theories are disputed at the ground of their long run relationship with real exchange rate, therefore, the VAR based Johenson Co-integration approach has been utilised to see the long run relationships. PPP has shown less satisfactory results either in its form of absolute version or relative version. Because, real exchange rate in Pakistan is a non-stationary process by Augmented Dickey Fuller unit-root test, predicting some pushing force behind the non-tradable sector. While favouring the PPP in tradable sector, the ADF and KPSS are indicating the presence of the HBS in Pakistan. On the other hand, the analysis of the HBS through co-integration is showing that relative productivity difference has an opposite relationship with relative non-tradable sector prices and with RER. However, the relationship between relative non-tradable sector prices and RER is much stronger and according to the theory. So, there have been incorporated some demand side and external factors to reduce the mis-specification of the simple HBS model. Therefore, in the extended HBS model, productivity difference, government consumption expenditure, terms of trade and world oil prices are appreciating the RER and money supply (a control variable) is pursuing depreciation in RER. So, these results yield some policy implications for Pakistan which can be useful for developing countries as well.