Volatility of the Exchange Rate Chapter 10: Volatility of the Exchange Rate The exchange rate of the rupee has demonstrated considerable volatility over the years. Over the last decade, its value with respect to the US$ has fallen by 58 percent. There have been years of big depreciation and some years of appreciation. For example, in 2018-19, the rupee fell by 25 percent but in 2020-21 it appreciated by 6 percent. The last year, 2021­22, witnessed another big fall in value of the rupee with respect to the US$ of 23 percent. The fundamental question is that if the exchange rate is market-determined, as has been the case since 2018-19 and till recently, then what are the factors in the market which influence the value of the rupee? Currently, the SBP is following a policy of slow managed float of the rupee. The question is what is the extent of divergence if it had been market­determined? Section 10.1 describes the approach adopted in the Macroeconomic Model to determine the equilibrium exchange rate in Pakistani context. This is followed in Section 10.2 by estimating the likely exchange rate at the end of 2022-23 under different assumptions. 10.1 Determinants of the Exchange Rate Based on extensive examination of the macroeconomic relationships the conclusion is that the best predictor of the exchange rate is the size of the import cover. This is the size of the foreign exchange reserves in relationship to the level of imports of goods and services. Figure 10.1 shows the percentage change in the real exchange rate with respect to the import cover from 2016-17 to 2021-22. The real exchange rate is the nominal exchange rate divided by the domestic price index. There is clearly a strong relationship between the two variables. The issue then is how the import cover of reserves, the rate of inflation, etc. are determined, since the exchange rate plays a big role in the outcome of the external balance of payments, especially on the level of imports and exports. 101