Abstract:
Inflation volatility is said to have adverse effects on consumption, as it introduces more uncertainty for consumers who are trying to allocate their budget between consumption and saving. Alexander (1952) stated that exchange rate volatility contributes to inflation volatility; it is shown to have a direct negative effect on consumption. This study intends to empirically examine the relationship between exchange rate and consumption and then find the impact of the exchange rate on household consumption in Pakistan and India by employing annual data for the period 1980 to 2018. The analysis is carried out by employing the ARDL technique. The bounds testing approach is applied to test for co-integration and error correction modeling is applied in order to estimate the short-run and long-run impact on domestic consumption. For India results are aligned with Alexander’s proposition that exchange rate negatively affects consumption whereas, it does not hold for Pakistan as it positively affects consumption. The positive relationship between exchange rate and consumption in Pakistan might be due to persistent habits and preferences to maintain standard of living even when exchange rates cause inflation. Consumption is the major component of GDP so policymakers use its determinants to fine-tune the economy. This study proposes that policymakers should consider exchange rate volatility in devising the monetary policy.
