This paper endeavors the relationship and the positive effect between exchange rates and interest rates in Pakistan by utilizing the foreign exchange market and current scenario of increasing interest rates because of increasing exchange rates to represent the economic position of Pakistan. The data by the researcher is all on daily basis for the above variables from the period of September 2001 to May 2008 for exchange rates, while for interest rates (6 month KIBOR) from the period of September 2001 to May 2008. The researcher implement regression model to test the effect of exchange rates progression on interest rates. So in this result, there is the issue of auto correlation exists and it shows the serial correlation between these variables. The issue should be resolved by taking time and KIBOR lag values as the dumm dependent variables. The study concludes on this way that there is the negative relationship between exchange rates and interest rates (KIBOR) in Pakistan and there is the impact of time and KIBOR on KIBOR.. It identifies that when exchange rates increases, there is decreasing in interest rates (KIBOR). This results and relationship is consistent as predicted by Meese and Rogoff (1988).

Every country has its own financial markets and it is the back bone of a country’s economy. The financial markets is divided in parts like foreign exchange market, stock market, money market, bond market etc. In this study, the researcher is focuses on the foreign exchange market, which is commonly known as ‘Forex’. It is the largest and most prolific part of financial market and defining the balancing of country’s economy, because every particular day, there are approximately one trillion amount of foreign exchange takes place in the countries around the world. The actual mechanism of the foreign exchange, that it is work as the main driving force for an any county’s economy in the world. Therefore, any country in the world should challenge their currency in the global economic markets. In the exchange markets for all the countries, home country currencies trade with other foreign country currencies. The foreign exchange market system is needed for every developed and under developed country; this system known as currency in exchange determination. For the determination of the value of a currency’s exchange rate, there are two main types of system is used, one is floating exchange rates system and the other is fixed exchange rates system. The intervention of government official’s authorities in the foreign exchange market is to influence the exchange rate fluctuation as a worldwide phenomenon. The authorities intervene maintaining the objective to orderly market conditions that ultimately help to achieve the overall macroeconomic goals. However, the exchange rate has playing an important role in terms of the flexibility in macroeconomic framework to deal with changes in the external terms of trade, but the monetary policy also aims the national objectives of economic diversification and to support export competitiveness. The ineffective monetary policy under fixed exchange rates as compared to flexible exchange rates, but fiscal policy under both fixed and flexible exchange rates remains weaker of achieving the level of output. (R.A. Mundell, 1968). The level of currency risk changes, it has no negligible impact on the rates of change of exchange rates and on relatives’ rates of interest between currencies. (Clas Whilborg, 1982). The risk premium of the currency is the important factor relative to floating exchange rate system, but movements in the exchange rate are dominated by the non speculative activity and it has the adverse effect on world economy. (John bilson, 1985). The true statement that in many cases the sign of the estimated exchange rate-interest rate differential relationship is consistent with the possible predominance of financial market disturbance (R. Meese & K. Rogoff, 1988). The consequences changes in the nominal interest rate reflect changes in the tightness of monetary policy. The higher the interest rate in the country attracts the capital inflow, which causes the domestic currency appreciates, so this gets the relationship could be negative between the exchange rate and nominal interest rate differentials. (J.A. Frankel, 1979). The assets are dominated and exchange risks interest reflects the interest rate parity when different currencies affect political risk and that’s why assets are issued in different currencies. Thus the interest differentials to the political risk of future capital control must be distinguished due to the effective tax that controls the place in interest earnings. (M.P. Dooley & P. Isard, 1980). The concept of political risk is that the probability authority of the state will be interposed between investors in one country and investment opportunities in other countries that is the probability that controls the imposed on capital flows. (R.Z. Aliber, 1973). If price levels and exchange rate are significantly volatile and cannot be costly hedged, are adversely affected in the real value of the domestic currency. There is some evidence that exchange rate fluctuations are a priced factor in cross sections of stock return converted into a common currency. (W. Bailey & P. Chung, 1995). In the perfect mobility the exchange rate movements and an adjustment of goods market is relative to asset market and consistent expectations. The extends that output responds to a monetary expansion in the short run, this acts as an effect on exchange depreciation which lead to an increase in interest rates. (Rudiger Dornbusch, 1976). The foreign exchange gain or loss is made in the course of covering; consider being capital assets, so this gain or loss treated on capital account. This shows the highly sensitive interest dynamics with exchange rates. (M.D. Levi, 1977). The variability of industrial production output will be higher in the regime of fixed exchange rates instead of regime of flexible exchange rates. (Flood & Hodrick, 1986). The effect of consumption goods purchases by the government is not the private utility, but per capita real government expenditure are the composite of individual consumption of goods. So notice that the demand of money its depends on consumption of goods rather than income and that is the important distinction of closed economies.(Obstfeld & Rogoff, 1995). The fixed and floating exchange rates depend on higher welfare yield and on the nature of sticky prices, so the risk would be shared and there are some opportunities to aware. The evidence, which should give opportunities about price setting and risk sharing are not refined and not to make the definite conclusions for the optimal regime of the exchange rate of that country. There are three types of ways which gives stickiness in prices, the prices which would set by the firms in their own currencies, the firms would set the prices for consumer’s currencies, or firms would set the prices in the currencies of producers. (Charles Engel, 2001). When the exchange rates changes, it may cause to appear the changes in relative prices and make to generate additional uncertainty for equilibrium in markets. However, there is also defining that the changes in terms of trade would play the larger role of changes in the exchange rates which affect the variability of exchange rates. (A.C. Stockman, 1980). This study explores to investigate the determinants of exchange rates in developing country such as Pakistan. The framework of this study is concern to be conceptual and theoretical and is to set up the ground of unidirectional causality from exchange rates to economy. In principal, it determines the exchange rates relationship with interest rates so it will spurs the determinants in Pakistan with related to the economy. This view implies that the choice of an exchange rates regime be a relatively simple, if countries were faced to intervene regularly in the foreign exchange market to stabilize, therefore the monetary authorities intervene with the objective of maintaining orderly market conditions, which ultimately help to achieve the overall macroeconomic goals. The discretionary nature of the existing monetary policy in Pakistan is inflation, and it is targeting to hit on the Pakistani economy by focusing attention on the monetary policy. So the government of Pakistan is to make their monetary policy more transparent for achieving their explicit goal, and decreasing the inflation. Therefore, it is increasing the public’s understanding of the central bank’s strategy to deliver the target, so the State Bank of Pakistan will help to provide an anchor for inflation expectations in the economy. The State Bank of Pakistan (SBP) has accorded a high priority to achieving a low rate of inflation, and the monetary policy also aims to support the objectives of the national country of Pakistan to meet their diversified economy and competitiveness in the export from other countries of the world. This study will also helpful to the SBP to developed their awareness of the relationship of exchange rates with KIBOR, so SBP may observed the controversy of their ups and downs fluctuations so it may controlled significantly. The bank treasury department should get the help because, they have continuously meet the exchange rates and make transactions of the country’s currency with others country currencies, so it should make them identify that if exchange rates increases or decreases it should not make effect on interest rates but their should be some inverse effect in nature. This effect should create controversy in the country economy so the central bank should make some authorized decision to controlled the exchange rates and interest rates The thesis is structures as follows. Chapter II provides literature review. Chapter III defines the outline of variables, their sample size, data sources and its formatting and the model. Chapter IV explains our findings and results. Finally Chapter V reports conclusion Chapter II Literature Review: This study relates to examine the relationship and effect between exchange rates with interest rates. Numbers of studies have done by the researchers, ‘Robert A. Mundell, (1961)’, ‘Bela Balassa (1964), ‘Robert Z. Aliber, (1973)’, ‘Rudiger Dornbusch, (1976)’, ‘Richard A. Meese & Kenneth Rogoff (1982)’, ‘H.M.S Gerlach (1988)’, to investigate the determinants of exchange rates have applied in the world exchange rates market and help for different countries in their market development and economic growth. Researchers attempted to exemplify whether, how and to what extent the determinants of exchange rates market can contribute to the process of economic growth. Purchasing Power Parity Theory: The purchasing power parity theory doctrine means different things to different people. It has two versions of this theory that can be called the ‘absolute’ and the ‘relative’ interpretation. The first version of purchasing power theory calculated as a ratio of consumer goods prices for any country would tend to the equilibrium rates of exchange. In the second version of relative interpretation the rate of exchange rate would be determined between two countries and quoted with general levels of prices of two countries. It amend the international trade theory which would be the part of PPP, in which introducing the non-traded goods (services), but the advantage is greater in regards of traded goods than non-traded goods, because of the assumptions of marginal rates of transformation. The relationship between purchasing power parity and exchange rates provides the international comparison of national incomes and living standards (Bela Balassa, 1964). (Lawrence H. Officer, 1976) is the researcher which gave another review of this purchasing power parity theory. It has define two applications in economics, the first application use of the conversion factor to transfer the data in one national way to another. The use of PPP is mainly the body of (index number theory) and applications of GDP that have improved over the years and path breaking studies in the area continue to appear. The second application of PPP has not the widespread acceptance, which has remained the unsophisticated applications. A.C. Stockman, (1980), develops the model of determination of exchange rates and prices of goods. The changes in prices of goods due to supply and demand would affect the changes in exchange rates with deviations of purchasing power parity. The changes in exchange rates have failed to resemble the changes in prices of goods, because exchange rates more volatile than prices levels and inflation rates. The research proposes the equilibrium of exchange rates behavior and different international goods that would have been traded. This relationship cannot be exploited by the government, because the greater the changes in terms of trade the larger the changes in exchange rates variability. The deviations from PPP persist that variation of exchange rates more than ratios of price indexes. The results found the two interpretation of the relationship between exchange rates and terms of trade. In the first, the causes that affect the changes in exchange rates would also affect the change in terms of trade because prices of goods do not adjust to clear the markets. This interpretation would also found in the research of ‘Dornbusch (1976)’, and ‘Isard (1977)’, they formally differentiates the system with respect to exchange rates and allow prices to change but not the changing in asset stocks. The another interpretation presented the elasticity approach of the foreign exchange market and the relation between the trade and exchange rates. Real supply and demand shocks affect prices and the derived demand of exchange rates. The affect of such a shift has the advantage to raise the value of currency in terms of foreign currencies relative PPP. These changes in demand for foreign exchange would result the supply and demand shocks and that should affect the equilibrium of exchange rates. In second interpretation the expected rate of change of exchange rates revealed on the forward foreign exchange market. This should be related the anticipated change in the terms of trade and the inflation differentials. A persuasive argument about the level of exchange rates is only associated with not causes of the relative prices changes. Clas Wihlborg, (1982), examined the relation of interest rates, exchange rate and currency risks in this research. It identifies the test which empirically impact of currency on interest rates and exchange rates. In this research there are three different ways in which the importance of currency risks for interest rate and exchange rate determination. First different risk characteristics of assets denominated in different currencies. Second changes in the level of risks that affect the elastic ties of substitutes among different assets and the monetary policy. Third changes in the level of risks on alternative assets which have a direct impact on rates of return. This research used the three specifications of the dependent variable to test the theory, firstly the rates of return is adjusted for the expected rate of changes in the exchange rates, second difference between nominal rates of interest and third rate of change of deviation from the exchange rate. The results presented here that substantiate the changes in the level of currency risk have a non-negligible impact on the rates of change of exchange rates and on relatives’ rates of interest between currencies. The risks explain the small share of variation in these variables. Another results indicate that the nominal interest rate seem to adjust in fiscal policies and savings behavior but not affect real rates of interest. But changes in relative risks level would affect relative rates on interest these changes still be important for the substitutability between assets of different currency denominations. Richard Meese & Kenneth Rogoff, (1983), analysis the out of sample forecasting accuracy on various models. It estimated the horizons of the dollar with different country currencies, like Dutch mark, Japanese yen, and Britain pound that traded to weight the dollar exchange rates. It’s also studied the flexible exchange rates with the monetary models of sticky price, so the model of sticky price, which incorporates the current account. The first model is structural models in which it requires to generate the forecasts of exchange rates and explanatory variables. It contains the explanatory power, but it’s predicted badly because the explanatory variables are difficult to predict. The second is the univariate time’s series model in which identify a variety of prefiltering techniques involve differencing, de-seasonalizing and removing time trends. The relative performance of these techniques is of interest in itself. The third model use is the random walk model; it should also link with this univariate time series model. It uses as the predictor of the current spot rate with the entire future spot rate, and it requires no estimation. In this research the performance of estimated univariate time series models or candidate structural model is so worse. From a methodological stand point the view that the out of sample model fit is an important criterion when evaluating exchange rate, but the estimation of out of sample is failure with time series models, that are well approximated the major country exchange rates. John Bilson, (1985), gives the empirical findings about macro economic and flexible exchange rate of the U.S dollar related to PPP theory. From the perspective of this research in which sluggish price adjustment in the commodity markets resulted in increased variability in exchange rates. For the demonstration of result it is important because the instability of floating exchange rate could be due to the inherent differences between commodity and foreign exchange markets. The determination of the expected future rate is impossible, because it is more difficult to reject the forward parity condition. The major part of the forward parity is the variation in the premium is due to the forecast. The object of this research is to determine that if the forward parity failed is the cause of instability in the same way that the failure of purchasing power parity. The findings develop that currency risk premium is the important factor relative to floating rate system, and movement in the exchange rate are dominated by the non speculative activity and it has the adverse effect on world economy. Roger D. Huang, (1987), evaluate that the expected change in the exchange rate of two countries equals the expected differentials in their inflation rats over the same holding period. It makes the empirical evidence link with PPP theory and obtained that the changes in expected nominal exchange rate is appear to deviate inflation rate systematically. It relates the PPP based on the constraint that, in efficient market the net return to speculators engaging in speculation on goods in the foreign country. The purpose of this research is to know the equality restriction between expected nominal exchange rate and expected inflation rate differentials. The investigation should have the result that the evidence is inconsistent with the current floating exchange rates over the major industrialized countries. Since the test perform meaningful in conjunction with market efficiency and simply indicate the failure expectations. John Doukas & Abdul Rahman, (1987), conducted the unit root test for the presence of evidence from the foreign exchange futures market, and gets the representation of foreign exchange currency future prices. The research describes the procedure from the foreign exchange future markets on five different currencies with varying maturity. It was found that presence in the series may cause the OLS estimates and its true value leading to errors, for small sample sizes the model has smaller forecast error. The process generate the log of currencies future rates by random walk, and it is consistent with other model of asset price determination that they imply the mean and dispersion of returns that don not change over short time period. But in general if follow the random walk; it is line with (Meese & Singleton’s) findings from the spot and forward exchange market. H.J. Edison, (1987), addresses that whether PPP is valid in the long run movements in exchange rates, though it is failed in the short run. However number of studies was conduct for the behavior of exchange rates, ‘Alder & Lehmann (1983)’, ‘Frankel (1986)’, developed more statistical techniques to examine the validity of exchange rates in the long run. Both of these have provided the evidence that PPP does not hold the exchange rates behavior in the long run. This research also incorporates the error correction mechanism and discusses the empirical results which generally show the result of failure of exchange rate support by PPP in the long run. In general, the result indicates the force which exists in the economy for driving the exchange rates towards the PPP equilibrium. The main conclusion from this research is the PPP relationship does not represents the exchange rates n the long run holding, so that the PPP permanent deviations cannot ruled out. This shows the reinforcement of PPP theory that was tested the fixed rate counterpart and the equalization of prices across countries, and it supports an interpretation of the PPP doctrine. This proportionality between the exchange rates and price level emerges in the long run. Richard Meese & Kenneth Rogoff, (1988), examined the relationship between real exchange rates and real interest rate differentials from different countries. It based on the joint hypothesis that the prices of the domestic currency are sticky and the disturbances of monetary policy are predominant, which would found the little evidence of a stable relationship between interest rates and exchange rates. It is true that in many cases the sign of the estimated exchange rate and interest rate differential relationship is consistent with the possible predominance of financial market disturbances, but the relationship is not stable enough to be statistically significant. In Quasi reduced form real exchange rate models, examined the real versions of alternative rational expectations monetary models of exchange rate determination. In the nominal rate models, the exchange rate depends on fundamentals such as relative national money supplies, real incomes, short-term interest rates, expected inflation differentials, and cumulated trade balances. The rationale view for this approach is that the nominal exchange rates poor performance is primarily attributable to money demand disturbances, so it can define the close relationship between there real interest differentials and real exchange rates, because, in the class of monetary models considered here, unanticipated money demand disturbances affect both variables proportionately. Feinberg & Seth Kaplan, (1992), evaluate and interacts the real exchange rates index expectations is developed and used to explore the role of determination on domestic producer prices. The fact that time path of the exchange rate will directly affect the input costs, and the price of substitutes strongly. To examine the links between both actual and anticipated movements in the dollar and relative domestic producer prices, it chooses to analyze price responses to real exchange rate changes. The effect is dependent on the nature of substitutability between imports and domestic goods. The major finding is that the period of appreciation and depreciation over the past 10 years to inhibit the pass through in to domestic prices. In depreciation the market share to enjoy the continued good times kept prices other than expected. Warren Bailey & Peter Chung, (1995), considers the study that the impact of fluctuations on exchange rates and political risk is on the risks premium and is reflected the individual equity returns. It suggests the factors which is common for emerging market equity, currency and debt markets, and make empirical implications to evaluate corporate and portfolio management. If price levels and exchange rate are significantly volatile and cannot be costly hedged, are adversely affected in the real value of the domestic currency. Some evidence that exchange rate fluctuations are a priced factor in cross sections of stock return converted into a common currency. The purpose of this research is to explore the impact of fluctuations on exchange rates and political risk which is consider on stock process of individual companies from the same country. The extent of measurement is that, which exposure factors explain cross sections of returns on individual securities and industry portfolios. The result suggests that the exchange rates and political risks could be significant in equity markets. The result also suggests that the risk premium can be time varying and not be detected by assuming constantly. This research shows the results that it did not find the evidence of the equity market premiums for the currency and political risk. It complements the importance to attach the exchange rates and political risk in the international finance. J.R. Lothian & M.P. Taylor, (1996), examines the real exchange rate behavior, and explains the variations in sample of stationary univariate equations in real exchange rates. It investigates the additional insight in the exchange rates behavior that can be gained by considering the floating rate from the perspective of the data. These issues can be best understood on the subject of real exchange rates stability between the currencies of the major industrialized countries. Some of the pre-float studies support the fairly stable exchange rates in the long run. Subsequently, ‘Dornbusch (1976)’, ‘Frenkel (1981)’, gave largely as the result of studies published, and reject the hypothesis of random walk behavior of real exchange rates. The PPP shows the empirical movements in real exchange rates were highly persistent and effective; although the PPP is reject the hypothesis of non-stationary behavior of real exchange rates in the long run. The result of this research shows that the longest span of two countries exchange rates are significantly mean reverting. The first model result indicates the 80 percent of the variation in the exchange rates of the history data of two countries. By using of another model, the results explaining the performance of remarkably well in the floating, so that they produce better forecasts of the actual exchange rates. In line with recent studies, it fined that this process of mean reverting is quit slow, with estimated adjustment of data. In the long run the PPP equilibrium is remaining a useful empirical approximation. The deviations of the PPP that observe are consistent with the existence of slowly mean reverting influences, which may be real or monetary regimes. Theory of Optimum Currency Areas: The theory of optimum currency areas, which is usually presented the other name called flexible exchange rate system, but it is proponents as a device of depreciation that take the place of unemployment when the balance of payment is deficit and appreciation when it replace inflation when it is surplus. The problem can be exposed and more revealing by defining a currency area within when exchange rates are fixed. To this three answer can be given; first certain parts of the world are going processes of economic integration, so new experience can be made and at what constitutes the optimum currency area can give the meaning of these experiments. Second those countries that have flexible exchange rates are likely to face problems with the theory of optimum currency areas, so it does not coincide the optimum currency areas with the national currency. Third the idea that illustrates the functions of currencies which have been treated in economic literature, and sometimes neglected in the problems of economic policy. In the currency area, different currency countries including national country currencies interact pace of employment in deficit, because there is the willingness to inflation by the surplus countries. The argument for flexible exchange rate system is based on national currencies, and is valid about mobility of factor, so if it is high in the country and low in the foreign countries, the flexible exchange rates system on home country currencies might work effectively. The concept of optimum currency area has practically applicable only in those areas, where the state has the political organization in the country. The factor mobility is most considered is more relative rather than absolute concept, with both industrial and geographical. It likely to change the alterations with time over time in conditions, where the conditions of political and economic stability. Money is the convenience that restricts the optimum number of currencies, so in terms of this argument the optimum currency area which is composed in number of countries. (Robert A. Mundell, 1961). In another review the author defines the stabilization of capital mobility policy under the exchange rates which is fixed and flexible in the currencies markets; it concerns the theoretical and practical approach of the increased mobility of capital. The assumption is that the interest rate differentials from the level of abroad cannot maintain by the country, if there is the degree of mobility. The securities system are perfect substitutes, because different currencies are involved can be taken in the perfect mobilization, and there exchange rates expected to persist indefinitely, but the forward and spot exchange rate are identical. It identify the monetary and fiscal policy, in which monetary policy assumed the open market purchase of securities while fiscal policy is to form of increase in government spending and financed by an increased in public debt. Its effect the floating exchange rate result when monetary policy does not intervene in the exchange market, but it intervene the fixed exchange rates, when the buying and selling of international reserves at the rate of fixed price. The results of this research analyze that, the fixed exchange rates is become a device for the monetary policy and for the levels of reserve, whereas the flexible exchange rates becomes a device for the fiscal policy and for the balance of trade, but policies are unaffected to the level of output and employment. The fixed exchange rates in the perfect mobility will lead to the breakdown as the absence of gold sterilization. The gold sterilization is frustrated the capital outflows and offsetting monetary changes through the exchange rates equalization. The conclude remarks is that, the fixed exchange rates as compared to flexible exchange rates is ineffective under monetary policy, but in fiscal policy both the exchange rates either fixed or flexible are remains weaker for achieving the level of output. The flexible exchange rates under fiscal policy to play some role in employment policy that can be expected, while monetary policy can have influence on output under fixed exchange rates. In this possibility existing, it wills lesser extent in the future. (R.A. Mundell, 1968). J.H. Makin, (1978), analysis the way to deal the risks involved in foreign exchange currency positions but exchange rates are uncertain. It incorporates the exchange rate changes with the changes in the determination of overall hedging strategy. The purpose is to survey the literature rather to examine the logic on hedge no hedge strategy and to suggest the viewing problem of exchange risk. It identifies the exchange risk diversification in two groups. First diversification investigates the exchange risk with the investor point of view selecting the locations of firms in different countries which denominated in different currencies. The second considers exchange risk with the firm manager point of view to decrease the impact of exchange rate fluctuations. The study concentrates the exchange risk and not overall corporate risk, so the analysis of corporate risk devoted the activity by the expected levels and determined with the corporate assets. For the hedging problem on a currency basis the value of information ignores of changes in exchange rates. The results asserted the strategy that works relatively on a free securities market where intervention of officials is significant. It achieves to justify exploration of returns and to forecast the expected changes in exchange rates. It believes that the forecasts are dealing with foreign exchange risk and implicit to follows directly from hedge no hedge approach on problems. In simple the current rate of change of the exchange rates is equal to the expected exchange rates. Jeffrey A. Frankel, (1979), defined that most of the recent work on floating exchange rate goes under the name of the monetary or asset view; the exchange rate has moving to equilibrate the international demand for assets, rather than the international demand for the flow of goods. But with the asset view there are two approaches. The first approach is ‘Chicago Theory’ in which assumes that prices are perfectly flexible. As the consequences when nominal interest rate changes, it would also reflect the changes in expected inflation rate, so as the domestic currency expected to loose value through inflation and depreciation. This is the rise in the exchange rates and gets the positive relationship between positive exchange rate and nominal interest rate differentials. The second approach is ‘Keynesian Theory’; it assumes that prices are sticky in the short run. As the consequences the reflection of changes in the nominal interest rates would also make changes in the tightness of monetary policy. The higher the interest rate in the country attracts the capital inflow, which causes the domestic currency appreciates, so it reflects the negative relationship between the exchange rates and interest rates differentials. This research develops a model of the asset view of the exchange rate, which emphasizes the role of expectations and adjustment in capital markets. It says that the increase in income or a fall in the expected rate of inflation raises the demand for money and lowers the exchange rate. Michael Melvin, (1985), has regarding and focused that how the choice of an exchange rate system can affect the stability of the economy. The appropriate nature of the exchange rate system will differ of the disturbance to the economy. It presented the evidence that indicate that the approach is more consistent according to practice by actual country. The other approach is to desirable the price stability, in which some mechanism tells the floating rates superiority is become less in the face of monetary shocks. It finds that the flexibility in exchange rates depends not on openness and less important in the mobility of capital, but its positive effects were found for the economic development. The purpose of this study is to consider the determinants of exchange rates system choice, which indicates the theoretical approach with the country choices. The result found that the choice of an exchange rate system has the role of the disturbance to the economy. It suggests that the money shocks are the key of exchange rate system choice in an economy, in which it seeks to minimize the fluctuations in the country price levels. It also suggests that the greater the price shocks the more is a float, so it effects the greater in domestic money shocks. H.M.S Gerlach, (1988), examine the dynamic interrelationship between innovations in monthly industrial production in a set of economies, specifically this research attempts the output fluctuations that have been correlated during the periods of fixed and flexible exchange rates. The current has to managed exchange rates flexibility would reduces the interdependence across countries. It should follow the recent article of ‘Flood and Hodrick (1986)’ in which argued that the variability would be higher during a regime of fixed exchange rates instead of flexible exchange rates, but their conclusion striking so sharply. It should be clear by this research that does not test any hypothesis which would concern the importance of exchange rate regime, but it should establish some statistical regularity with respect to the output during the recent periods of fixed and floating exchange rates. The results of this study of multi country output movements under fixed and flexible exchange rates are clear. The variances of growth rates should be higher in the flexible exchange rates and in the fixed exchange rates periods. These variances are statistically significant related to the degree of openness and national income. Thirdly the output movements are correlated across countries under exchange rate regime, particularly the co movements in output are more important in the business cycle frequently during the recent years of managed exchange rates flexibility. M. Obstfeld & K. Rogoff, (1995), analyses the global macro economic dynamics to supply framework based on competition and nominal prices. This research incorporates the prices rigidities that explain exchange rate behavior without insights of the intertemporal approach to the current account. The effects of macro economic policies on output and exchange rates have not been yet persuaded to abandon. The framework which integrated exchange rates dynamics and current account yields is a new perspective, it realize that when prices are sticky the government should spend on shock raises short run output and long run output. The assumption is that home and foreign government purchases the consumption goods that do not directly affect the private utility, but the per capita real government consumption expenditure is a composite consumption of individual goods. Its explain that the composite consumption for the services is to balance the opportunity cost and notice that the money depends on consumption rather than income, that distinction is more important in closed economies. The results of this research develop framework that give new foundations about some of the fundamentals problems in international finance. It realizes that the existing Keynesian model is incomplete to offer a satisfactory treatment of exchange rates, output and the current account, but the model which is used in this research is more complex, because its yields simple and intuitive insights of monetary and fiscal policies. It can be extended in a number of dimensions, including non traded goods, market behavior, government spending, and labor market distortions and so on. Its goes beyond the essentially statistical approach that handles the current account and exchange rates issues, most importantly this approach allows to analyze the welfare implications of policies. Charles Engel, (2001), examines the policy of exchange rates and sticky prices, in which households and firm optimize horizon an environment of uncertainty. Under this condition the fixed and floating exchange rates yield higher and depend on nature of price stickiness on the risk sharing opportunities. It also presents and suggests some empirical evidence of the consumer prices behavior that considers failure in Mexico. The opportunities of price setting and risk sharing are not refined and make the conclusions for the optimal exchange rates regime. The approach of fixed and flexible exchange rates regimes are in the short run stabilizing properties. The famous ‘Friedman’s (1953)’ argued that floating exchange rates are stipulates in the long run, and the exchange rate system does not have real consequences, he identifies that the flexible exchange rates is consider a vehicle for rapid change in international prices. The floating exchange rates are in the presence of capital mobility, become more complicated and depends the sources of shock which was monetary and the degree of capital and factor mobility. This research following ‘Obstfeld and Rogoff, (1998)’ in that way that firms sets prices to maximize the value of the firm, there are three types in which prices are sticky, firms set prices in their own currencies, sets prices in consumers currencies, and some sets prices in producers currencies. For this reasons the prices of the goods should be different, because it is fixed in the home country from where the goods is going to produced, but the variation in price according to the exchange rate risk for foreign consumers. In the world, where flexibility of perfect prices, the devaluation of wealth would not any real changes necessarily, but with the short run the prices are sticky in the nominal devaluation and in the real devaluations. The results stabilizing that the properties of exchange rates regimes and their effects on the level of efficiency are dependent for the economy on the price setting. The price setting behavior interact the financial markets, that which have seen the law of price holds for all goods and there is complete consumption in the absence of asset trade. This result also emphasize on role of capital mobilization and setting of prices. The degree on which, the choice of exchange rates does not matter to the capital mobility, so it depend the goods prices are set. Finally it should describe that the exchange rate regime and the capital markets has well depend on the country to set prices for their currency. G.A. Calvo, (2001), examined the optimal choice foreign exchange system that would challenges which was faced by the policy makers in emerging market economies, Ems, to contain the recent financial crises that taking in to account. These factors extreme foreign exchange regimes have shown to become much more attractive. This research research also discusses the dollarization pros and cons and the inflation that targeting the creditability to those found in exchange rates based on stabilizations. The EM’s partly resulted is that the surge of capital flows from new market structures and conditions combined with creditability. The rationalization is concerns that fix and not be attractive for the country when the currency is pegged. It realizes that the domestic firms have the information for the exchange rates than the foreign investors. The exchange rate exercise is much more costly because it involves on monetary policy and in a relatively institutional environment, so this cost likely be incurred by firms and individuals so that it has applying for the chance of knowledge for other purposes. This research defines the three positive features of a dollarized system. (1) Creditability, (2) low information costs, (3) providing relative price changes. The results concluded to identify the importance of creditability for the design of macroeconomic policy; it is also a specific characteristic for a country. A policy maker makes unanticipated policy changes. The research argues the traditional approach for the selection of exchange rate system but it ignores the features of EM’s. For the dollarization is an extreme form of fixed exchange rates, so the true systems meet the conditions and hold the promise for greater policy effectiveness. Bencivenga, HuyBens, and Smith, (2001), evaluate and consider following applications, first that the adoption of currency is reduce or enhance the scope of volatility to emerge, second that the adoption of currency is reduce or enhance for indeterminacies to rise, thirdly that there is a justification for the adoption of a single currency, and fourthly that if any fiscal consequences for a move to a single currency. In this equilibrium it defines two comparison of determination; one country issues its own currency, and the other country adopts other country currency, this degree of integration depends on capital markets. When the country credits markets are poorly in condition the equilibrium of regime between two currencies play a unique role, so there when capital market segmented there is the source for arising volatility. The justification of dollarization has adverse fiscal consequences. So the results of credits market are substantially different. Many advocates take the dollarization as a means of price stability, but the currency conversion and involve the risk of exchange rate movements are obtaining the low rates of inflation. The analysis is focuses on the indeterminacies and arise the volatility, and makes a strong implication for the different monetary regimes. For fiscal consequences so there is the capital markets segmented the dollarization and implies the government that must raise some taxes to keep expenditure unchanged. Mundell (1961), defined the currency area in a way that as for region it is a highly factor of mobility, so this research also focuses in the importance of capital mobility and define the optimal currency area. The research shows the results in the way that, it compares the characteristics that, one country issues its own currency, and the other that the country adopts another country currency, so the result very much on the integration of capital markets between countries. Where credits markets are substantially different, it has the monetary regime in place. The credits markets are fully integrated, so it does not affect the indeterminacy, and arising volatility. It suggests that the justifications of dollarization are weak when segmentation of capital markets, but when financial markets exists it could not disappear entirely. The country, if adopts the currency of other country as legally, so there central bank no longer provide the lending to last resort. Finally the integration on financial markets is interesting the effect of dollarization between the countries involved in it. Interest Rate Parity Theory of Exchange Rate: This simple interest rate parity theory is the adjustment of the discount, or premium on forward exchange rates with the short term interest rate differentials between home country and foreign country. If the short term interest rate of foreign country is high in home country, it will profitable of funds in foreign country, and it will covered exchange risk, when this equilibrium exists, so the interest parity established. The usual comparison of interest parity are equal, this will approximate equality between interest rate differential and the forward exchange cover. The demand and supply of interest arbitrage to be equal at forward exchange rate, but the forward rate falls when the interest arbitrage supply is equal to demand. In the present context, the flow of interest arbitrage funds will cause a larger discrepancy from interest parity than would obtain. The explanations that emphasize the limited amount of arbitrage funds have different policy implications, where interest differentials are wide in the forward market. This mobility desired interest rates at home and abroad are more closely aligned. (John H. Auten, 1963). Jacob A. Frenkel, (1973), specifies the revised the interest rate parity condition, this introduces the spread between borrowing and lending interest rates and assumes supply of funds. The interest rate parity theory maintains the equilibrium or discount on a forward contract for foreign exchange related to interest rates. An interpretation of the deviations from interest rate parity in terms of elasticity implies and that are very low. The low values of the elasticity imply is to be taken seriously, so then arbitragers have a relatively high monopoly power. The traditional interest rate parity can be interpreted being equilibrium; if there exist a neutral band so it could not cover arbitrage is profitable. (Robert Z. Aliber, 1973), analysis the reinterpretation of interest rate parity theorem of the behavior of foreign exchange market relies on interest rates. This theorem rely the forward exchange rates to the money market interest differentials, and it gives the F= forward exchange rates, S= spot exchange rates, and R= domestic interest rate. It identifies the participants as speculators or arbitragers basis of their position toward exchange risk. Arbitragers shift funds between national money markets and to exploit the difference between the interest rates and exchange rates. The distinction of speculators and arbitragers is conceptual. Three types of explanations are defined in this research for apparent opportunities for an arbitrage are transaction costs, default risks and non monetary returns. This explanation involves the market imperfections in the supply of foreign exchange to speculators, because that the purchase of foreign currency is equivalent to borrowing domestic currency. The interest rate parity also is consistent with investors’ expectations when the securities are to compute the interest in terms of political risks. The interest on these securities are similar in terms of political risks can be compared with exchange rates, when the predicted and observed exchange are same. The interest also reflects payments demanded by investors for carrying exchange risk and political risks. Changes in the interest reflect of investor expectations about the future exchange rates. Their expected return is higher, if investor carries both political and exchange risk, because investor can obtain larger position in foreign currency. E. Dwight Phaup, (1981), gave another review on the reinterpretation of this modern theory of forward exchange rates and it has been accepted as an improvement the traditional interest rate parity theory. The theory contends the equilibrium the forward rate which called ‘F’ and covered the interest arbitrage as the primary force equilibrium condition for the forward market. In this research another reason is based only on the profit maximizing behavior, but the primary conclusion is that ‘F’ can diverge from ‘F’. For this modern theory and its assumptions they covered interest arbitrage and forward speculation as determining force. This research also develops the discussion, that potential speculator can open position in foreign exchange in two ways. First a long position can be attained by purchasing foreign currency on the forward market at F, second if the dollars of that open position and take long position assumed by borrowing. In such situation, speculators have a choice of purchasing a future claim in the foreign currency. If all speculation occurs in spot market, but ‘F’ is temporarily different with treating as the combined operation. This research follow the article which is written by “Tsiang” deals with spot speculation in two ways, first that spot speculation is an uncovered interest arbitrage transaction and regarded as equivalent to speculator taking his open position by an appropriate forward sale, but this equivalent convention for handling spot speculation does not address the implications for a high degree of substitutability between forward and spot speculation. After describing the equivalence area the second comment is that they find can carry the speculative stock at a lower net interest and liquidity cost than the banks. The implication is that the analysis of non substitutability assumption and the available empirical evidence suggest that the assumption is not easily defended. The problem is that the modern theory is in its popular interpretation, if beta is equal to zero the implication is that speculation plays no role in determining ‘F’. In short, that the advantage of modern theory over interest rate parity theory is that the former better allows for capturing of speculative sentiment on ‘F’, in fact it can obscure that effect. John J.V. Belle, (1974), analysis the objective indicators of speculative behavior foreign exchange markets under floating exchange rates. To examine the speculative indicators, this is the basic framework for this analysis. The examination indicated the IRPT be modified for non compatibility of the arbitraged assets. Stein’s indicates that the PPP theory would get the short term capital for this speculative behavior, so the representation expected spot rates of past values as a speculative indicator. PPP theory does not able to distinguish between bullish and less bearish behavior for analysis. The modern theory of IRPT gives the proper specification of modification for the non compatibility of assets. Hedging and non compatibility can generate margins that would indicate speculation, while arbitrage operations could prevent margins which were arising in the face of severe speculation. Rudiger Dornbusch, (1976), evaluates the exchange rate movements under perfect mobility, and an adjustment of goods market relative to asset market and consistent expectations. The extends that output responds to a monetary expansion in the short run, this acts as an effect on exchange depreciation which lead to an increase in interest rates. The purpose of this research that is suggestive of the observed fluctuations in exchange rates, and at the same time establishes such exchange rate movements are consistent with expectations formation. The adjustment process to a monetary expansion serves to identify several features that are suggestive of recent currency experience. During the adjustment, rising prices may be accompanied by an appreciating exchange rate, so the trend behavior of exchange rates stands potentially in strong contrast. It’s identify that the monetary policy on interest rates and exchange rates is affected by the behavior of real output. The real output is fixed, and then it affect to low the interest rates and cause the exchange rates to overshoot. The exchange rate and interest rate changes will be dampened, but exchange rate still depreciated and interest rates may actually rise. This research used the theory of exchange rate model which relate to the interest rate parity, in which it relates the capital mobility, the money market, the domestic goods market, and equilibrium of exchange rates. The model confirms that there is the empirical link between interest rates and exchange rates that emphasized on popular interpretation of foreign exchange events. This observation is correct, because rising interest rates are accompanied by the expectations of an appreciating exchange rate. These analyses could follow the ‘Mundell-fleming’ results and proves that capital mobility and flexible rates can affect monetary policy. The exchange rates prove the transmission of monetary changes to an increase in aggregate demand and output. Therefore the fixed output retains relevance, and particularly if output adjusts sluggishly to changes in aggregate demand. Maurice D. Levi, (1977), points out the choice of domestic versus foreign money and capital market instruments on the basis of covered yields. It shows the two components of foreign yields, which are different rates of taxation on interest and exchange gains. Its also shows the US-Canadian situations of their observe tax payers simultaneously buying securities of the other and also buying their domestic securities. It consider that if political risk and portfolio balance are of no importance, the highest offer securities would hedged the attractive choice of international money and capital market investors. These types of capital flows would be considered abnormal according to the theory of international capital movements. It identifies that in both US and Canada interest income is treated on income account and taxed at ordinary income rates. If a foreign exchange gain or loss is made in the course of covering, consider to be capital assets, then this gain or loss treated on capital account. But when gains is made covering capital assets are capital gains and have to determine to be capital assets in nature. A gain on the same security could income to some investors and some to capital gains. This research shows the result of highly sensitive interest and dynamic investors, and funds night not flow in he direction of suggested by the differentials. The consideration of taxation shows result, that the investor purchase of foreign short term securities and short term domestic securities, and some investors invest in long term securities of both the countries with the low covered yields. Jeffrey A. Frankel, (1979), defined that most of the recent work on floating exchange rate goes under the name of the monetary or asset view; the exchange rate has moving to equilibrate the international demand for assets, rather than the international demand for the flow of goods. But with the asset view there are two approaches. The first approach is ‘Chicago Theory’ in which assumes that prices are perfectly flexible. As the consequences when nominal interest rate changes, it would also reflect the changes in expected inflation rate, so as the domestic currency expected to loose value through inflation and depreciation. This is the rise in the exchange rates and gets the positive relationship between positive exchange rate and nominal interest rate differentials. The second approach is ‘Keynesian Theory’; it assumes that prices are sticky in the short run. As the consequences the reflection of changes in the nominal interest rates would also make changes in the tightness of monetary policy. The higher the interest rate in the country attracts the capital inflow, which causes the domestic currency appreciates, so it reflects the relationship could be negative between the exchange rates and interest rates differentials. This research develops a model of the asset view of the exchange rate, which emphasizes the role of expectations and adjustment in capital markets. It says that the increase in income or a fall in the expected rate of inflation raises the demand for money and lowers the exchange rate. Michael P. Dooley & Peter Isard, (1980), explained the interest differential due to political risk, given the prospects of future capital controls. It depends on the gross stock of debt against different governments and the distribution of wealth among different political jurisdictions. The interest rate parity reflects exchange risk when assets are denominated in different currencies and effects political risk when assets are issued in different currencies. Thus the interest diiferentials to the political risk of future capital control must be distinguished due to the effective tax that controls the place in interest earnings. It defines the ‘Aliber (1973)’ concept of political risk, is that the probability authority of the state will be interposed between investors in one country and investment opportunities in other countries, that is the probability that controls the imposed on capital flows. This research has explored the result that political risk associated with capital controls can lead to deviations from interest rate parity. The interest differential due to political risk depends essentially on the gross stock. The problem it suggest is to separate the interest differential due to the political risk with prospective control from the differential to the effective tax imposed by existing controls, so it was forced to be some what arbitrary in modeling and estimating it. L.P. Hansen & R.J. Hedrick, (1980), examines that the speculation in the expected rate of return of the forward foreign exchange market is zero, which typically characterize the relationship between spot and forward exchange rates. The purpose is to first examine the efficient market of foreign exchange of several different currencies. Its mean that the speculation in the expected rate of return of the foreign exchange market conditioned on available information is zero. The second purpose is to implement a computationally estimations procedure for examining restrictions. This type of estimation problem is importance since often rational expectation restrictions on forecasting. Its identify that if economic agents risk is neutral, costs of transaction is zero, and the market is competitive, the foreign market will be efficient, so the speculation in the expected rate of return of the forward exchange market will be zero. The econometric procedure advocates and employs more efficient techniques which have been used in the study of forward exchange rates. This research recognize the result that first he identify the ‘Grauer et al (1976)’ indicate that, the forward exchange rate is equal to the expected future spot rates. This provides the potential explanation with low margins of significance, which found the result that analyses the relationship between the forward exchange rate and expected future spot rate and the risk premium will separate these two results. The reorganization is ‘Roll & Solnik (1977)’ in which implement the theory by constructing a weighted average forecast errors. Now this research shows the result in two different explanations, the first is that to use large sample in computing probabilities with their test statistics. The second explanation is that the implicit need to specify that how monetary policy conducted and when capital controls will be applied. It’s indicated that the rejection of hypothesis cannot be identified with inefficiency in the exchange market. While it found the evidence that the forward rate is not the predictor for future rate for some currencies. R.E. Cumby & M. Obstfeld, (1981), evaluates that nominal interest rate differential between similar assets in different currencies explained entirely by the change in the exchange rates over the holding period. It covered the interest parity by the nominal interest differentials between premium and discount on forward exchange rate. Nominal interest rate differential reflect risk in addition to exchange rate movements. This research should emphasized the tests which should be joint test with Fisher hypothesis and assume some informational efficiency and arbitrage condition that equals the expected percentages changes between exchange rate and nominal interest differentials. To summarize the results the procedure this research employed the same conclusion and suggests that the relationship of Fisher parity does not hold. The deviation which Fisher parity appears to be highly auto correlated and behaves like expectation errors. These findings support to recent theories that suggested the foreign exchange market efficiency with the existence of risk at equilibrium. Chapter III Variables: For this study the objective is to identify the determinants of exchange rates and following variables have utilized.

- Exchange Rates – Independent Variable:The exchange rates known as foreign exchange rate between two currencies, and it specifies how much one country currency is worth in terms of other country currencies. It tells us the value of an international currency in terms of the national currency. The foreign exchange market is one of the largest markets in the world, and about 3.2 trillion of USD currency changes. It has two types fixed and floating exchange rates. Richard Meese and Kenneth Rogoff (1988), it depends on fundamentals such as money supplies, real incomes, interest rates and inflation.
- Interest Rates (6 months KIBOR) – Dependent Variable:Interest rate is the price from which the borrower pays the uses of money that they borrow from the lender. It is the fundamental of capitalist society, and normally expressed as a percentage rate over the one year period for borrowing the money. It is a vital tool for monetary policy with dealing variables like, investment, inflation and unemployment. In this research the 6 months KIBOR as the base on interest rate, its define as the Karachi Inter Bank Offering Rate, it is the daily indicative rate at which banks offers to lend unsecured funds to other banks .

H1: Exchange rates have the positive effect on Interest rates Sample Size: For the sample size the exchange rates data should be available from past twenty years, but for the interest rates (KIBOR) the data should be available from September 2001, because the KIBOR should developed and introduced from September 2001 by State Bank of Pakistan and before the KIBOR the PKRV rates should applied for banks to interrelated their commercial financing. So the reasons are to study the exchange rates relationship with KIBOR is to analysis the activities of commercial banks with central banks and their operations. For this study, 7 years data have employed for these two variables. Both these variables have different time period data available. The exchange rates data is available from many years you want but based on this research it should get from September 2001 to May 2008. While for the interest rates (6 months KIBOR) it should get from September 2001 to May 2008. Sources of Data: Exchange rates and interest rates are the two vital tools for the development and balancing the economy of the countries. The data of these variables should be obtained from State Bank of Pakistan Statistical Bulletin their Annual Reports and some various issuances from forex exchange websites. Data Formatting and Testing: Since the data on exchange rates will be on daily, monthly, and yearly basis, whereas, the data on interest will also available on daily, monthly and yearly basis, so therefore not required any formatting. The requirement on any basis of data is available for research on these variables. Therefore researcher do not face any problem to keep both the variables at same scale, and the regression testing statistical tool for applying for analyze relationship of these variables. The Model: After defining and explained the dependent i.e. interest rates and independent i.e. exchange rates variables and also discussed the effects of exchange rate on interest rate and how it will affects on economic of a country. In this study the researcher may first analysis the correlation between these two variables, and identifies the significant relationship. After that the researcher analysis and evaluate the empirical investigation in regression model as a statistical tool. The researcher simple regression model which can be defining the equation that represented below: From the above explaining model, the hypothesis testing technique and equation that can be uses by the researcher could develop the following estimation and uses for the establishment of the model. Therefore, the all compatible data has entered in to SPSS for statistical analysis. Chapter IV

The correlation technique use to determine the correlation between independent variable i.e. exchange rate and dependent variable interest rate. Then it shows the analysis of F-test by using the simple regression model to determine the relationship between these two variables. The result shows the analysis, by using the correlation in the form of table 1, and simple regression model in the form of table 2 and table 3 which should define below: Table-1 shows that the correlations between the independent variable i.e. exchange rates and the dependent variable i.e. interest rate (KIBOR) is moderate and it’s up to 28.2%, because the Pearson correlation value of both these variables are below at the level of 0.50. Its mean that there is the significant correlation between these two variables at the 0.00 level, because the significant value of both these variables below the point of 0.01. From the above applying regression model, the researcher conclude the result in the way that it’s explain the relationship of both the dependent and independent variables significantly. Since sample data is based on time series so autocorrelation was an important issue which is tested by Durbin Watson and concluded that there is serial correlation exist between variables as D-W test is showing value of .006 which is very low as compared to normal value of 2. This value of .006 is indicating that there is positive serial correlation exists. After analyzing this issue, in this study the researcher used time and KIBOR lag value as a dummy dependent variable to remove autocorrelation issue. Now the new model is as follows. Table-4 shows that the regression model in the form of model 1 and model 2. In model 1 this table explains that the relationship between all the dependent and independent variables are significant at 99.8% and the F-value of this model is significant at 0.000 levels, which indicates the regression model is best fit. But in model 2 the table defines the variation of all the variables and deducted those variables which have insignificant value and then relates those variables which have a significant value at the 0.000 level. The total variation explained in the regression model as indicated by R-square. The significant F-value suggests that the calculation of R-square in the model is correct. This result is consistent with the research of Meese and Rogoff (1988) which shows the positive effect of these variables and their F-test value is significant. In another research Feinberg and Kaplan ( 1992) its shows the results consistently in their RÂ² and F-test value, whenever RÂ² improved the F-test value is also increase and improved. Table-3 the result summary shows that the reflection of the variable in the form of model 1 and model 2. In this table explain the relationship between variables, in which the constants variables is the intercept, the exchange rates which is independent variable, the KIBOR lag values and the time series data of the exchange rates and interest rates. In model 1 the table explain the relationship between the above mentioned variables and all the variables are independent but the results are not significant at all, the value of exchange rates is insignificant and is not statistically significant at the 0.05 level, but the time variable is showing its impact on KIBOR and KIBOR lag value is also showing its impact on KIBOR. It means that exchange rate is not explaining change in KIBOR rate. After defining model 1 the issues that is to describe in model 2 the results is resolve the issue of insignificant variables impact on KIBOR, so in model 2 the result shows variables i.e. time values and KIBOR lag values which had the relationship exists with KIBOR and their impact on KIBOR and deducted those variables which has insignificant values and their relationship and not exists and does not impact on KIBOR. So the exchange rates has deducted in this model 2 because it has the insignificant values. Its means that there is the negative relationship between exchange rates with related to interest rates in Pakistan, and it is not significant at all. The KIBOR lag variable and time variable result shows that there beta values are positive at T-value and their relationship is significant at the 0.000 level. So the results conclude that the exchange rates should not significantly play their role in the relationship with related to interest rate (KIBOR), but the time and lag variables should play a significant role in the relationship with interest rate (KIBOR). It would be clear that the hypothesis is not accepted and that there is the negative relationship between exchange rates and interest rates (KIBOR). The equation of regression model can be written below: K= – .003 + .004(time) + .997(KIBOR?-1) This result is also consistent with other researchers who reported a negative connection between exchange rates and interest rates. Meese and Rogoff (1988) an aggregate disturbance in many cases is the sign of estimation of exchange rates and interest rates differentials of relationship is consistent and is the possible predominance of financial markets disturbances. R.E. Cumby & M. Obstfeld, (1981), nominal interest rate differential reflect risk in addition to exchange rate movements and the foreign exchange rates efficiency make the existence of risk at equilibrium on interest rates Chapter V

This study is concluded to examine the affiliation between exchange rates and interest rates (6 month KIBOR) in Pakistan by utilizing the annual data for the exchange rates period from September 2001 to May 2008, while for interest rates period from September 2001 to May 2008. In this research the researcher has applied exchange rate as independent variable and interest rate (6 month KIBOR) as dependent variable. For the availability of data, all the data should be available on daily monthly and yearly basis, but the researcher used these data in order to consistent as daily basis. The regression model has been formulated for these variable relationship investigations. The researcher developed the hypothesis that the exchange rates has the positive effect on interest rates in Pakistan, and supported their findings with consistent as predicted from other researcher that is Meese an Rogoff (1988), and R.E. Cumby & M. Obstfeld, (1981). The researcher examines their findings with applying correlation, in which it’s indicating the correlation, and to support their analysis and defined that there is the moderate relationship between their variables. After correlation the researcher applying the linear regression model, in which the researcher analysis that exchange rates should affect the interest rates but in this analysis the result is not highly significant. Since sample data is based on time series so autocorrelation was an important issue which is tested by Durbin Watson and concluded that there is serial correlation exist between variables as D-W test is showing value of .006 which is very low as compared to normal value of 2. This value of .006 is indicating that there is positive serial correlation exists. After analyzing this issue, in this study the researcher used time and KIBOR lag value as a dummy dependent variable to remove autocorrelation issue. The researchers define the impact of these two dependent variables on KIBOR and create new regression model and applying as a statistical tool. In the first model the results shows that all the variables are independent included backward method use and there is the relationship between time series and KIBOR lag values with interest rates (KIBOR), but the relationship is not statistically significant between exchange rates and KIBOR. But in the second model the results shows that the exchange rates which has the insignificant values should deducted from second model because it does not impact significantly on KIBOR, but the time and KIBOR lag variables has significant values at the 0.00 level and should identify the relationship and impact with KIBOR. The negative effect of exchange rates on interest rates would shown that if exchange rates increasing or decreasing it should some times effect on interest rates but all the time the effect should inverse with interest rates in variations. So in this research, the hypothesis that should developed for study is rejected from the above analyses. The result also complement that the exchange rates is the back bone of foreign exchange market in Pakistan, and it should effect very consistently to interest rates as an inflationary basis. Therefore the regulatory authorities such as State Bank of Pakistan and Government officials should realize the role of exchange rates in the economy and cautiously faced and address the issues that why exchange rates increasing, and why the interest rates increases due to foreign exchange volatility. If the Government taking effective actions against these issues so it can facilitate the investors to gain confidence in the foreign exchange market and our currency value might be strong from other foreign currencies and investors take more part in exporting and importing the items for usage in our country. So it will create the opportunity to earn foreign investment by the local investors, this will turn our Pakistani currency would be stronger, which it will turn boost to our economic growth.

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- www.forex.pk
- www.FMA.org.com
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