International Journal of Applied Economic Studies Vol. 5, Issue 5, October 2017 Available online at http://sijournals.com/IJAE/ ISSN: 2345-5721 1 An analysis of exchange rate volatility and FDI inflow in Pakistan; using ARDL bound testing technique (1981-2015) Usman ullah Khan (corresponding author) E-mail: usmanwazir91@gmail.com M.phil Scholar Department of Economics Hazara University Mansehra, Pakistan Farhad Sultan E-mail: farhad4210@yahoo.com M.phil Student Department of Economics Hazara University Mansehra, Pakistan Zia Ur Rehman Department of Economics Gomal University Dera Ismail Khan Abstract Using ARDL bound testing framework, the impact of exchange rate volatility and foreign direct investment was investigated in Pakistan for the period of 1981 to 2015. The purpose of research is to examine the impact of exchange rate, exchange rate volatility, GDP, trade openness and current account balance on FDI. ARDL technique is used to find the short run and long run relationship of these variables with FDI. The result shows that exchange rate volatility and current account balance have negative impact on FDI in short as well as in long run. While the result of all the other variables are according to our expectation and prior studies. The empirical results obtained in this paper recommend the economy’s politicians in Pakistan to implement exchange rate policies that promote stability of exchange rate, which can help reduce exchange rate volatility in order to attract more FDI. Keywords: Exchange rate volatility, FDI, ARDL, Current account balance. 1. Introduction Foreign direct investment is the net inflows of foreign investment in a country. On the importance of inward FDI in host countries empirical studies implies that the inflow of foreign capital increases the funds supply for investment thus enhancing capital formation in the host country. Developing countries of the world face various problems, scarce financial resources are one of the main problem. With the passage of time investment requires to raise along with other things, these needs are fulfilled through capital inflow from developed countries to the less development countries either in the form of aid or foreign direct investment (Ellahi and Ahmad, 2011). FDI is an important source of capital inflow that carried out the technological spread out and managerial know-how in the least development countries through introducing better production methods. So it is necessary to keep up smooth inflow of inward investment into these countries, and control any factors that cause disruption of this FDI stability (Agnes and Thierry, 2005). Exchange rate volatility is a type of risk faced to international traders and investors engaged in FDI. Therefore, we conclude that exchange rate volatility is an important factor that restrict the trade volume and decrease the investment. When this volatility appears in developed countries causes instability in the world (Chege, 2009). It is a large recognised fact that exchange rate uncertainty in LDCs is the important factor that brings economic instability in the whole world (Chege, 2009). Exchange rate volatility affects FDI by the way that the depreciation of the currency of host country against the home country currency increases the relative wealth of foreigners which results in boom of attractiveness of FDI inflow as firms are able to acquire assets cheaply available in the host country. Therefore a depreciation of host country currency should raise the FDI inflow in the host country, on the other hand an appreciation of the host country currency must declined the FDI (Froot and Stein, 1991). Recent studies have attempted to explored channels through which exchange rate affects FDIs. As domestic currency appreciates enable the FDI attractive to domestic firms by two reasons. The first is as domestic currency appreciates exports more expensive in foreign market and established production units in the foreign country become more attractive to domestic firms. Second, the initial cost of production in the foreign market will be cheaper as a result of domestic currency appreciates. In the past studies of Cushman (1988) and Barrel and Pain (1998) investigated that the appreciation of domestic currency decreasing the FDI inflow, but the study of Goldberg and Klein (1997) found that depreciation increasing the FDI inflow. Hence appreciation of domestic currency flight out the capital of the countries on both accounts. Domestic currency appreciation means development of the economic fundamentals of a country and as a result better expected investment returns. Current account balance is an important factor of the quality of macroeconomic management, so the expected relationship between FDI and current account balance is positive. Although the issue of impact of exchange rate volatility on FDI inflow has been increasingly attention among the researchers concerning the case of Pakistan, contribution to the short run and long run relationship between exchange rate volatility and FDI in Pakistan rather limited as compared to its importance. Up to date, a little empirical studies (e.g. Ellahi, 2012; Ullah, 2012; Yousaf, 2013) have been conducted to investigate the impact of exchange rate volatility on FDI inflow in Pakistan. For example, the study of Ullah et al, (2012) address causality between exchange rate volatility and FDI in Pakistan, but their study show limitations in terms of analysis of short run and long run