Combating Covid-19 through Policy Rate management

Abstract

The markup payments on domestic public debt are determined by the policy rate which is decided by the Central Bank’s monetary policy committee. Low policy rate leads to low markup payment on domestic debt and an expansion in the fiscal space which is necessary to make a package for the relief and rehabilitation of the people affected by the Covid-19 pandemic.  However, the State Bank of Pakistan is reluctant to cut down the policy rate due to fear of rising inflation. This is despite the fact that some very highly influential studies such as Gibson (1923) and Sims (1992) have found that the high policy rate is associated with high inflation. This paper shows that contrary to the assumption of the State Bank of Pakistan and other central banks the higher policy rate is a cause of high inflation, not a cure. The paper shows that contrary to the common literature, the positive association between the policy rate and inflation is supported by one of the oldest theories in monetary economics i.e. Tooke’s Banking School theory. Therefore, the paper shows that the policy rate can be reduced without the fear of inflation creating a huge fiscal space along with enabling environment for the business which is necessary to deal with the effects of the Covid-19 pandemic.