The Conduct of Monetary Policy in Pakistan

Abstract

The conduct of monetary policy is not a frictionless combination of monetary operations as in case of Keynesian demand for liquidity, nor as mechanical as in the case of New Keynesian Taylor Rule. Ignoring the issue of output gap and feedback from monetary aggregates can result into explosive results for targeting inflation. The issue of inflation is beyond the simple Taylor principle. Our results show a significant relationship between inflation and interest rate, and money supply turned out to be insignificant. There is significant evidence of output gap in Pakistan and our results from Taylor rule show that State Bank of Pakistan preferred cyclical, not aggressive policy. There is no evidence of using active interest rate rule for forming future expectations. Using the combination of monetary aggregates and output gap for controlling inflation is not insignificant either. Inflation in the long run converges to the steady state but the conduct of the monetary policy calls for interest rate adjustment.