The Economics of Inflation, Issues in the Design of Monetary Policy Rule, and Monetary Policy Reaction Function in Pakistan

By Ahmed, Ather Maqsood; Malik, Wasim Shahid | The Lahore Journal of Economics, September 2011 | Go to article overview
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The Economics of Inflation, Issues in the Design of Monetary Policy Rule, and Monetary Policy Reaction Function in Pakistan

Ahmed, Ather Maqsood, Malik, Wasim Shahid, The Lahore Journal of Economics


The objective of this study is to estimate a monetary policy reaction function for Pakistan. To do this, we use data for the period 1992Q4-2010Q2. Our results show that the State Bank of Pakistan reacts to changes in the inflation rate and economic activity in a manner that is consistent with the Taylor (1993) rule, and with the explicit objective of interest rate smoothing and exchange rate management. This policy has remained consistent for most of the sample period, except for the last two years, during which a price hike and the massive depreciation of domestic currency led to a significant change in the parameters of the policy reaction function. We also find evidence of nonlinearity in the reaction function as the response to an inflation rate above 6.4 percent is found to be more aggressive than that in low inflationary episodes.

Keywords: Inflation, Monetary Policy, Pakistan.

JEL Classification: E52, P44.

(ProQuest: ... denotes formulae omitted.)

1. Introduction

The ultimate objective of monetary policy is to maximize society's welfare, which can be achieved by keeping unemployment at its natural rate and prices stable. If some labor is unemployed, output remains below its potential level, which results in lower living standards. If the inflation rate exceeds a certain threshold, it is harmful for economic growth. Price instability is a major source of uncertainty in financial markets since it distorts economic choices for economic agents, thereby causing the economy to perform below its potential level.1 The stability of certain other economic indicators such as the interest rate and exchange rate also helps achieve the objective of social welfare. Abrupt changes in the interest rate, for instance, destabilize the financial system, resulting in the poor intermediation of loanable funds. Sudden changes in the exchange rate destabilize international trade and discourage foreign investment. Therefore, monetary policy is concerned mostly with keeping output at its potential level while keeping prices, the interest rate, and exchange rate stable. The real challenge for monetary authorities, however, is to resolve the tradeoff among these objectives, especially in the short run. Thus, the art of monetary policy lies in being able to achieve an optimal mix of these variables, in which case policy is said to be optimal.

In designing monetary policy, an important issue is the choice of appropriate variables to target and the numerical targets for those variables. The vector of chosen variables may include the inflation rate, a measure of real activity, the interest rate, and the exchange rate. A zero-output gap may be used as a benchmark for real activity, but the real gross domestic product (GDP) growth rate is also an option. It must be said at the outset, however, that monetary policy alone cannot maintain a high growth rate in the long run. To achieve price stability, which is the primary objective, the threshold rate of inflation (above which inflation is harmful for economic growth) can be considered a target. The nominal exchange rate is adjusted such that the misalignment of the actual real exchange rate from its equilibrium value is minimal. Finally, the interest rate-the policy instrument-is adjusted gradually to avoid abrupt changes.

Monetary authorities achieve these objectives through one of two alternative policy frameworks: rules and discretion. The discretionary framework is more flexible on the part of the policymaker, and so appropriate decisions can be made according to current and expected future economic conditions. However, Kydland and Prescott (1977) argue that even optimal discretionary policies are time-inconsistent. These inconsistent policies create uncertainty in financial markets and even in the labor and goods markets.

A policymaker may lose credibility through policy reversals. Taylor (1993) prescribed a simple, easily verifiable rule for monetary policy according to which the short-term interest rate (the monetary policy instrument) responds to the deviation of the inflation rate from the target and that of output from its potential level.

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