Academic journal article Pakistan Economic and Social Review

Estimating Monetary Policy Reaction Function of State Bank of Pakistan

Academic journal article Pakistan Economic and Social Review

Estimating Monetary Policy Reaction Function of State Bank of Pakistan

Article excerpt

Byline: GHULAM SAGHIR and WASEEM SHAHID MALIK

Abstract. A near consensus in the contemporary monetary economics is that monetary policy can achieve its objectives more precisely if it is designed as a rule rather than discretion. The objective of this paper is to estimate monetary policy reaction function. For this purpose, Taylor type rules and McCallum rules are estimated using quarterly data of Pakistan economy over the period 1993 Q3 to 2013 Q2. Both types of rules have been modified by incorporating exchange rate management and interest rate smoothing as policy objectives. Moreover, we have found recursive estimates of the parameters to sort out policy inconsistency. We have also looked into the issue of nonlinearity of the monetary policy reaction function with regards to output gap and inflation rate assuming asymmetric preferences of monetary authority.

We find that monetary authority in Pakistan does not follow Taylor rule as coefficient of output gap is negative and statistically insignificant and the coefficient of inflation rate, though statistically significant, is far below the benchmark value suggested by Taylor (1993). State Bank of Pakistan (SBP) is found to involve in exchange rate management and interest rate smoothing and this result is robust to different modifications in the Taylor rule. The parameters of output gap, inflation rate and differenced exchange rate, in the reaction function, are not stable over time and vary over the business cycle and across different inflationary regimes. The variation in the coefficient of output gap is found countercyclical while the coefficient of inflation rate follows the same pattern with respect to inflationary regimes. Coefficients of exchange rate and lagged interest rate remain almost stable.

The threshold value of output gap is found 2.5% below which the response of interest rate to output gap fluctuations is positive but above which the response is insignificant. The threshold rate of inflation is found at 6% and coefficient of output gap is found positive only in high inflationary regime while the coefficients of inflation rate and exchange rate are significant only in low inflationary regime. Monetary authority responds to currency depreciation more strongly when interest rate is low compared to that when it is high. Moreover, the response of interest rate to output gap is significant only if currency depreciation is below threshold (estimated at 0.68) while response to exchange rate is significant only if there is high speed of depreciation (above threshold). The results are robust to inclusion of fiscal deficit in the Taylor rule.

In Pakistan, fiscal deficit negatively affects interest rate which is because of the borrowing of government from State Bank of Pakistan (SBP) for budgetary support. In a modified version of the Taylor rule, interest rate is found to negatively respond to changes in growth rate of real GDP. Growth rate of monetary base negatively depends on the difference between nominal GDP growth rate and its average value indicating countercyclical response at the part of monetary authority. Moreover, growth rate of money exhibits strong inertia and is negatively related to currency depreciation. The coefficients in the McCallum rule too are not stable during the sample period. The coefficients of growth rate of nominal GDP and exchange rate are not stable over time, while the parameter capturing inertia is stable over the sample period.

The response of monetary growth rate to nominal GDP growth rate and to exchange rate are significant only when nominal GDP is above its threshold value and/or when currency depreciates at higher rate.

Keywords: Nonlinear Taylor Rule, McCallum Rule, Threshold Inflation Rate, State Bank of Pakistan

I. INTRODUCTION

The prime objective of monetary policy is to stabilize some aggregate measure of prices along with stabilizing real economic activity and financial sector. …

Search by... Author
Show... All Results Primary Sources Peer-reviewed

Oops!

An unknown error has occurred. Please click the button below to reload the page. If the problem persists, please try again in a little while.