Academic journal article The Lahore Journal of Economics

Adopting Inflation Targeting in Pakistan: An Empirical Analysis

Academic journal article The Lahore Journal of Economics

Adopting Inflation Targeting in Pakistan: An Empirical Analysis

Article excerpt

Abstract

The objective of this paper is to assess the conditions for inflation targeting in Pakistan. The recent inflationary surge in Pakistan calls for rethinking monetary policy afresh. This paper argues the case for inflation targeting in Pakistan as a policy option to achieve price stability. The country experienced an inflation rate of just below 10 percent during 1970-2009, which makes it a potential candidate for inflation targeting. Applying the VAR technique to data for the same period, inflation is shown to be adaptive in nature, leading us to reject the accelerationist hypothesis. The Lucas critique holds as people are found to use forward-looking models in forming expectations about inflation. The paper also sheds some light on the State Bank of Pakistan's level of preparedness for the possibility of adopting inflation targeting, for which transparency and autonomy are prerequisites. The interest rate channel can play the role of a nominal anchor in the long run.

Keywords: Monetary policy, central bank, inflation targeting, Pakistan.

JEL Classification: C32, E31, E52.

(ProQuest: ... denotes formulae omitted.)

1. Introduction

In recent years, the macroeconomic discourse has shifted from stability versus growth to stable growth because high inflation is a hindrance to sustained growth. The discussion then turned toward the effectiveness of monetary policy in controlling inflation. Money is not neutral, at least in the short to medium run, and it can generate inflation with lags; the central bank has no mechanism to exercise complete control over inflation. In the last two decades, countries have faced a contagion phenomenon and a worldwide liquidity crisis, raising the specter of another Great Depression. The experience points toward the miscalculations of monetary authorities in determining the role of money and its impact on the real economy. The question is, how does a country that is otherwise doing well land itself in a financial crisis? The answer lies in people's self-fulfilling expectations and the fallacy of composition on the part of policymakers. Expectations about the future play an important role in investment and gross domestic product (GDP) growth. Emerging economies face increased import bills due to liberalized trade and fluctuations in commodity prices and shortages in food grains. Declining productivity, an acute shortage of energy, imperfect markets, and poor fiscal management present another challenge to the central bank agenda of price stability.1

Broadly speaking, central bankers have three choices available for achieving a stable inflation rate which can contribute to economic growth. First, the central bank can adopt discretionary monetary policy without any framework-a policy which simply fails to answer the questions that a central bank has to confront in light of an unstable money demand function. Alternatively, the central bank can control the exchange rate-a policy that relies heavily on the policies of central banks in importoriginating countries, besides requiring strong financial and economic conditions. Second, the central bank can opt for a rule-based monetary policy, which targets income instead of money or prices. Third, a central bank may choose to target inflation explicitly as "enemy number one"2 by making a transparent conditional forecast to make it accountable. A single choice or even a blend of all three is not considered the best policy for all countries, all time periods, or all types of environment. There is no such thing as a single, ideal monetary policy. It varies from country to country and with changing conditions. Each country needs a monetary policy that is robust, along with a conducive set of institutions, and commitment to fiscal responsibility for achieving the objective of price stability.

The idea behind inflation targeting (IT) goes back to the early Keynesian-monetarist debate on rules versus discretion. …

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