Academic journal article The Lahore Journal of Economics

On the (Ir)Relevance of Monetary Aggregate Targeting in Pakistan: An Eclectic View

Academic journal article The Lahore Journal of Economics

On the (Ir)Relevance of Monetary Aggregate Targeting in Pakistan: An Eclectic View

Article excerpt


This study attempts to identify a stable money demand function for Pakistan's economy, where the monetary aggregate is considered the nominal anchor. With evolving financial innovations and regulations, the stability of money demand has been the focus of numerous debates. Where earlier studies have provided conflicting explanations due to inadequate specifications and imprecise estimations, we find that money demand in Pakistan is stable, if specified properly. For developing countries such as Pakistan, it is important to target monetary aggregates or respond to deviations from the desirable path if monetary policy is to be effectively implemented and communicated; this should remain, if not a primary, then an auxiliary target in the monetary policy framework.

Keywords: money demand, stability, monetarism.

JEL classification: C20, E12, E41, E5.

(ProQuest: ... denotes formulae omitted.)

1. Introduction

The role of monetary aggregate(s) as a virtue has long been debated in the conduct of monetary policy. It is generally believed that money carries important information about the underlying state of an economy and can help predict discernible monetary facts. Although most central banks have used monetary aggregates as an intermediate target in their monetary policy frameworks, the usefulness of monetary aggregates has diminished, particularly since the early 1990s when the money demand function became subject to structural changes (see, for instance, Mishkin, 2000; Woodford, 1998, 2008).

It is generally argued that successful monetary aggregate targeting requires a stable, or at least predictable, relationship between money growth and inflation. However, this relationship has become more obscure, particularly in advanced economies, since the 1990s with the evolution of the financial sector.1 Financial deregulation and innovation have significantly changed the preferences of households and the financial sector and thus destabilized the money demand function (Arrau, De Gregorio, Reinhart, & Wickham, 1995; Bernanke, 2006).2 As a consequence, many developed and developing countries have changed their nominal anchor and switched from a monetary aggregate targeting regime to inflation targeting or price level targeting.

Nevertheless, monetary aggregates contain important information and their significance in monetary policy frameworks cannot be ignored. A detailed assessment of monetary trends and their relationships with goal variables (output growth and inflation) can provide useful information on the demand pressures in an economy-this, in turn, drives our analysis of the specification and stability of the money demand function in Pakistan.

The core functional specification of money demand is derived from a set of intertemporal optimal decisions made by households and firms in a dynamic stochastic general equilibrium (DSGE) setting. This specification is then estimated empirically using various econometric techniques while investigating other potential determinants of money demand in terms of their goodness of fit. This is because the preferences of households and firms have, to some extent, changed and the operational scope of the financial sector widened over the last two decades (see State Bank of Pakistan, n.d.). However, the development of structured financial instruments is still in an evolutionary phase, making it necessary to analyze different empirical specifications for a robustness check.

Another important empirical contribution of this paper is that it provides an eclectic stability analysis both in terms of models and parameters. Although numerous empirical estimations of the money demand function have focused on the stability of money demand and the velocity of money in the context of Pakistan, the results are mixed.3 Some studies find a robust relationship between money and the goal variables (see Qayyum, 2005; Omer, 2010; Azim, Ahmed, Ullah, Zaman, & Zakaria, 2010) while other find an unstable money demand function (see Moinuddin, 2009; Omer & Saqib, 2009). …

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