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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. Even a well intentioned discretionary monetary policy becomes time
inconsistent while consistency is at the heart of rule based policy adopted by an
autonomous and transparent central bank. In standard Macroeconomic Models a loss
function, defined over output gap and deviation of inflation from its optimal value, is
assigned to the central banker who has the autonomy to choose its operating target so that
the loss to the society is minimum. Assuming behavioral equations of the private sector as
constraint, the first order conditions are derived from loss minimization, which after
manipulation give a policy reaction function that is made explicit in an instrument rule
while it remains implicit in the targeting rules (Svensson 1997). Empirical literature
brings to light the superiority of rule based policy in a variety of Macroeconomic Models
and against a bunch of structural shocks that may hit the economy.
The underlying thesis sets two objectives regarding monetary policy of Pakistan.
The first objective is to estimate monetary policy reaction function. For this purpose, the
Taylor type rules and McCallum rules are estimated using quarterly data on Pakistan
economy over the period 1993 Q3 to 2010 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. The second objective is to estimate loss, defined as
sum of variances of output gap and inflation rate, associated with different specifications
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of the rules, which is then compared with that found in the historical data. 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. The 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 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.
The simulation analysis confirms that policy consistency can improve welfare
significantly and rule based policy, in general, is found superior to the one that has been
observed during the sample period. Moreover, the original Taylor (1993) rule is found the
best among all specifications and inclusion of exchange rate and lagged interest rate
negatively affects welfare and the condition of zero lower bound on nominal interest rate
is violated, in most of the cases, when interest rate smoothing is included as a policy
objective. Interestingly, making monetary policy reaction function nonlinear does not add
to the performance of the rule. The stochastic simulation also confirms that Taylor rule
can perform well in a variety of shocks that may hit the economy. Finally, it is found that
Taylor rule may perform well even if the fiscal deficit partially dilutes the stance of
monetary policy but the performance of the rule is better in a model of monetary
dominance. |
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