Measurement and effectiveness of the monetary policy shocks and test of opportunistic approach to monetary policy: evidence from Pakistan

The recent literature focuses on achieving macro-economic stability by an active use of the monetary policy instruments.The present study focuses on identifying monetary policy shocks and traces their impact on Pakistan’s economy.To this end, nonlinear policy rules have been used to be able to use monthly data on monetary variables. We have used the standard SVAR and STAR approaches that are popular in making basic OLS estimation and the simulations in a new-Keynesian type closed economy model. We state identification conditions to reveal the dynamic effects of monetary policy shocks on the non-policy block of variables.For nonlinear analysis we have pursued a general-tospecific methodology whereby, by imposing straight restrictions on the general model, to find the model that is statistically sound and fits the data the best. A threshold regression model comprising three monetary regimes is used for analytical purposes. An important finding of the present study is that a higher-than-normal increase in money supply has had the expected effect of stoking the fires of unusual inflationary episodes.The policy response has been to curb inflation by using different monetary policy instruments namely, manipulation of the key interest rate and changes in the total reserve requirements of the banking system to restrain the inflationary tendencies.The empirical results confirm remarkable differences in the monetary policy transmission mechanism during the three sample periods. We conclude that the State Bank of Pakistan (SBP) can exercise an effective control on inflation and adjust output growth forecasts in the middle of the three threshold periods identified in this study. We also find that when inflation forecasts are within a moderate range, around the long-run inflation target, the SBP tends to assume an essentially accommodating policy stance with respect to the manipulation of the key interest rate. In general, the monetary authority relies on encouraging demand and supply shocks to restore inflation to its desired long-run level. On the contrary, when inflation forecast tends to fall outside the tolerance range (which according to resent study is 4.13 to 11.21), aggressive adjustments in the interest rate can take place.An important implication of our analysis is that only a small proportion of the observed repetitive variation is attributable to random variation in monetary policy and the real effects of monetary policy are smaller than is usually believed. Pakistan’s experience with monetary policy supports the existence of the so-called Price Puzzle namely, that a positive shock to interest rate tends to increase the price level instead of reducing it Yet another finding of the present study is that inflation variability around the central projection can be contained by increasing short run nominal interest rates.The policy implication of this finding is that, with asymmetric output-inflation trade off, a vigilant policymaker would keep the average interest rate higher than the symmetric specification.One more interesting aspect of our analysis is that interest rate based policy has been much more sensitive to exogenous shocks in the period after 1999-2000. The policy responses of the SBP during this period have been asymmetric.Under this policy framework the SBP responds not only to current or lagged inflation; it keeps in view expected inflation as well.Another implication is that the monetary authority should extend its objective function to include not only price stability but also output stabilization.