CID Graduate Student and Research Fellow Working Paper No. 41, October 2009

Monetary Policy Channels of Pakistan and Their Impact on Real GDP and Inflation

Karrar Hussain

Abstract:

This paper is an attempt to estimate the relative impact of monetary policy on key economic variables i.e. output and inflation in Pakistan by covering the period from 1964-M1 to 2007-M12. For this purpose Vector Autoregression (VAR) approach is used, which is based on error correction model (ECM).We considered five pertinent channels through which monetary policy can affect economic activity of the country namely interest rate channel, exchange rate channel, government expenditure channel and credit channel. The objective of this paper is to identify the relative importance of each of these channels by employing Vector Autoregression (VAR) approach. We also generate Impulse Response Functions to confirm the response of a shock in a variable upon itself and other variables.  Our study concludes that exchange rate is also a significant monetary policy instrument in Pakistan’s case for both controlling inflation and minimizing output variance in the economy.

Keywords: Outputgap, Inflation, Vector Error Correction

JEL codes: C32, E31, E37, B41

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