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Monetary Policies in Pakistan

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Policies adopted by any country's Central Bank that influence interest rates and credit conditions, which in turn, influence consumer and business spending, is termed as "Monetary Policy". Monetary policy is amongst the key tools which a Government uses to influence its economy. The government with its authority to control the supply of money in the economy, it influences the overall level of economic activity which are formulated keeping in mind the political objectives. The objectives primarily are:

Low inflation,

Low unemployment,

A positive balance of payment, and

Economic growth.

A "Central Bank" appointed by the Government usually controls the monetary policy.

Many economists believe that monetary policy is a far more powerful tool than fiscal policy for controlling inflation. It involves changing the value of the exchange rate which results in fluctuations in the currency and have a strong impact on the macroeconomic activity such as incomes, output levels, prices, etc.

Changing short term interest rates affect the expenditure and savings behavior of mainly households and businesses over time and are feed through the circular flow of spending and income. Monetary policy works with great consideration of time lags which result on the interest elasticity of demand for various goods and services.


In line with trends world-wide, Pakistan adopted liberal and market-oriented monetary policies and procedures. This involved a move to indirect tools of monetary policy management and a major departure from the age-old practice of relying on direct interventions, such as liquidity reserve ratios and credit ceilings and controls.

Accompanying this policy change were gradual changes to the legal and institutional framework of monetary policy formulation, its targeting and operating procedures as well as development of infrastructure for treasury operation to allow for effective open market operations.

These changes have had a subtle but profound impact on monetary management which in turn has impacted economic management of Pakistan. Like in several other places, there however remains a level of ignorance regarding the virtues and technicalities of monetary policy management and there is a debate on some key issues. Structuralisms doubt whether monetary policy has any significant impact, in particular on price stability. Frustrations are also evident among different economic players who are forced to change their behaviors and expectations in line with tighter monetary discipline and interest rate adjustments. There is less understanding and patience for the lagged effects of monetary policy to defuse the inflationary pressures or to ease the liquidity conditions.

Monetary policy of Pakistan now for some years has been largely supportive of the dual objective of promoting economic growth and price stability. It achieves this goal by targeting monetary aggregates (broad money supply growth as an intermediate target and reserve money as an operational target) in accordance with real GDP growth and inflation targets set by the Government.

The given uncertainties concerning the fiscal sectors present that stance of monetary policy is striking a difficult balance between reducing inflation, ensuring financial stability, and supporting the recovery of the economy. An upward adjustment in the State Bank of Pakistan's policy rate, at this point in time projects the risk of blocking and severely hindering the still emerging recovery whereas a downward adjustment projects the risk of fuelling an already high inflation.


Monetary policy has two different facets. There is either an expansionary or a contractionary monetary policy. In an expansionary policy the supply of money in the economy is increased so that there is a boost in the economy. On the other hand, a contractionary monetary policy aims at decreasing the level of money supply in the economy. Contractionary monetary policy according to the State Bank of Pakistan also aims on increasing the supply at a slower pace than otherwise. An expansionary policy may be put into action to control factors such as unemployment. This is done through decreasing interest rates.

In eras of a boom when inflation is taking place the State Bank of Pakistan may make use of a contractionary policy, in which it increases the interest rates, therefore making investment a much more feasible option for the people. This decreases the amount of money rolling in the market. This happens in a way in which the final product is that the amount of money changing hands decreases, because saving money is at such times a much more feasible option for the people.

The State Bank of Pakistan also dictates what the minimum balance requirement is for the banks. This is a crucial factor and also one of the most important factors when it comes to reducing the supply of cash in the economy.

The policies and the stance that the state bank takes in relation to the imports and exports of the country also differ from time to time.


Monetary policy is one of the fundamental tools of government used to stabilize the economy, it's a process through which government or the central bank i.e. State Bank of Pakistan control or administer the supply of money in the economy. Monetary policy works on the expansion and Contraction of investments and is associated with consumption and expenditure. The impact of monetary policy on economy basically regulates the flow of money in the economy, & to control inflation, the goal of monetary policy is to excel economic growth without the change in price level.

Monetary policy regulates the interest rates which affect the economy on whole. An increase and decrease of interest rates changes the pattern of economic activity. A decrease in interest rate would encourage more borrowing from banks as the cost of borrowing is reduced, there would be more investments, more employment would be generated, consumer spending would increase resulting in raising household resulting in increase of money supply in the economy concluding to increase in price level.

A decrease in interest rate accelerates the economy but its results in Inflation and to accommodate it government increases the interest rate which shrinks the money supply in the economy and minimal the economic activities.

Expansionary policy (decrease in interest rate) effect the exchange rate as the deposit is reduced due to increase in consumption level of individual. There are fewer deposits in domestic currency as compared to foreign currency resulting in depreciation of currency ensuing in domestic goods cheaper than imported goods resulting in demand of domestic good to amplify.

During the expansionary phase of monetary policy there is demand of stocks as compared to bonds as the there is reduction in interest rates which makes bonds less attractive , reduction in interest rates bids up stock prices and make it cheaper for finance houses and make the stock and real estate prices goes high and impacts on aggregate economy.

An increase in money supply would result in diminution of short-term market rates making the cost of capital and the real interest rate to decline as the individual are spending more and may result in high demand of wages and incremental increase in prices if the manufacturing market is utilized effectively.

The diagram below depicts the functioning of a monetary policy and the channels it uses in order to have an impact on the economy.



Since April 2005 the monetary policy had been in tightening phase, due to the increasing inflation rate with SBP addressing this issue by raising policy discount rate from 7 to 9% in April 2005, further on SBP continuing this trend raised its policy rate to 9.5% in 2006 and also raised the Cash Reserve Requirement from 5% to 7% on demand liabilities.

Tightening the monetary policy had clear effects on the economy in different fields, most important of which is the downtrend of inflation and also providing opportunities of growth with respect to the annual target, the non-food consumer price index (CPI), continued its downtrend that is 7.8 in 05 to 6.3 in 06 to 5.1% in FY07. Though much of the achievements of tight policy were balanced by the unexpected rise of inflation of food, if the food inflation would have remained as expected in 06 (6.9%), then the CPI would have easily achieved its target of 6.5% that year.

The inflation risks also increased due to the growth in money supply(M2) which increased by 19.3% which is 5.8 % points higher then expected, this money supply was largely due to the high foreign exchange inflows, similarly a negative aspect was the Government borrowings from central bank, despite that the Government managed to retire the borrowings it still caused stress in the structure of the central bank. And another irregularity raised in 2007 from the increased level of central bank refinancing for working capital as well as long-term investments for the exporters, so all in all not only monetary management but also these aspects caused distortion in the economical structure.

Government borrowings from the central bank during the year were more or less equally stressful. The pressure from the fiscal account came from the mismatch in the budgetary inflows and expenditures. By the end of the fiscal year 2007, SBP holdings of Government papers was still around Rs 452 billion, despite a net retirement of Rs 56.0 billion during the year.

In 07, central bank raised its policy rate by 50bps to 10% for policy rate was raised by 50 bps to 10 percent simply to clear the unnecessary foreign inflows, and reduce the projected inflationary pressures, these inflows made sure the balance in exchange rate and building of foreign reserves, and also the Government borrowing was coming on track so in the end the economic system was depicting that monetary tightening was working, so then monetary trend reduced its speed and liquidity was injected in the economy which directed to diminishing of major interest rates and increase in money growth. And at the same time international prices of food and oil made a huge impact on inflation and due to this stress arose in economy.

Keeping in view the above risks and challenges, SBP has adopted the following

Policy measures: [1] 

Effective from 1st August 2007 SBP will raise policy discount rate from 9.5

percent to 10 percent.

(ii) Zero rating of Cash Reserve Requirement (CRR) for all deposits of one-year

and above maturity (to encourage greater resource mobilization of longer tenor)

and 7 percent CRR for other demand and time liabilities.

Recognizing the shortage of Shariah-compatible papers that are used by Islamic

Banks to meet SLR requirements, their cash in hand and balances with NBP are

being allowed to count towards SLR.

Introduction of modifications in the refinancing limits and resource

sharing arrangements for EFS to reduce its consequences for reserve

money growth and promote efficient utilization.

The SBP is introducing a new Long Term Financing Facility (LTFF) to

promote export led industrial growth in the country.

Simplification and Liberalization of External Commercial Borrowing

(ECB). [2] 


In 2008, keeping the progress of in view 2007 and future stance, SBP decided to strengthen demand management thus raised policy rate to 10.5%, however the international prices of oil and food also continued to raise, so the load of subsidies and increasing spending demand further increased the economic inequality and exchange rates faced more high pressure.

This rise in inflationary financing started to result in slacken the monetary conditions in the economy. Also the foreign current account deficit increased considerably to US$5.6billion compared to 2.0 billion in last year.

So keeping in mind all these pressures in economy the central bank introduces emergency monetary policy measures to restore balance and stability in the structure. These measures assisted in re-establish the tight monetary conditions as the real interest rates increased, though these measures did help but the risks still were around the corner as the international commodity prices were increasing and Government relied heavily on SBP borrowings, the data available showed that there will be a high deficit in GDP as high as 7 percent and the trade and foreign deficits may further increase it by 1.5%, at the same time due to the increasing international commodity prices, CPI could increase by 4.3% points, and most importantly the food inflation has crossed the inflationary expectations. The inflation rose to an alarming level as it rose from 8.8 in December 2007 to 17.2 in april 2008 and as mentioned earlier food inflation crossed the expectation rising from 12.2 to all time high 25.5%.

So cope up with these challenges the SBP recommended to

Retire borrowings from SBP

To accept quarterly limit on the borrowings from SBP

Adopt a balanced debt strategy

These were some of the recommendations of SBP due to the major issues, following are steps taken by the SBP in 08: [3] 

Increase in the SBP policy discount rate by 150 bps to 12.0 percent.

Increase in the (CRR) for all deposits up to

one year maturity by 100 bps to 9.0 percent while keeping the CRR for

deposits of over one year maturity unchanged at zero percent. In addition,

the Statutory Liquidity Requirement (SLR) is increased by 100 bps to 19

percent of the total time and demand liabilities.

Effective 1 June 2008, all Banks are required to pay a minimum profit

rate of 5 percent of Saving/PLS saving products.

Effective 23 May, the L/C margins on all imports except for oil and

selective food imports is being imposed at 35 percent.

The Government is well advised to sterilize the expected foreign inflows

by using the foreign resources to settle its obligations to SBP. Rather than

use fresh foreign inflows to finance new expenditures, retirements of

MRTBs will help reduce the reserve money pressures.

The Government is being further advised to amend the Fiscal

Responsibility and Debt Limitation Act, 2005 to incorporate appropriate

provisions to restrict the debt monetization. [4] 


The Interim Monetary Policy Measures were announced on November 12 to solve the problem faced in 2008 and to regain the stability in the system, the policy discount rate was increased from 13 to 15% after analyzing that there was no significant developments during the start of 2009 even after the measures taken, it however was one element of the stabilization program several other adjustments were required to put the economy back to the path of progress and growth. Although the basic of the stabilization program were laid but still it needed a lot of amendments to bridge the gap. But gradually signs of improvement in some important areas of system appeared such as import growth, inflation, foreign exchange reserve and borrowing of Government from state bank.

After the stabilization measures, economy made sound improvement, the inflation decreased to 19.1% in March 2009 from 25.3% in 2008, though it's still higher than the required level but it has shown improvement due to the measures taken by SBP, tight monetary policy and the control of fiscal expenditure are the main reasons due to which these improvements are achieved and these further got assistance from adjustments in exchange rate and decrease in international oil prices.

Although these improvements occurred but still there are still some factors creating uncertainty, most importantly the power shortage issue in our country and also the law and order situation that is counterproductive for our economy. But keeping the declining rate of inflation and growth SBP decided to lower the policy discount rate to 14%.

SBP is aware of these domestic structural limitations and global progress and their likely unfavorable impact on the economy. The problem is to achieve a balance between stabilization and sustainable recovery, to improve further and provide a path to progress, State Bank of Pakistan has decided to reduce the policy rate by 100 basis points to 13%.

SBP decided to take further steps in addition to improve the monetary system:

To increase the monetary policy decisions from 4 to 6 times in a year and communicate through a brief press release which will help to communicate the doubtful and changing economic conditions.

Formation of an independent monetary policy committee (MPC) that will have experts including external members as well as internal members from SBP. This will give transparency and credibility of monetary policy formation.

SBP will adopt a new system for its monetary operations by launching a passage for the money market overnight repo rate. While the SBP policy rate will serve as a 'ceiling', the repo rate on the new overnight deposit facility, 300 bps below the SBP policy rate, will offer a binding 'floor'. This facility will allow banks to deposits their surplus funds with SBP against T-bills. This system will improve liquidity management, enhance effectiveness of market signaling and strengthening its role in fostering price stability. [5] 

An overall look at the economy shows considerable growth and thus SBP's policy is rate to be cut by 50 bps. Inflation has fallen to 8.9% and is expected to remain under 11 in the near future, with Government borrowing under quarterly limits; the broad money has also remained controlled. However the elements indicating inflation return has also increased which shows that another phase of inflation might hit the economy, electricity and some food products are example of those elements, it is possible that in coming years the system might lose its balance again due to liquidity management and Government's budgetary financing, thus the overall risk and uncertainty had increased given the present law and order situation. Keeping a balance between monetary and financial stability and real economic activity has turn out to be more and more complicated. Therefore SBP decided to keep a close watch on economic stability and lowered the policy rate for now to 12.5%.


After the steady recovery in 2009 the starting of 2010 remained same that is progress at a slow rate, the policy rate didn't change but gradually as indicated the inflation is continuing to persist mainly due to the energy sector prices, although the increased CPI came down to 13% in February 2010, but it is high compared to 8.9 % in October 2009. Inflation came back due electricity tariffs, price of petroleum products and commodities like wheat, sugar etc

Despite these problems the domestic economic activity has picked pace in recent months, but the main problems here is energy sector because this single problem triggers many others like bank borrowing, energy deficiency, un-productive activities etc.

As expected the inflation and fiscal weakness are consuming the improvements that initially occurred in 2010, investments has declined substantially, aggregate supply has decreased due to energy shortages and law and order situation. These problems along with rising debt are pressurizing the economic stability. The inflation is 2.7% higher than the target, that is 11.7% these factors indicate risks of further increase in inflation.

To lessen the threat on the macroeconomic stability, monetary policy has to take account for containing aggregate demand pressures coming mainly from the expansionary fiscal position. Therefore, State Bank of Pakistan has decided to increase the policy rate by 50 basis points to 13%.


The recent floods that devastated about two-thirds of Pakistan have serious implications in terms of growth and macroeconomics perspective. Although these conditions had worsened even before the floods, it's high time that changes should be implemented. By the end of Fiscal year2010, fiscal deficit rose to almost 6.3 percent of the GDP, and inflation has sky rocketed! Post-Flood examination suggests that changes that are brought in should be intensive as to eradicate macroeconomic imbalances, and support the primarily occurring aggregate demand from the fiscal side. Experts suggest that economic growth would be stagnant in future, accompanied by rising inflation. Furthermore, there is occurrence of trade imbalance and pressure on the fiscal accounts. Commercial Banks would also be under great stress due to excessive borrowing by the government. While damages to infrastructure, and agricultural sector due to the floods is visible; the invisible damages occur in the form of reduction of work force and stress on industries. Experts also suggest that economic growth could reduce to 2.5 percent from targeted 4.5 percent for the fiscal year 2011. This occurs as the government needs to spend more on the rehabilitation of flood victims, and less on investments. The food supply chain were also disrupted, hence there was an increase of 5.1 percent in the Month-on-Month food inflation for August. This caused the Month-on-Month CPI inflation to rise to 2.5 percent. SBP suggests this spike in prices is the result of floods. Although the increase was more than the average M-O-M growth of inflation (1.6 percent) and CPI inflation (1.1 percent), economists suggest that the inflation rate would reduce to normal level in few months. But increase in electricity prices, introduction of reformed GST and further borrowings by the government would alleviate the inflation rates. Furthermore, frequent short term borrowings from commercial banks, by the government in the form of T-Bills has increased the rollover risk. Foreign borrowing has also increased due to reduction in foreign investments and domestic national savings. Although there has been reduction in the external current account deficit for FY10, this helped to improve imports after the floods. But exports are still constant and no growth is visible for now. Thus there could be an increase in the external current account deficits and uneven foreign inflows, which could in turn affect the SBP's foreign exchange reserves and exchange rates. Another important effects of the floods is that NDA (net domestic assets) could grow due to the banking system, while the NFA (net foreign assets) might stay constant that increases inflation.


Since the flood conditions also affect the economy, several strategies need to be applied so as to improve the scenario. Firstly Tax reforms should be implemented so as to generate more revenues for Pakistani government. Secondly the energy sector should be provided with subsidies and circular debt should be implemented so as to generate economic growth. Thirdly efforts should be continued to help and improve life of those affected by the floods. Plus SBP should curtail the government's borrowings so as to check on inflation, and attain macroeconomic stability. The CPI inflation for FY11 is expected to be between 13.5-14 percent, this can be reduced by government spending on development and reconstruction of the flood damaged areas. Financial resources should be managed more efficiently, which includes transparency and quick availability of accurate financial figures. Tax reforms should be analyzed, and check and balance should be maintained on current expenditures of the government, while they should invest more in development expenditures. The last three months are crucial to see if the government complies with SBP request to reduce its borrowings from SBP and private banks. The government should now also play an important role towards development and new strategies so that the inflation rate is curbed and the private economy need not suffer.

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