The effectiveness of monetary policy

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(Akhter, 2008) The Effectiveness of Monetary Policy in Pakistan, discusses the issue of effectiveness. She has said the main objective of monetary policy according to SBP Act 1956, is to achieve the target of inflation and growth set annually by the government and to support public welfare by focusing on price stability. The policy is formulated around the targets announced by the government. (Akhter, 2008) focus on price stability is because actual inflation outcome in the economy is largely due to by the level of output gap i.e. the demand and supply of the economy and inflation outlook. When the gap in output increases, the actual output is more than what the economy can maintain in the long run with stable inflation. This reflects excessive demand for available resources in the economy, which pushes up general prices. In order to stop the increase in cost and the general price level in the economy reduce the demand in the short run or increase the production capacity in medium to long run. If we reduce aggregate demand it can result in reduction in current output and an increase in the unemployment level in the economy.

The famous classical Phillips curve that captures the tradeoff between stabilizing inflation and controlling unemployment was criticized by Phelps and Friedman in the late 1960s because they argued that if inflation expectations react to changes in actual inflation, then any tradeoff between inflation and unemployment would be shortlived at best. If wages are set once a year and for some reason the output prices increase, then the producers have an incentive to increase their output by hiring more workers. However it is only possible if workers' expectations of inflation remain unchanged during the period of increase in output prices. If workers adjust their expectations in accordance with actual inflation and demand higher nominal wages, it leaves relatively little incentive for firms to increase the output. Therefore the focus has shifted away from this tradeoff and new consensus has emerged in the literature that price stability is key to long run growth prospects. These theories suggest that monetary incentive can only affect real economic activity in the short run. Central bank should give more weight age to price stabilization and now a days most central banks focus on this rather than output growth and financial exchange rate stability. (Akhter, 2008) emphasize that Fiscal authorities, social and cultural support is needed by state banks to coordinate the policy effectively because SBP focus is to increase growth not to slow it down in future.

Monetary policy decisions affect the level of economic activity in the economy. (Akhter, 2008) was of the view that monetary actions affect the economy with some time and the outcomes are unpredictable and volatile but this can be forecasted. According to her there are many monetary channels to achieve targets as these channels level are affected by financial products, technological changes, institutional strengthening, and expectations about future policy, etc. These channels should be reviewed continuously and updated on regular intervals. First channels among all are the association between changes in the shortterm nominal interest rate and the longterm real interest rate that ultimately affect components of aggregate demand such as consumption and investment in an economy and these components are affected by change in long term interest rate. The second channel is credit channel; in this channel ability of banks to lend is controlled by central bank. The third channel is asset price, which deals with bonds and equities. Changes in nominal interest rate affect the prices of bonds and stocks which results in change in firms market value and consumption level. The fourth channel is that the interest rate change can affect exchange rate which affects balance of payment and aggregate demand. It directly affects inflation if there is change in prices of imports. The fifth channel is based on the future and forecasted results of monetary policy which affects variables in forward looking- manner.

SBP monetary policy framework in Pakistan begins with start of every fiscal year with SBP setting the money supply (M2) target in line with government targets of inflation and money demand in the economy. The aim is to keep money supply close to its estimated demand level, as both a significant excess and a shortfall may lead to considerable deviations in actual outcomes of inflation and real GDP growth from their respective targets. (Akhter, 2008) outlines the underlying framework have two strong assumptions: first, there is a strong and reliable relationship between the goal variable (inflation or real GDP) and M2; and second, the SBP can control growth in M2. Net foreign Assets (NFA) and Net Domestic Assets (NDA) of the banking system are the two major components of money supply. Sharp NFA reduction reflects worsening BOP position and a pressure on exchange rate. In such a case, a higher NDA growth, though helps in expanding M2 to reach its target level, may further deteriorate external accounts, sharper depreciation of local currency, and higher depletion of countrys foreign exchange reserves. To keep M2 growth at desired level policy actions required are change in policy discount rate, Open Market Operation; cash reserve requirement and statutory liquid reserve requirements.

The different channels transmit the monetary policy shocks in Pakistan in different ways. Generally, historical evidence does reflect that Pakistan has been a high inflation which has weakened its structure. Monetary policy stance was however altered as the inflationary pressures started to build up in 2005. At the end of the 2005 fiscal year the fiscal module started to show signs of stress as the fiscal balance was converted into a deficit and the stock of external debt and liabilities, These indicators largely capture the high and growing aggregate demand in the economy on account of sustained increase in peoples income. With the emerging domestic and global price pressures, SBP tightened its monetary policy after a prolonged gap of a few years. The efforts restrict inflation, however, proved less effective due to a rebound in international commodity prices and a rise in domestic food prices later on. SBP in FY06 increase the policy rate, the central bank focused on the shortend of the yield curve, draining excess liquidity from the interbank money market and pushing up shorttenor rates. Consequently, not only did the overnight rates remain close to the discount rate through most of the year, the volatility in these rates also declined. With this measure the targets were met without affecting economic growth. In FY06 core inflation declined very little so SBP increase the CRR and SLR for the scheduled banks; and its policy rate by 50 basis points (bps) to 9.5 percent. Moreover, proactive liquidity management helped in transmitting the monetary tightening signals to key interest rates in the economy. The impact of the monetary tightening was most evident in the continued deceleration in core inflation during FY07. Increase in money supply growth largely from an expansion in NFA due to the higher than expected foreign exchange inflows and there were large increase in government borrowings from the central bank during the course of the year and SBP extended the refinancing, for both working capital and longterm investment, to exporters. FY08 was an exceptionally difficult year. U.S dollar slide against major currencies and rising prices of food and crude oil cause inflationary pressure. With the exception of few developed countries, most central banks showed a strong bias towards addressing the risk of inflation and responded with tightening of monetary policies. Considering the size of macroeconomic imbalances and the emerging inflationary pressures, SBP launch steeper monetary tightening and increase discount rate to break the demand pressures and restore macroeconomic stability in FY09 to achieve price stability.

(Akhter, 2008) elaborates need to make monetary policy formulation and implementation more transparent, efficient, and effective, SBP has introduced structural changes in the process of monetary policy formulation. Effectiveness of monetary and fiscal coordination would be helpful. The track record of the Monetary and Fiscal Policies Coordination Board (MFPCB), established in February 1994 that requires quarterly meetings of the SBP and the government, has been less than satisfactory. The budget making process has not respected the monetary compulsions. With rising spending and stagnating revenues, the budget assumes at the start of the year certain recourse to the central bank rather than treat it as mere ways and means advances. The effective analysis of developments and policy making, timely and quality information is extremely important. However, due to weaknesses in the data collection and reporting mechanism of the various agencies of the country, information is not available with desired frequency and timeliness. There should be defined government borrowing from the SBP to control inflation

Another issue is to make a clear distinction between exchange rate management and monetary management. SBP actions should direct to achieve price stability through achieving monetary targets by changes in the policy rate; it is not possible to maintain exchange rates at some level with free capital mobility. This can only be achieved by putting complete restrictions on capital movements, which is not possible and finally there should be differentiation between liquidity management and monetary policy stance. It is important that a independent medium term development strategy, would help minimize one agency interest and help the budget making process more rule based than the incrementally driven process to satisfy conflicting demands.

(Khan, Ejaz, & Gill, 2007) Impact of Supply of Money on Food and General Price Indices: A Case of Pakistan, discussed impact of supply of money on food and general price indices by estimating a series of equations taking CPI food, CPI general, WPI food, WPI general, GDP deflator and SPI as measures of inflation and M1, M2 and M3 supply of money as explanatory variables. (Khan, Ejaz, & Gill, 2007) said that core inflation is an indicator and also used as forecaster of underlying long term inflation as it eliminates the items like food, energy which have temporary price shocks. , In relation to Pakistan the other food and general indices are wholesale price index (food) and wholesale price index (general). The remaining general price indices are sensitive price indicator and GDP deflator. To investigate the effects of components of money supply on food and general measure of inflation is the core of present study.

In their model they have employed linear regression model and method of least square to examine the relationship between measure of inflation, i.e. consumer price index (CPI) food, CPI general, whole sale price index (WPI) food, WPI general, GDP deflator and sensitive price indicator (SPI) and components of supply of money, M1 (liquid measure of money), M2 (broader money) and M3 (broadest measure of money). A series of model explaining the effect of three types of supply of money on price indices have been established.

(Khan, Ejaz, & Gill, 2007) used time series data and this data are fixed over the long-run which is the violation of the one important assumptions of OLS method. This non stationary time series can result into false regression. An important indicator of false regression is that Durbin Watson statistics should be less then Co-efficient of Determination. The Durbin Watson statistics supports model specification as it is no-autocorrelation. The annual time series data of all the variables under discussion for the years 1976 to 2007 has been used. The data of M1, M2, M3 (million rupees) is taken from Economic Survey of Pakistan 2006- 07 (SBP various issues). The data on CPI, WPI, GDP deflator and SPI has been taken from (GOP various issues) and it has been rebased on 1976 values.

(Khan, Ejaz, & Gill, 2007) estimated OLS regression results of effect of supply of money on food and general price indices have correct sign and statistically significant at 5 percent level of significance. Result of M1 equation shows 10 percent increase in M1 supply of money would increase CPI (food) by 4.5percent. While M2 supply of money has statistically insignificant coefficient and M3 supply of money has negative effect on CPI (food). This is because of the given supply of food items, the increase in M1, i.e. increase in cash and demand deposits results into increase in demand for food items. It puts pressure on the prices of food items in the market. The increase in M3 (broadest measure of money), i.e. M1 + time deposits, institutional money-market fund, short term repurchase agreements and larger liquid assets increase the financial savings which ultimately positively affect the investment and output in the long-run. In their model there was indication that the increase financial savings has positive effect on investment and output because the increase in M3 supply of money has resulted into enhanced investment and output of food items and decreased price of these items in the market due to larger supply.

They discussed that Pakistan is facing severe problem of inflation for the couple of decades. It is posing a major threat to macroeconomic stability. To control the inflation has become one of the major objectives of national economic policy. (Khan, Ejaz, & Gill, 2007) concluded from the study that supply of money M1 and M2 affects the food and general indices in the same way. However, M1 supply of money affects the CPI general strongly than CPI food. M1 supply of money cause the inflation if the increase in M1 is not supported by increase in output. There study goes against heavy government borrowing from central bank to finance budget deficit without increasing the output in the same ratio which results in inflation. The M2 supply of money is less important than M3 supply of money. The findings in the research support the argument that increase in savings positively affect investment and output. SBP should limit their finances to government to cover deficit. The printing of money should be limited that does not affect other monetary actions to decrease CPI and SPI. Increase in M3 supply of money influence inflation to decrease and SBP should frame policies to induce people towards financial savings as banking monopoly has increased their spread rate through high lending and low deposit rate. Increase in M3 supply of money through institutional money-market funds, short-term purchase agreements and large time deposits can cause inflation to decline.

(QAYYUM, 2009) Does Monetary Policy Play Effective Role in Controlling Inflation in Pakistan, discusses effectiveness of monetary policy in controlling inflation. The main objective of this study is to assess the efforts of SBP to control inflation in Pakistan. Policymakers blame uncontrollable factors for rise in inflation. (QAYYUM, 2009) says poor people in the economy have very limited options to protect them from the inflation as their savings are in the form of cash and resource allocation slows down because of unclear inflation. He is of the view that policy should be framed keeping in view the factors causing inflation in the economy. It was still undecided that either the current inflation was caused by cost push factors such as wheat procurement price or oil price increases or accommodative monetary policy is responsible for current surge in inflation. State Bank of Pakistan was established with two broad objectives; to secure monetary stability and to find fuller utilization of countrys productive resources. These objectives are confined under the head of ‘Functions and Responsibilities of the Central Board by making it responsible to secure monetary stability and soundness of the financial system. Target rate of inflation is the prime objective of monetary policy in Pakistan. Monetary policy management is one of the primary goals of the State Bank of Pakistan (SBP).

In Pakistan the monetary policy has been supportive of the dual objectives; promoting economic growth and price stability. However, during the period from 2001 to 2005 monetary policy in Pakistan was biased towards supporting growth because of expectations that inflation could be maintained at low levels while giving the economy a monetary stimulus. Tight monetary policy was maintained to control core inflation since 2004. (QAYYUM, 2009) is of the view that tight monetary policy stance, has begun to lose some of its steam as manifested by a moderate increase in KIBOR and banks lending rates, almost flat Monetary Conditions Index (MCI), a fall in the effective CRR, and persistently high annualized M2 growth rate. Inflation started rising from 2004 and remained above the target level except one year that is 2006 when it was exactly equal to the target rate. At the end of the financial year 2007-08 actual inflation substantially (100% higher) surpassed the target level of inflation set by the federal government. In order to achieve the objectives of monetary policy the SBP targets monetary aggregate (M2) in accordance with the targets of real GDP growth and inflation set by the Government. Below are the inflation figures;

Year Actual Target

2004-2005 9.3 5.0

2005-2006 7.9 8.0

2006-2007 7.8 6.5

2007-2008 17.5 6.5

Money supply is the one of most important tool to control inflation in Pakistan. M2 variable influence rate of inflation strongly. SBP set target rate of growth of M2 using estimated money demand function. Because of very close relation of prices and supply of money, SBP uses Fishers equation of exchange to calculate M2 growth. According to the law and practice target rate of growth and target rate of inflation are fixed by the Federal Government. The SBP just combine those targets and obtain target rate of growth of money supply. During calculation of target value it is implicitly assumed that the velocity of circulation money in Pakistan is constant.

Velocity of money has decreased due to the structural changes in the financial sector of Pakistan which means the developments in the real and financial sectors must be considered in process of formulation of monetary policy as it can affect the process of setting target for rate of growth of money.

The research finds out that M2 growth remained higher than the target rate of money growth set by the SBP to control inflation after 2001 and it means either SBP failed control growth of money supply or following loose monetary policy during this period. (QAYYUM, 2009) said that money supply growth at first round affects real GDP growth and at second round it affects inflation. Different instrument adapted in monetary policy are discussed by author are: Open Market Operation (OMO) is an important instrument of monetary policy in Pakistan. The SBP can influence/manage domestic liquidity through purchase or sale of government securities in the secondary market. The OMO can also be used to maintain the level of reserve money according to the operating target. SBP imposes cash reserve requirement on all deposits of scheduled banks as an instrument of monetary policy. Discount rate is another important instrument. Current Monetary Policy seeks to check rising inflation through change in discount rate and CRR as it was assumed that changes in both will reduce inflation and supply of money. According to him the SBP did not understood the transmission mechanism link among interest rate, money supply and inflation and it appears to him that complete understanding of issues like state of effectiveness of different channels, Lag structure of monetary policy changes, magnitude of pass-through of policy changes to inflation and output and nature of relationship amongst, instruments and goals of monetary policy (inflation and output) is lacking. Initially in 21st century SBP adopt loose monetary policy but then it adopts tight policy and interest rates were increased. (QAYYUM, 2009) notes that during recent period interest rate and money growth are negatively correlated that is -0.71. If demand for goods does not increase than producers will transfer the financial cost to consumers causing inflation. If interest rate is changed transmission mechanism is that it affect money market rate, saving rate and lending rate but private borrowing will not be affected by change in interest rate. He sees SBP has based its money growth keeping in view the growth target fixed by the government. The increase in interest rate would increase interest payments on government debt thereby increasing fiscal deficit and government borrowing are already beyond the agreed level from the SBP so it increases the likelihood that government would finance the higher deficit because of higher interest payment by more borrowing the central bank, in this way the decline in monetary growth due to higher interest payments might be compensated. He concluded that monetary authority was successful in controlling inflation when it successfully controlled the money supply target. SBP has failed in recent times to control supply of money and inflation as there is lack of coordination between Fiscal and Monetary Authorities. He sees Reaction Functions of Monetary Policy inconsistent overtime and finds that understanding of process of transmission mechanism of monetary policy is missing and it should be analyzed.

(Qayum, 2009) Inflation Expectations Survey, discusses future inflation have a central role in macroeconomic theory as it provides direction to consumption, saving and investment decisions of economic agents. Inflation targeting framework requires the use of inflation expectations in monetary policy decisions. It helps in making effective policy to stable prices. The response has taken from doctors (PhD), professors, bankers, bureaucrats, businessmen and young economists. (Qayum, 2009) survey results on inflation expectations reveal that people are expecting high inflation together with high unemployment, a decline in growth rate and decreasing currency value and also both demand pull and cost push factors are responsible for current inflation in Pakistan, the most prominent being global economic conditions and high food and fuel prices. High cost of living induced by inflation is now the most important problem in Pakistan. The lower income segments of the society and after them the middle income group is most affected by this.

The survey reveals that the current monetary policy has not been effective in curbing inflation, highlighting the need for coordinated monetary and fiscal policies to control inflation. Majority of the respondents expect higher inflation in the next year as compared with the current year and expect that the rate of unemployment will increase in the next six months and this situation is likely to persist in the next year. Nearly two-third of the respondents expects that the rate of growth will drop in the next six months. Exchange rate stability is in question mark while a majority of the respondents (81%) believe that the political scenario affects inflation expectations. The results suggest that international inflation, foreign aid and financial development are also believed to affect inflationary expectations and current inflationary pressure in Pakistan, in their opinion, is due to global financial crisis, food prices and oil prices and they show strong view that monetary policy is ineffective in controlling the rate of inflation in Pakistan. The survey shows consensus in the opinion that coordinated move by the authorities implementing monetary and the fiscal policies will be effective in controlling inflation.

(Gul, 2009) Economic Survey of Pakistan, discussed that inflation an important factor and variable used by cnetral banks in setting policy rate. Inflation should be kept at sustainable level to protect low level income group and keeps cost of doing business at low level. Inflaion was in focus through out this fiscal year as it start decling in the second half of the fiscal year. Pakistan are among few countries facing high inflation which was 25% in august 08 which is macroeconomic stability. Pakistan is developing country so it must have stableand controllable inflation rate. Apart from food inflation index, non-food indices also show rising trend. House rent index which is major part of CPI has increased due to calculation methodology. The increase in interest rates was in accordance with the international rising trends and these measures were also taken to curtail the lending ability of the commercial banks to the private sector. It aimed to limit strong domestic demand that was one of the main driving forces for fueling inflation. (Gul, 2009) was of the view that because government has removed subsidies and its heavy borrowing from SBP to finance deficit, the levying of custom duty on various imports in order to curtail imports; increase in the support prices of some major crops like wheat and sugarcane; supply-side structural issues and mismanagement; speculation, smuggling and hoarding of goods; political unrest and a deteriorating law and order situation have all hampered government efforts to stabilize domestic prices through 2008-09.

According to (Gul, 2009), inflation was key factor used by SBP in setting benchmark rate in monetary policy so SBP kept tight monetary policy at start of fiscal year but then loose the policy in the second half. Government has financed the increase in oil prices by borrowings from the SBP which negates the tight monetary policy stance. There are expectations that as demand pressure is easing the SBP will reduce the policy rate further down. The effects of continuous high prices can be that the wages be increased and producers will transfer high cost of production to consumers which add to inflation so government is expected to curtail this situation with the support of SBP. Based on current tendencies, the contribution of food and non-food inflation to the overall CPI is estimated at 48.0 percent and 50.7 percent respectively. The effect of monetary policy on prices is reflected in core inflation with a lag of six months to a year, making it a good predictor of future CPI inflation. The measures taken in monetary policy so far has now showing results as private sector borrowings and budget financing is on the lower side. Because of macroeconomic stabilization program the government borrowings are now from scheduled banks and it has retired part of its dues to SBP and deposits with SBP has increased mainly due to foreign aid.NFA has improved because of loans and NDA has decreased because of fall in credit from private sector. A failing external account position and the tight monetary stance of the SBP left the money market short of liquidity during most part of the current fiscal year 2008-09. The tight monetary policy stance of the SBP faced a major challenge during initial months of 2008-09 particularly due to exceptionally high pressures on rupee liquidity in the inter-bank market. A contraction in money supply, rise in currency in circulation, rising private and public drawings are main reasons of that. SBP intervened in the domestic money market through several measures such as drastic reduction in reserve requirement, liquidity injections through Open Market Operations (OMOs), and discounting window.

Akhter, S. (2008). The Effectiveness of Monetary Policy in Pakistan. Retrieved 2009, from Bank of International Settlements:

Khan, A., Ejaz, R., & Gill, A. R. (2007). Impact of Supply of Money on Food and General Price Indices: A Case of Pakistan. IUB Journal of Social Sciences and Humanities Vol.5 No.2 . 126-143.

QAYYUM, D. A. (2009, January 30). Does Monetary Policy Play Effective Role in Controlling Inflation in Pakistan. Retrieved 9 28, 2009, from Munich Personal RePEc Archive:

Qayyum, D. A. (2009). Inflation Expectations Survey. Retrieved October 2009, from Pakistan Institue of Development Economics:

Government of Pakistan. (2009). Economic Survey of Pakistan. Islamabad: Finance Division.