An empirical assessment of monetary discretion: The case of Pakistan

Assessing the Role of Money versus Interest Rate in Pakistan

“…This is important because only a small fraction of variations in monetary policy instruments may tend to relate to a small fraction of variations in target variables (such as inflation and/or real economic growth) given that the central bank may not necessarily exercise full control over the variations in monetary policy variables especially broad money. This postulation, as a starting point, is consistent with Bullard, 1999;Uhlig, 2005& Hayat et al 2016. We derive indicators of persistent variations from (a) growth in broad money, (b) market interest rate, (c) inflation, and (d) the real GDP growth rate in two steps as follows.…”

“…In order to examine the relative importance of money versus interest rate as monetary policy tools as well as their evolution over time, following Hayat et al (2016), we first generate indicators representing persistent variations in variables of interest and then use them to estimate their long-term relationships through the ARDL approach (see next section). This is important because only a small fraction of variations in monetary policy instruments may tend to relate to a small fraction of variations in target variables (such as inflation and/or real economic growth) given that the central bank may not necessarily exercise full control over the variations in monetary policy variables especially broad money.…”

“…One may ask about the justification of the use of the HP filter. First, our choice of this filter is driven by the fact that the filter allows the trend to vary over time and hence the magnitudes of deviations, which may better represent policy responses (variations) in the underlying policy as well as goal variables (Hayat et al 2016). Second, double HP filter outperforms other detrending and smoothing methods in turning point signal stability, i.e.…”

“…Figure 2 shows that by and large, double filtering has not led us to lose significant information as exhibited by correlation coefficients with respective base and cycle variables, especially in case of inflation and interest rate indicators. Instead, it seems that rather the noise part has been purged, which may not necessarily be representing policy-induced actions and responses in goal variables as all the shocks may not be treated to be representing informed policy actions or responses (see Hayat et al 2016). 5 For example, the correlation between the base variable CPI inflation and its cycle series (CPIT) is 0.71 and that of CPI inflation and our generated indicator is 0.63 (see Figure 2).…”

“…In contrast to the aforecited literature, we use; (i) the framework used by Hayat et al (2016) to extract indicators of persistent changes in the variables of interest to be able to closely observe the most relevant underlying relationships and, (ii) apply the ARDL approach to estimate such relationships.…”