Estimating Monetary Policy Reaction Function of State Bank of Pakistan

• Author: GHULAM SAGHIR and WASEEM SHAHID MALIK

Abstract. A near consensus in the contemporary monetary economics is that monetary policy can achieve its objectives more precisely if it is designed as a rule rather than discretion. The objective of this paper is to estimate monetary policy reaction function. For this purpose, Taylor type rules and McCallum rules are estimated using quarterly data of Pakistan economy over the period 1993 Q3 to 2013 Q2. Both types of rules have been modified by incorporating exchange rate management and interest rate smoothing as policy objectives. Moreover, we have found recursive estimates of the parameters to sort out policy inconsistency. We have also looked into the issue of nonlinearity of the monetary policy reaction function with regards to output gap and inflation rate assuming asymmetric preferences of monetary authority.

We find that monetary authority in Pakistan does not follow Taylor rule as coefficient of output gap is negative and statistically insignificant and the coefficient of inflation rate, though statistically significant, is far below the benchmark value suggested by Taylor (1993). State Bank of Pakistan (SBP) is found to involve in exchange rate management and interest rate smoothing and this result is robust to different modifications in the Taylor rule. The parameters of output gap, inflation rate and differenced exchange rate, in the reaction function, are not stable over time and vary over the business cycle and across different inflationary regimes. The variation in the coefficient of output gap is found countercyclical while the coefficient of inflation rate follows the same pattern with respect to inflationary regimes. Coefficients of exchange rate and lagged interest rate remain almost stable.

The threshold value of output gap is found 2.5% below which the response of interest rate to output gap fluctuations is positive but above which the response is insignificant. The threshold rate of inflation is found at 6% and coefficient of output gap is found positive only in high inflationary regime while the coefficients of inflation rate and exchange rate are significant only in low inflationary regime. Monetary authority responds to currency depreciation more strongly when interest rate is low compared to that when it is high. Moreover, the response of interest rate to output gap is significant only if currency depreciation is below threshold (estimated at 0.68) while response to exchange rate is significant only if there is high speed of depreciation (above threshold). The results are robust to inclusion of fiscal deficit in the Taylor rule.

In Pakistan, fiscal deficit negatively affects interest rate which is because of the borrowing of government from State Bank of Pakistan (SBP) for budgetary support. In a modified version of the Taylor rule, interest rate is found to negatively respond to changes in growth rate of real GDP. Growth rate of monetary base negatively depends on the difference between nominal GDP growth rate and its average value indicating countercyclical response at the part of monetary authority. Moreover, growth rate of money exhibits strong inertia and is negatively related to currency depreciation. The coefficients in the McCallum rule too are not stable during the sample period. The coefficients of growth rate of nominal GDP and exchange rate are not stable over time, while the parameter capturing inertia is stable over the sample period.

The response of monetary growth rate to nominal GDP growth rate and to exchange rate are significant only when nominal GDP is above its threshold value and/or when currency depreciates at higher rate.

Keywords: Nonlinear Taylor Rule, McCallum Rule, Threshold Inflation Rate, State Bank of Pakistan

1. INTRODUCTION

   The prime objective of monetary policy is to stabilize some aggregate measure of prices along with stabilizing real economic activity and financial sector. Optimal monetary policy rules can help to achieve these objectives. The term optimal monetary policy is used in the conventional meaning of successfully stabilizing inflation around a low average level and with some concern for real stabilization in terms of stable economic activity.

   In formulating monetary policy rule an important issue is the choice of appropriate variables to target. The vector of choice variables may include measures of real activity, prices, and relative price of the currency. The output gap may be taken as a measure of real activity but at the same time real GDP growth rate is an alternative choice. It should be noted however that maintaining a high growth rate in the long run is not possible through continuous lose monetary policy. For the prime objective of price stability, different aggregate measures of prices like CPI, WPI, GDP deflator, and weighted average of prices of commodities in core basket, can be a target. However, the most of the central banks in the world use inflation rate, rather than the price level, as a policy target. Similarly, for relative price of a currency, nominal spot exchange rate, nominal effective exchange rate or real effective exchange rate can be used.

   Furthermore, the choice of variables to be included in the rule also depends on whether or not the policy maker is forward-looking. In case of forward-looking policy, only future forecasts of the target variables appear on right hand side of the rule. But with backward-looking behavior, only lagged values are included.

   Another issue in this regard is functional form of the reaction function. In one setting, just like Taylor (1993), monetary policy instrument can be formulated as linear function of the target variables. But at the same time this would be inappropriate if there are regime shifts in the history of monetary policy, (see for instance Leeper 2005)1. The choice of monetary policy instrument is yet another issue to be addressed. Besides the academic discussion regarding price level indeterminacy in New Classical literature, most of the countries in the world are now using short term interest rate as operational target2.

   For the case of Pakistan, there is good number of studies available on money-inflation relationship but the number is limited in case of rule based monetary policy. Qayyum (2006) identifies significant role of money in explaining inflation variability. Chaudhary and Choudhary (2006) find that inflation is imported rather than monetary phenomenon. Khan and Schimmelpfennig (2006) find inflation as monetary phenomenon in the long run but government support prices play significant role in the short run. Omer and Saqib (2009) conclude that Quantity Theory of Money does not hold in Pakistan as velocity is not constant. Agha et al (2005) find that interest rate channel along with credit channel and asset price channel are active in Pakistan, while Khan and Qayyum (2007) find that exchange rate channel and supply side shocks, compared to demand side shocks, play more important role.

   For the rule based policy, to our knowledge, there are only two studies that, based on simulation analysis, suggest adoption of rule, (for details see Malik and Ahmad 2010, and Tariq 2010)3. However, both the studies take interest rate as monetary policy instrument and assume backward looking behavior of monetary policy. Moreover, the output gap and the inflation rate are taken as target variables. Malik (2007) identifies, however, five objectives - output stabilization, price stability, exchange rate management, interest rate smoothing, and minimizing trade deficit - of monetary policy in Pakistan. However, it is only positive analysis and normative analysis needs further investigation.

   In Pakistan the Taylor rule has been estimated by Malik and Ahmed (2010) and Tariq (2010) but a reaction function with monetary base as policy instrument, like the McCallum rule, has not been estimated. Moreover, both the studies do not deal with the issue of policy consistency despite the fact that policy reversal has been observed most of the times in the history of Pakistan. Another area where empirical literature, with regards to Pakistan economy, lacks is the nonlinearity of rules. There is only one study, Ahmed and Malik (2011) that highlight nonlinear aspect of monetary policy reaction function of Pakistan. However, even that study does not investigate the optimality of nonlinear Taylor rule. The underlying study contributes to the empirical literature of Pakistan by filling this literature gap and setting objectives accordingly.

   In this context, the objective of the study is regarding positive analysis of monetary policy in Pakistan. More specifically, the objective is to estimate monetary policy reaction function with regard to Pakistan’s economy. Keeping in view the existing literature with reference to Pakistan’s economy, the focus is more on nonlinear specification along with focusing on different target variables and policy instruments. More specifically, we considered alternative measures of target variables, like the output gap, the GDP growth rate, the inflation rate, the lagged interest rate, and the exchange rate. This has been done for both monetary policy instruments - interest rate and monetary base - and two types of functional forms - linear and non-linear. Policy consistency, through parameters stability in the reaction function, is also investigated.

   For achieving these objectives, we have estimated various types of monetary policy reaction functions for Pakistan by using quarterly data over the period 1993Q3 to 2012 Q2. For policy consistency, recursive estimates of the parameters in the reaction function are found.

   The study finds that State Bank of Pakistan has not been following the Taylor rule and Taylor principle is not satisfied. There is strong inertia found in the monetary policy instrument and exchange rate significantly explains changes in interest rate. Policy, throughout the sample period, has not been consistent as parameters in the policy...