The Economics of Inflation, Issues in the Design of Monetary Policy Rule, and Monetary Policy Reaction Function in Pakistan

The objective of this study is to estimate a monetary policy reaction function for Pakistan. To do this, we use data for the period 1992Q4–2010Q2. Our results show that the State Bank of Pakistan reacts to changes in the inflation rate and economic activity in a manner that is consistent with the Taylor (1993) rule, and with the explicit objective of interest rate smoothing and exchange rate management. This policy has remained consistent for most of the sample period, except for the last two years, during which a price hike and the massive depreciation of domestic currency led to a significant change in the parameters of the policy reaction function. We also find evidence of nonlinearity in the reaction function as the response to an inflation rate above 6.4 percent is found to be more aggressive than that in low inflationary episodes.