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Monetary Policy: Inflation In Pakistan

The economies of all countries whether under developed, developing or developed are all suffering from recession these days. Persistent rise in prices or inflation is a major concern and problem in today’s world. It is merely due to various reasons i.e. first, the inflation rates are pretty high as compared to the experienced earlier periods. Secondly, in these years high rate of unemployment coexists with inflation, which is a newly faced phenomenon and has made it difficult to control inflation in this era of global recession.

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Developing countries may face difficulties in establishing an effective and operative monetary policy. The primary difficulty faced is that a few developing countries have deep markets in government debt. The matter is further complicated by the difficulties in forecasting fiscal pressure and money demand to levy the inflation tax by rapid expansion of the monetary base. The central banks have poor records in managing monetary policy in many developing countries. This often happens when the monetary authority is not independent of government in developing countries, thus good monetary policies are left behind in the political desires of the government or are used to quest for other non-monetary goals. For this and other reasons, a currency board or dollarization may be instituted by developing countries that want to develop a credible monetary policy. Such forms of monetary institutions restrict the government from interference and it is desired that such policies will import the monetary policy of the anchor nation.

Controlling inflation has been a top priority for policy makers all over the world since the 1970’s. It is a consensus amongst economists and policy makers that price stability is the prime objective of monetary policy despite of a long and unsettled theoretical debate. Thus, it is the responsibility of the central bank to maintain price stability and it is

accountable for not achieving price stability. State Bank of Pakistan (SBP) like other central banks of the world is also explicitly mandated to ensure price stability. It is well established that SBP is fully capable of implementing its own independent monetary policy that is consistent with the needs of the domestic economy and is able to foresee and achieve the inflation targets ahead.

The recent inflationary rise in Pakistan has once again triggered a debate on the causes and factors responsible for inflation, which is similar to the debates that took place duing the nineties (90’s). Policy makers are even divided on the issues of inflation. Some of the policy makers have contended that the current inflation has been caused by cost push factors such as oil price increases and wheat procurement price. Whereas, on the other side it is argued that accommodative monetary policy is responsible for the current heave in inflation. Further, it has been pointed out that monetary overhand is a cause of inflation. It is not surprising that the policy making authorities are indicating those factors that are beyond their control as the cause of inflation and commentators are targeting SBP for its inability to control money supply growth and policy failure. The main objective of this study is to assess the effectiveness of monetary policy in controlling inflation in Pakistan.

The core objective of the thesis is to investigate whether the currently adopted monetary policy has been effective in controlling the inflation rate.


Inflation is termed as a rise in prices that causes a nation’s purchasing power to fall. As long as the annual percentage of inflation remains low, it is a normal economic development; once the percentage rises over a pre-determined level, then its considered as an inflation crisis.


There can be various causes for inflation, depending on a number of factors or variables. For e.g. inflation takes place when government prints money in excess to deal with crisis; as a result of which prices end up rising at high rates to keep up with the currency surplus. This phenomenon is termed as demand-pull, in which prices are forced upwards due to high demand.

The rise in production costs is another cause of inflation, which leads to an increase in the final price of products. For e.g. if the price of raw materials increase, this may lead to increasing the production cost; thus in turn leading the company to increase the product prices to maintain steady profits. Rise in labor costs can also lead to inflation. As workers demand increase in wages, the companies choose to pass on those costs to their consumers/customers.

Inflation is also caused by national debts and international lending. As nations borrow money, they have to pay interest, which in turn causes prices to rise as a way of keeping with their debts. A major drop in the exchange rate can also result in inflation as the government may have to deal with the differences in the level of import/export.

Finally, federal taxes on consumers such cigarettes or fuel can also cause inflation. As the taxes rise, the same burden is passed over to consumers by the supplier; the catch however is that once the prices increase, they rarely go back even if the tax rates are reduced at later stages. Wars are also often the cause for inflation since the government must both recoup the spent money and repay the borrowing from the central bank. War often affects everything from labor costs to product demand to international trading, so in the end producing a rise in prices.


Monetary policy is termed as the regulation of interest rate and the availability of money to maintain steady growth and prevent hard market crashes.

An institution in charge of the monetary policy usually does it in two ways. One of the ways is by buying back securities from banks. This increases the reserves of the central bank, thus stimulating them to lend money to other institutions. The second way is to set interest rates at a certain level, which can also affect the economy.

Monetary policy initially takes in account the performance of the economy. In difficult times, when the economy is sluggish, a lowering in interest rates may be needed to perk up borrowing. As borrowing increases, the economic activity associated with the borrowing may also increase, which in turn may create jobs and provide money to others. In case if the economy is going well, the Federal Reserve or other governing bodies may become concerned that there is ample growth, which could lead the economy up for a hard crash. In order to avoid any such incidents, the interest rates are increased to gently cool off the economy.

However, any institution or governing body that monitors and controls the monetary policy needs to be aware that interest rates are correlated with inflation to a great degree. As the interest rates are lowered, money becomes cheaper for borrowing and is passed around more. This devaluates the currency rate by leading to an oversupply thus causing inflation to rise. If interest rates are increased, then inflation may decrease since there may be less money flowing through the system; thus making it more valuable.


Monetary base:

Monetary policy can be implemented by varying the size of the monetary base. By doing so, it directly changes the amount of money circulation within the economy. In order to change the monetary base, the central bank can use open market operations. In exchange of hard money, the central bank may sell/buy bonds. Upon collection/disbursement of the currency payment, the amount of currency is altered in the economy as a result altering the monetary base.

Reserve Requirements:

Implementation of the monetary policy can be ensured by changing the proportion of total assets held by banks in reserve with the central bank. The banks only maintain a small portion of their assets in liquid form for attending immediate cash withdrawal needs; the rest is invested in illiquid assets such as loans and mortgages. By changing the proportion for the total assets to be held for immediate cash, the Federal Reserve changes the availability percentage of the loanable funds. This acts as a change in the money supply. The central banks/regulatory authorities do not often alter the reserve requirements since it gives birth to the lending multiplier and creates very volatile changes in the money supply.

Discount Window lending:

The opportunity provided to commercial banks and other depository institutions to borrow reserves from the Central bank at a discount rate is termed as discount window lending. This rate is usually set below the short term (T-bill) market rate. It enables the banks to vary the credit conditions thereby affecting the monetary policy (i.e. the amount of money they have to loan out). It is pertinent to note that the central banks do not have

total control over Discount window, and it’s the only instrument this is not fully controlled by the regulatory authorities.

Interest rates:

The money supply contraction can be achieved by increasing the nominal interest rates indirectly. In different countries, different level of control of economy wide interest rates is observed by monetary authorities. In case of various nations, the monetary authority is able to authorize specific interest rates on saving accounts, loans and other financial assets. Rise in interest rates by the monetary authority can result in contracting the money supply since higher interest rates encourage discourage borrowing and encourage saving. The size of the money supply is reduced by both of these effects.

Currency board:

A monetary arrangement that connects the monetary base one country to the other, the anchor nation is termed as a currency board. There are three principal rationales behind a currency board:

To maintain a fixed rate of exchange with the anchor nation

To import monetary credibility of the anchor nation

Establishing credibility with the exchange rate (it is hardest form of fixed rate of exchange outside of dollarization.

Unconventional monetary policy at Zero bound:

Unconventional monetary policy is termed as other form of monetary policy used when interest rates are near or at 0% and there are concerns about occurrence of deflation. These include signaling, quantitative easing and credit easing. The central bank purchases private sector assets, in order to improve liquidity and improve access to credit in case of credit easing. For lowering market expectations for future interest rate, signaling can be used. For e.g. an indication was provided by the US Federal Reserve that rates would be

low for an extended period during the credit crisis of 2008.


A process through which the level of economic activity and inflation is affected by monetary policy decisions in the economy is termed as monetary transmission mechanism. Policy variables are affected with considerable lag and high degree of variability and uncertainty due to monetary policy actions, thus it is important to ascertain the impact and extent of monetary policy actions on the real variables. It is critical to ascertain which channels are more effective for transmitting changes in monetary policy actions in order to achieve policy goals.

Financial sector developments regarding introduction of new financial products, technological changes, future policy expectations, institutional strengthening can ultimately change effects of the monetary policy measures. There’s a need to update, test and reinterpret transmission channels on a regular basis. Five basic channels of monetary policy are perceived to transmit the impact into the real economic activity.

The first channel relies on the linkage between the short term nominal interest rate changes (i.e. by changes in policy rate) and the long term real interest that may affect the aggregate demand components such as investment and consumption within an economy. The changes in the long term real interest rates have an impact on business investment, aggregate consumption and other components of aggregate demand(AD).

Secondly, changes in monetary policy that not only affects the net worth of firms to borrow (i.e. by affecting the ability to borrow) but also the lending ability of banks. The degree of allowance of the central bank to extend to which banks can extend their loans and dependence of the borrowers on the bank loans is the core strength of this channel. The aforementioned are clearly influenced by the regulations and the structure of the financial system.

The third channel focuses on asset prices (i.e. other than rate of interest) such as real estate prices and market value of securities (equity and bonds).The price of bonds and stocks can be affected by policy induced changes in nominal interest rates, that may change the market value of firms relative to the replacement cost of capital thus affecting overall investment. Moreover, household consumption can be affected due to change in wealth as a result of change in price of securities.

The exchange rate that in turn affects the net exports, foreign financial flows and thus aggregate demand are affected by policy induced changes in the domestic interest rate. The exchange rate channel strength is based on responsiveness of the exchange rate to monetary shocks, sensitivity of private inflows, net worth of firms, the degree of openness of economy and net worth of firms and their capacity of borrowing if they have taken any exposure in foreign currency. Moreover, changes in exchange rates lead to domestic price changes in consumption of imported goods and imported production inputs directly affecting inflation.

The fifth channel is based on the economic agent’s expectation of the prospects of economy in the future and stance of the monetary policy. As per the “expectation channel”, economic variables are mostly determined in a foreseeing manner and are impacted by the expected monetary (i.e. monetary policy) actions. Therefore, a credible, transparent and consistent monetary policy can potentially affect the economy path by affecting expectations.


MONETARY POLICY DECISION (as of 29th September 2010 by SBP) *Source http://www.sbp.org.pk/m_policy/MPD-Sep-2010-(English).pdf

The recent catastrophic floods have serious implications for macroeconomic stability and growth prospects. However, even before the floods, the macroeconomic conditions and outlook were looking fragile. By the close of FY10, inflation was high and the fiscal

deficit had risen to 6.3 percent of GDP. Early assessments indicated that these pressures were unlikely to abate in FY11. Post-flood projections raise legitimate concerns about the worsening of the macroeconomic balances since the initiatives required addressing the underlying cause for the primary stimulus to aggregate demand, coming from the fiscal side, having yet to be launched with vigour and coherence. They show that inflation will increase further accompanied by a drop in economic growth, both the trade balance and fiscal accounts will be under stress, and the banking system may witness pressure on account of rise in NPLs of the private sector and borrowings of the government, unless a comprehensive and coordinated response is developed to meet these challenges.

The clarity on the nature and scale of such a package would depend on the complete assessment of losses to the economy expected to be completed in October 2010. Nevertheless, the components of the economic strategy that would need to continue to be in focus despite uncertainty would include implementation of tax reforms to enhance much needed revenues, resolution of the energy sector subsidies and circular debt to restore economic growth, relief measures for those affected by the floods, and containment of government borrowing from SBP to restrict inflation. Committed and credible progress on these fronts will be critical for reviving confidence and stability and stimulating economic growth, otherwise the burden of any adjustment will continue to fall on the engine of growth, the private sector.

Given the scale of the devastation caused by the recent calamity, it is difficult to fully and accurately determine the extent of damage to the economy. Losses in agriculture and infrastructure are more direct and visible while the impact on industry and opportunities for the work force is going to be indirect and nuanced. Highly provisional estimates suggest that economic growth for FY11 could come down to 2.5 percent from an earlier target of 4.5 percent. While aggregate private consumption may decelerate as a result those of the government will most likely increase to meet the urgent needs of the flood victims and their rehabilitation, leading to a sharper deterioration of the fiscal accounts.

The disruption in the supply chain of food items caused the month-on-month (MoM) food inflation to jump to 5.1 percent in August 2010, pushing the MoM CPI inflation to 2.5 percent. In SBP’s assessment this temporary spike in prices is largely due to floods as

it is over and above the average MoM growth in food inflation (1.6 percent) and CPI inflation (1.1 percent) during Ramazan in the previous five years. It may take two to three months for food inflation to return to normal levels. Slowdown in private demand later in the year will at best have a moderating effect on CPI inflation as it is likely to be neutralized by an expected increase in government spending in general and on reconstruction in the flood affected areas in particular. It is estimated that average CPI inflation for FY11 may fall between 13.5 and 14.5 percent. Further, likely increases in electricity prices, induction of the Reformed GST and continued reliance of the government on borrowings from the SBP only add to the uncertainty surrounding inflation expectations.

In the aftermath of the floods, bringing inflation down to single digits would require a supportive and sustained financial and fiscal effort over the next couple of years. Better management of financial resources including more transparency and timely availability of fiscal figures, broadening of the tax base, controlling discretionary current expenditures and re-prioritizing development expenditures would be imperative for fiscal consolidation. These steps would remove any ambiguity arising from the pre-flood budget for FY11, which initially announced a deficit of 4 percent that shot up to 5.2 percent of GDP after the combined provincial budgets were unveiled. How the fiscal policy response to the floods is incorporated in the revised budget remains to be seen, but it is clear that even attaining the deficit of 5.2 percent of GDP will require considerable adjustment in the key fiscal parameters. The year-on-year growth of 7.5 percent in the Federal Board of Revenue’s (FBR) tax revenues during the first two months of FY11 compared to the budget target of 25.6 percent for the full year does not instil much confidence.

To finance the budget deficit the government has increased its reliance on the SBP; it borrowed Rs220 billion during 1st July – 24th September, FY11 according to provisional figures compared to Rs126 billion during the corresponding period of last year. This is against the spirit of macroeconomic stabilization, since the elimination of government borrowing from the SBP was one of the Main commitments of such a program. Moreover, given the heavy borrowings from the scheduled banks over the last couple of years through short term Treasury Bills (T-bills) there is a significant ‘rollover risk’ during FY11. Fresh borrowings from the banking system during FY11 will increase these borrowings even further, especially if the spending requirements increase and there is no commensurate increase in tax revenues.

This entails substantial risks to economic stability in the immediate future and places a considerable pressure in the medium term on the already high debt burden of the country. Rising NPLs and relatively low private sector credit demand may incentivize the already risk shy banks to meet government’s borrowing requirements at the cost of private investment in the economy. This could make the task of reviving economic growth and bringing inflation down to single digit level much more difficult.

The dependence on foreign borrowings has also increased due to continuous decline in domestic national savings and private foreign investments in the country. The substantial narrowing of the external current account deficit in FY10 provided some breathing space. After registering a reduction of 2.3 percent in FY10, imports seem all set to grow significantly, especially after the floods, and may post a double digit growth in FY11. Although the growth in exports was also projected to increase in FY11, the recent floods and the resulting disruption in productive activity could act as a dampener if the damage to the cotton crop turns out to be extensive. Thus, the expected increase in the external current account deficit and uncertain foreign inflows could put pressure on SBP’s foreign exchange reserves and exchange rate in FY11.

In these circumstances, most of the expansion in broad money in FY11 is expected to be driven by a considerable growth in the Net Domestic Assets (NDA) of the banking system accompanied by a possible decline in the Net Foreign Assets (NFA), which does not bode well for the inflation outlook. Thus, there may be possible liquidity pressures in the market. The SBP stands ready to manage the system wide liquidity and maintain the short term interest rates consistent with its monetary policy stance. However, more is expected from the fiscal authority to articulate and implement a coherent strategy and the market continues to look to government for greater fiscal discipline to allay expectations of rising inflation. The key features of this strategy, as already mentioned above, will have to include broadening of the tax base, adhering to the principles of the Fiscal Responsibility and Debt Limitation Act (2005) in letter and spirit and restriction of government borrowing from the SBP. Failure to do so will only increase the economy’s reliance on foreign borrowings with its own complications and risks.

The next quarter will be crucial in forming an assessment of the effectiveness of government efforts to contain the fiscal deficit and its inflationary borrowings from the SBP and the banking system. On its part, the SBP is raising its policy rate by 50 basis points to 13.5 percent with effect from 30th September 2010. The monetary policy stance is formed by the consideration that the impact of continued inflation is substantial and felt by the entire economy. A tightening of the stance is thus called for in full recognition that the difficulty to contain fiscal deficit has resulted in the private sector bearing the full brunt of such an adjustment.


This research is based on “Effectiveness of monetary policy in controlling inflation in Pakistan”

This research is an effort to determine:

The need to control Inflation.

Has Monetary Policy been implemented in a prudent manner.

Have effective measures been developed and implemented to regulate Inflation.


This study provides a bird’s eye view to understand the whole scenario in which the recent high inflation rates may have an adverse affect on the overall growth, the financial sector development and the vulnerable poor segment of the population.

This report is most significant for the students of finance and economics since it defines how effectively monetary policy is controlling inflation rates in Pakistan.

This research is also helpful for the SBP and regulatory authority as I hope to identify whether the current Monetary Policy is being implemented correctly. In general context this research is also helpful for the student of Bahria University and all entities interested in increasing their knowledge on mechanism of Monetary Policy and Inflation Rates.


The data covers the period 1994-2009 on yearly basis. In this research, the analysis is based on five years of Pakistan during which the country has undergone a series of economic and political changes. In particular, there have been significant improvements in the monetary sector.


Results will be calculated on certain assumptions which may change in future. These changes may have adverse or positive impact. If any changes occurred after completing this report the results will not be feasible but may remain as a guideline to analyze the past trends. Biased information from the respondents of the study might affect the research work.


Consumer Price Index: (CPI) measures changes through time in the price level of consumer goods and services purchased by households.

Wholesale Price Index: (WPI) measures and tracks the changes in price of goods in the stages before the retail level. It reports monthly to show the average price changes of goods sold in bulk, and they are a group of the indicators that follow growth in the economy.

Net Domestic Assets: (NDA) cover dues of private persons and business entities, the public sector net borrowing and the balance of other items (net). In accounting terms, it is a difference between the total money supply and the size of net foreign assets.

Net Foreign Assets: (NFA) is the value of the assets that country owns abroad, minus the value of the domestic assets owned by foreigners. The NFA position of a country reflects the indebtedness of that country.

Open Market Operation: is the means of implementing monetary policy by which a central bank controls the short term interest rate and the supply of base money in an economy, and thus indirectly the total money supply.

Nominal Interest Rate: In finance and economics, it refers to the rate of interest before adjustment for inflation

Cost Push Inflation: is a type of inflation caused by substantial increases in the cost of important goods or services where no suitable alternative is available.



The research study undertaken is descriptive research. Within Descriptive research it can be further segmented into a research survey because the problem statement attempts to analyze interpret and report the present status of inflation. It deals with the cross-section of past and present data so that future assessments can be made.


The nature of this study is exploratory, because detailed information will be gathered regarding effectiveness of monetary policy in controlling inflation rates in Pakistan.


Study setting for this report is non-contrived, because the research is conducted in natural environment so, nothing is being manipulated for the purpose of this study.


Time horizon for this project report consists of 6 months of the final year of MBA. In this project the data is collected just once to answer the research question that’s why it’s a cross-sectional study.


The respondents to this study would mainly be SBP (State Bank of Pakistan) since it’s the regulatory authority for monitoring and implementation of Monetary policy for effectively controlling inflation in Pakistan.


Research will be based on two types of data collection methods, which are:

Primary data -The primary data of the project is collected from unstructured interviews

Secondary data -The secondary data was collected from the published materials and related web sites pages and websites.

But this study is based on secondary data and the data is gathered from many sources that include:





Data obtained from the secondary sources is carefully organized and critically analyzed in quantitative as well as qualitative manner. Numerical data is analyzed and interpreted in required manner and by applying statistical tool (Correlation Formula).


Data will be analyzed in the forms of quantitative framework as well as qualitative forms. No. of facts, figures and trend are presented in the form of:




In this study the hypothesis that will be tested is:


“Monetary policy is effective in controlling inflation in Pakistan”


“Monetary policy is not effective in controlling inflation in Pakistan”


Money supply/Monetary policy is considered as independent variable.

Inflation is considered as dependent variable.





Historical Money Supply Growth Rate and Inflationary Trend


Money Supply Growth Rate

Inflation Rate














































*Money Supply Growth Rate– http://finance.gov.pk/survey/chapter_10/05_Monetary.pdf

*Inflation Rate– http://finance.gov.pk/survey/chapter_10/06_Inflation.pdf



The correlation between two securities is a statistical measure of the relationship between the price movements of the two securities. This relationship, which is expressed by what is known as the correlation coefficient, is represented by a value within the range of -1.00 to +1.00.

R= N∑xy – (∑x) (∑y)

[N∑x2 – (∑x) 2 ][N∑y2 – (∑y) 2]


N = Number of values or elements

X = First Score

Y = Second Score

ΣXY = Sum of the product of first and Second Scores

ΣX = Sum of First Scores

ΣY = Sum of Second Scores

ΣX2 = Sum of square First Scores

ΣY2 = Sum of square Second Scores



Money Supply Growth Rate (x)

Inflation Rate (y)















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