The Pros and Cons of a Discretionary Moetary Policy Strategy : An Empirical Assessment

This paper empirically assesses the pros and cons that emanates when the discretionary monetary policy maker aims to achieve the dual objectives of inflation and output. In order to facilitate theoretically plausible empirical analysis a typical case of a discretionary monetary policy s of a developing economy of Pakistan is considered. A two-step strategy is adopted to generate three novel behavioural time series indicators namely discretion indicator (DI), inflation objective indicator (IOI) and output objective indicator (OOI) using Hodrick and Prescott filter. These indicators tend to capture the discretionary behaviour of the monetary policy maker and the potential resultant corresponding behaviours in inflation and output over time respectively. ARDL bounds testing and estimation approach is used to obtain stable long and short run estimates from these behavioural indicators. The results indicate that discretion is biased towards the inflation objective in the long run. It slightly helps achieve the output objective only in the short run but its channel is not the conventional inflation-output trade-off (due to its negative relationship) rather it might accrue via the close link of money supply with the credit. The indicative welfare gains from discretion are nominal and accrue only in the short term as against disproportionately higher indicative welfare losses, which incurs in the long run