The response of macroeconomic aggregates to monetary policy shocks in Pakistan

Purpose – This paper aims to empirically examine how shocks to monetary policy measures (the short-term nominal interest rate and broad money supply) affect macroeconomic aggregates, namely, output growth of the economy, national price levels and the nominal exchange rate. Design/methodology/approach – Johansen’s (1995) cointegration technique and error correction models are used to explore the long-run relationship among variables. To investigate how macroeconomic aggregates respond to a one-standard deviation shock to the underlying monetary measures, the authors estimate impulse response functions based on error correction models. The study uses quarterly data covering the period 1980-2009. Findings – The results provide evidence that there is a long-run stable relationship between the authors' monetary measures and the underlying macroeconomic aggregates. They also find that the industrial production adjusts at a faster speed relative to commodity prices and the exchange rate over the examined period. Further, they show that the short-term interest rate has relatively stronger effects on output as compared to broad money supply, whereas prices and exchange rates adjust more quickly to their long-run equilibrium when money supply is used as a measure of monetary policy. Finally, the authors find significant evidence of a price puzzle regardless of whether they consider a closed or an open economy case. However, an initial appreciation of exchange rate is observed in response to a one-standard deviation shock to money supply, indicating the overshooting hypothesis phenomenon. Practical implications – The findings of the analysis suggest that the interest rate-oriented monetary policy is more effective when the monetary authorities’ objective is to enhance the output growth of the economy. However, in case of inflation targeting, the broad money supply seems a more appropriate instrument. Our findings also suggest that the monetary policy has a significant role in stabilizing both real and nominal sectors of the economy. Originality/value – The main value of this paper is to examine the significance of monetary policy for a developing and relatively small open economy, namely, Pakistan. The authors use the error correction model, which improves the estimation by accounting for the long-run association. They also take into account the world oil prices by including the world commodity price index as a control variable in their empirical investigation. Finally, they utilize quarterly data rather than annual, and they cover a relatively recent sample period.