This document summarizes a study examining the impact of monetary policy on economic growth in Pakistan from 1991 to 2011. It finds that inflation rate, exchange rate, and external reserves are significant monetary policy instruments that influence growth. It recommends establishing primary and secondary government bond markets to increase monetary policy efficiency and reduce reliance on the central bank. The document provides context on monetary policy objectives in Pakistan and reviews literature on the relationship between monetary policy and economic growth.

1. THE IMPACT OF CHANGES IN MONETARY POLICY BY
SBP AFTER 2010
PREPARED BY
Khizer Qasim
Hamza Nazim
SUPERVISED BY
SIR KHALID

2. ABSTRACT
This study examines the impact of monetary policy on economic growth in Pakistan. The
study uses time-series data covering the range of 1991 to 2011.The effects of stochastic
shocks of each of the endogenous variables are explored using Error Correction Model
(ECM). The study shows that Long run relationship exists among the variables. Also, the
core finding of this study shows that inflation rate, exchange rate and external reserve are
significant monetary policy instruments that drive growth in Pakistan. It is therefore
recommended that the establishment of primary and secondary government bond markets that
can also increase the efficiency of monetary policy and reduce the government’s need to rely
on the central bank for direct financing.
Keywords: Policy instruments, Economic Growth, GDP, Money supply, monetary policy
INTRODUCTION
The aim of this study is to examine the impact of monetary policy on economic growth.
Economic growth is an important macroeconomic objective for any country. Monetary policy
has direct relation with economic growth. Folawewo and Osinubi (2006) stated monetary
policy as the arrangements which are planned to control supply of money in a country. In
many countries the basic aims of the monetary policy are to stabilize prices, keep the balance
of payment equal, promote the employment and increase in economic development.
Since the foundation of State Bank of Pakistan (SBP) in 1948 it has playing its role to
stabilize economic growth through monetary policy. The main purpose of monetary policy in
Pakistan as described in the State Bank of Pakistan Act 1956 is to attain steady growth and
control on inflation. In search of this mandate SBP determine the monetary policy which is
most desirable for attaining stated objectives. From many years Pakistan has been controlling
the economy through variation in the stock of money. Whereas evaluating the impact of
Structural Adjustment Programme (SAP) resulted that minimizing stock of money by
increasing interest rates would reduce Gross National Product (Laidler), 1993).
Cassola and Morana (2004) described that the interest rate increase when there is tight
monetary policy which leads to reducing inflation and the easing of monetary policy enhance
the level of economic activities. There is a long run relationship between interest rate and
economic growth. Thus in Pakistan interest rate is a valuable determinant of economic
growth.
The main purpose of this study is to assess the effectiveness of the SBP’s monetary policy
over the years. This would go a long way in evaluating the impact of monetary policies on
growth process of Pakistan using the main objectives of monetary policy as yardstick
(Ahmad et al, 2005). The remaining portion of this paper is organized as follows. In section
two, literature review is presented. Section three consists of methodological framework while
section four contains empirical results. Finally section five concludes the paper.

3. OBJECTIVESOF MONETARYPOLICY
In any country monetary policy is used as an instrument through which the government
achieves the goals and objectives for economic growth and stability. In Pakistan monetary
policy is the role of State Bank of Pakistan. Money supply (M2=currency + demand deposits
+ time deposits) is an important target variable of monetary policy in Pakistan. The target
growth rate of money supply is set through estimated money demand (Qayyum, 2002).
From recent some years Monetary Policy of Pakistan has dual objectives which are stability
in prices and boosting economic growth. SBP mainly used monetary policy variables to attain
desired goals. To control the supply of money and inflation SBP may use contractionary or
expansionary policy. Job creation (full employment) and eradication of poverty are also
crucial objectives of monetary policy (Shamshad, 2006).
MONETARY POLICY MANAGEMENT IN PAKISTAN OVER THE
YEARS
State Bank of Pakistan has altered its administrative monetary policy towards a liberal and
market oriented policy management. The inflation rate of Pakistan for 2009 was expected to
be 20% which was 40% higher than the last year 12%. On the other side growth rate of GDP
for 2010 was estimated to be 4%. The monetary policy has to change to guide economy for
the future (Asma, 2009).
SBP has designed contractionary policy to limit the inflation, increase in money and credit in
economy. At present, most of the countries have adopted contractionary policy to control
inflation. On the other side Expansionary monetary policy is used to increase the credit and
broaden the monetary base by reducing the interest rate (State Bank of Pakistan, 2004).
Money supply instrument is used by SBP to obtain the main objective of monetary policy i.e.
price stability and economic growth. Moreover in order to hold inflation within the expected
level State Bank of Pakistan used money supply instrument. The statistics shows that growth
in money supply has gone above its targeted level from 2002 to 2005 due to Expansionary
monetary policy (State Bank of Pakistan, 2006).
GROWTHAND MONETARYPHENOMENON
Before 2005, monetary policy was mainly supporting the economic growth due to low
inflation level but from 2005 the inflation is going to rise. The monetary policy after 2005
concentrated on limiting the inflation rate (State Bank of Pakistan, 2006).
High rate of inflation not only influence economic performance but it also adversely affect
the real economic growth. There is relationship between inflation and economic growth.
According to Smyth (1992) 0.1% increase in inflation in USA it reduced the annual growth
by 0.223%. If the rate of inflation is high then it has significant negative effect on economic
growth but at low rate of inflation the relationship is negative but not significant. Inflation not
only influences economic growth negatively but it also increases economic uncertainty in the

4. economy. Due to the harmful impacts of inflation most of the world’s Central Banks have
considered to stabilize the prices and make it the basic function of monetary policy (Blejer,
2000).
LITERATURE REVIEW
Many studies have been presented on this matter of monetary policy and influence on
economic growth. This issue has been discussing globally. I have critically reviewed some of
these studies to enlarge objectives in the framework of Pakistan and moreover to analyze it to
draw conclusions.
As indicated by Monetary Theory, Monetary policy influences the supply of money and
interest rate in such a way to fulfill the goals of the manifestation of the ruling party (Shoaib
k, 2010).
For developing economies, the empirical literature shows that monetary policy shocks have
many modest impacts on economic parameters. Ganev et al. (2002) stated the effects of
monetary shocks in ten central Eastern European countries. This study finds no evidence that
explains when interest rate changes it affect output but find many sign that exchange rate
change influence output. in the same context Starr (2005) by using a SVAR model finds little
evidence of monetary policy in five Commonwealth of Independent States (CIS) with the
exemption that interest rate have notable effect in Russia.
Rafiq and Mallick (2008) finds in developed countries like United States and some other
European countries there is evidence of the usefulness of monetary policy on real economic
parameters, on the other hand in developing economies like Pakistan the indication is weak
and full of “puzzles”. Moreover Balogun (2007) used simultaneous equation models to test
hypothesis of monetary policy ineffectiveness in developing countries and find that instead of
promote growth; erstwhile domestic monetary policy was the source of stagnation and
constant inflation.
Chaudhry et al (2012) analyze that there is long-run and short run relationship of monetary
policy and economic growth in Pakistan by using co-integration and causality analyses during
the period of 1972-2010. The findings shows that credit to private sector the variable of
financial depth, real exchange rate are found significantly influencing GDP in Pakistan. The
analyses of monetary policy in Pakistan show that actual growth remained higher than target
rate of money growth set by the SBP. Moreover money expansion has an inflationary impact
on the economy of Pakistan.
Abhay Gupta (2008) has found the presence and importance of bank lending channel of the
monetary policy transmission in India and Pakistan using the structural Vector Auto
Regression (SVAR) approach. The findings of econometric analyses support the presence of
significant bank lending channel in these countries. Changes in the monetary policy
instruments affect the credit variable (private sector claims) which in turn transmits the
shocks to the real side of the economy, i.e. output and prices. Compared to the bank lending
in other developing countries the channel in these countries is different and more vital.

5. Another finding is that apart from interest rates, money also seems to play an important role
in these economies and its shocks are significantly transmitted to the real macroeconomic
activities through changes in the credit variable.
Meenai (2001) has given a historical record of growth and development of banking in
Pakistan, a record of important events in monetary management and a review of monetary
policies pursued in the country from 1947 till 2000. The author has strongly recommended
that Pakistan should discard market based monetary policy and that the central bank should
play the primary role for promoting development. He has further recommended that Pakistan
should de-link from the international financial system by repudiating its foreign and domestic
debt. Most of the recommendations of the author can be termed as ‘wishful thinking’.
Tradable economic activities are "special" in developing countries. These activities suffer
disproportionately from the institutional and market failures that keep countries poor.
Sustained real exchange rate depreciations increase the relative profitability of investing in
tradable, and act in second-best fashion to improve the economic cost of these deformation.
That is why episodes of undervaluation are strongly linked with higher economic growth.
There exist a unique long-run relationship between interest rates and economic growth. Thus,
interest rate is an important determinant of economic growth in Nigeria. However, the
deregulation of interest rates in Nigeria may not optimally achieve its goals, if those other
factors which negatively effects investment in the country, as suggested by Guseh and
Oritsejafor (2007), are not tackled.
A recent study by Chimobi and Uche (2010) examined the link between Money, Inflation and
Output in Nigeria. The study adopted co-integration and granger-causality test analysis. The
co-integrating result of the study showed that the variables used in the model exhibited no
long run relationship among each other. Nevertheless money supply was seen to granger
cause both output and inflation. The result of the study suggested that monetary stability can
contribute towards price stability in the Nigerian economy since the variation in price level is
mainly caused by money supply and concluded that inflation in Nigeria is to an extent a
monetary phenomenon. The Error Correction Mechanism and Co integration technique was
employed by Adefeso and Mobolaji (2010) estimate the relative effectiveness of fiscal and
monetary policy on economic growth in Nigeria using annual data from 1970-2007. The
empirical result showed that the effect of monetary policy is stronger than fiscal policy and
the exclusion of the degree of openness did not weak this conclusion.
Amassoma et al. (2011) examined the monetary policy variables and GDP. He conducted
study in Nigeria from 1986-2009. He found using Least Squared method that there is
significant relationship among monetary policy exchange rate and money supply. He found
that monetary policy had reasonable effect on money supply and exchange rate. He also
stated that there is insignificant relationship between monetary policy and instability of price.
Onyeiwu (2012) analyzed the impact of monetary policy in Nigeria. He used Ordinary Least
Squares Techniques to identify the impact by using the data from 1981-2008. His findings
show that there is positive impact of monetary policy variables on GDP. He also found that

6. there is negative impact of monetary policy on inflation rate. Moreover his study shows
significant impact of monetary policy on real economic growth.
Unlike the conventional trend prevalent all over the world regarding the focus,
implementation, monitoring and scrutiny of monetary policy from the very start of financial
establishment, the intensity in diverting the focus towards monetary policy management and
its reforms took a while to emerge on Pakistan’s economic screen. The review of literature
has shown that monetary policy has relation with economic growth in Pakistan.
METHODOLOGY AND DATA
In the developing countries economic growth is the most considerable problem. To determine
economic growth and its variable, there are many modals. The empirical modal is formulated
through the platform provided by Keynesian IS-LM function. Chasing McCallum (1991),
following equation is derived;
Y= 𝛽 𝟎 + 𝜷 𝟏M + 𝜷 𝟐RI + 𝜷 𝟑INF + 𝜷 𝟒RER + 𝜷 𝟓ER + e
Where;
To develop the well-built, vigorous and consistent models that highlight the connection
between the variables of monetary policy and economic growth, the econometric techniques
of the Error Correction Term are used as the estimation technique. The method of ECT is
mathematically much simple and easy to calculate than any other econometric technique so it
is largely used for regression analyses (Gujarati, 2003).
For the purpose of this study the data on stated variables has been collected from 1990-2011.
The major source of data collection is State Bank of Pakistan. Different other websites like
Ministry of Finance and Pakistan Statistical Bureau are also used for this study. Moreover the
World Development Indicators is also used for analyses of Monetary Policy and Economic
Growth.
Y Real Gross Domestic Product
M Money Supply
RI Rate of Interest
INF Inflation rate
RER Real Exchange Rate
ER External Reserve
e The Error Term

7. HYPOTHESIS
Hypothesis has an important role in research which explains the problem and used to resolves
the problem in research modal. The following hypothesis developed for research modal on
the basis of literature review.
H1= an increase interest rate has positive impact on out put
H2= Money supply has strongly positive impact on output
EMPIRICAL RESULTS
Table 1 shows the summary of statistics used in this study. It is shown in the table that GDP
has lowest mean value of 0.04 with 0.02 value of S.D while ER has the maximum mean value
of 6.99 with 5.91 of S.D. The averages of INF, IR, M2 and RER are 0.09, 0.13, 0.15 and 1.08
respectively.
Table 1 Summary of Statistics Used In Regression Analyses
GDP INF IR ER M2 RER
Mean 0.044627 0.091741 0.136364 6.997727 0.154059 1.084118
Maximum 0.0896 0.2003 0.2 17.7 0.293 1.2539
Minimum 0.0036 0.031 0.08 1.05 0.0431 0.9709
Std. Dev. 0.020915 0.042826 0.030945 5.916112 0.055302 0.094738
observations 22 22 22 22 22 22
Source: Authors’ Calculations Using E-Views software
The extent to which the relationship between two variables existing is called correlation.
There may be positive or negative correlation. The correlation results are presented in
table-2. The results are calculated using e-views software. The results show that M2 and RER
are positively correlated with GDP. While as INF, IR and ER are negatively correlated with
GDP.

8. Table 2 Results of correlation
GDP INF IR ER M2 RER
GDP 1.0000
INF -0.0509 1.0000
IR -0.2047 0.4082 1.0000
ER -0.0123 0.1010 -0.6472 1.0000
M2 0.3467 -0.0592 0.1002 -0.0104 1.0000
RER 0.0355 0.2336 0.6824 -0.7043 0.2501 1.0000
Source: Authors’ Calculations Using E-Views software
GDP is taken as dependent variable while as monetary policy variables are independent
variables. In this data the Least Squares method is used. Included observations are 22 and
the data is taken from 1990-2011.
Dependent Variable: GDP
Method: Least Squares
Date: 06/12/13 Time: 16:10
Sample (adjusted): 1990 2011
Variable Coefficient Std. Error t-Statistic Prob.
C 0.09004 0.0863 1.0433 0.3123
INF 0.15178 0.14292 1.06204 0.304
IR -0.4548 0.24882 -1.8277 0.0863
ERB -0.0018 0.00143 -1.2482 0.2299
M2 0.16567 0.08889 1.86376 0.0808
RER -0.0095 0.08101 -0.1179 0.9077
R-squared 0.27845
F-statistic 1.23493
Prob(F-statistic) 0.33844
From the estimation, we find that interest rate has negative and significant impact on output.
It is shown from the value –0.455 tight monetary policy in term of increase interest
rate has significant negative impact on output in this Ho is rejecting. Money supply has
positive impact on output its show from value 0.16 which is positive Ho is accepted. Inflation
and output is positively correlated which show from the value 0.152. Exchange rate also has
negative impact on output which is show from the value -0.009. R-squared value is 0.278,

9. which is, means 27% variation in output explained by the monetary policy variables
(inflation, M2, ER, interest rate).
Vector autoregressive (var) models are widely used in the empirical analysis of monetary
policy issues. This methodology has undoubtedly the merit of avoiding the need for a
complete specification of structural model of the economy however, when the effects of
monetary policy action are to be evaluated, fundamental identification problem must be
solved. Policy action, which is endogenous response to current developments in the economy,
must separate from exogenous policy action. Only when the latter are identified the
dynamic analysis of the var system may yield reliable information on the monetary
transmission mechanism.
CONCLUSION
It is clear from this study that Monetary policy adopted in Pakistan depends upon the
instruments of monetary policy like interest rate, exchange rate, money supply etc. this study
clearly assess the effects of monetary policy instruments within the institutional framework
for economic growth. It is found from this study that monetary policy has nominal as well as
real effects on economic growth of Pakistan. This study also evaluates that the
implementation of monetary policy in a developing country like Pakistan has supplementary
challenges which are not present in the developed countries like treat of currency substitution
and fiscal dominance.
This study conclude therefore that the inability of monetary policies to effectively
maximize its policy objective most times is as a result of the shortcomings of the
policy instruments used in Nigeria as such limits its contribution to growth even
though monetary policies had brought impressive contribution over the years.
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