Monetary Policy and Its Effect on Economy

Topics: Inflation, Monetary policy, Central bank Pages: 16 (4799 words) Published: May 14, 2011
1.The effectiveness of monetary policy in Pakistan
ARTICLE (December 09 2008): Alongside is the text of the speech of the Governor, State Bank of Pakistan, at the Institute of Business Management on December 6. Economic policies aim to increase the welfare of the general public, and monetary policy supports this broad objective by focusing its efforts to promote price stability. Embedded in this objective is the belief that persistent inflation would compromise the long term economic prospects of the country.

The objective of monetary policy in Pakistan, as laid down in the SBP Act of 1956, is to achieve the targets of inflation and growth set annually by the government. In pursuit of this mandate, SBP formulates the country's monetary policy that is consistent with these announced targets. In my remarks today, I plan to provide perspective on:

• First, why central banks focus on price stability?

• Second, how the monetary policy transmission mechanisms work?

• Third, what are the principal features of Pakistan's monetary policy framework?

• Fourth, selected thoughts on effectiveness of Pakistan's monetary policy framework

• Finally, what measures are needed to improve the effectiveness of the monetary policy framework in Pakistan?

These questions have been a subject of much debate lately, as monetary tightening - an inevitable policy response for regaining macroeconomic stability - has aroused anxiety but better public understanding of this question will help them to appreciate central bank's monetary policy stance.


Before getting into other intricacies of monetary policy, it is useful to bring forth the importance of price stability as an overriding objective of monetary policy. Actual inflation outcome in the economy is driven largely by the level of output gap (the difference between what the economy is demanding and what it can potentially produce) and inflation expectations.

When the output gap widens, the actual output is more than what the economy can sustain in the long run with stable inflation. This reflects excessive demand for available resources in the economy, which pushes up general prices. In order to stem the increase in resource cost and the general price level in the economy, this gap needs to be narrowed or stabilised.

This can be achieved by either reducing the demand in the short run or increasing the productive capacity over the medium to long run. Reducing aggregate demand, however, entails reduction in current output and an increase in the unemployment level in the economy. The famous classical Phillips curve that captures the trade-off between stabilising inflation and controlling unemployment was criticised by Phelps and Friedman in the late 1960s.

They argued that if inflation expectations react to changes in actual inflation, then any trade-off between inflation and unemployment would be short-lived at best. If wages are set once a year and for some reason the output prices increase, then the producers have an incentive to increase their output by hiring more workers.

However it is only possible if workers' expectations of inflation remain Unchanged during the period of increase in output prices. If workers adjust their expectations in accordance with actual inflation and demand higher nominal wages, it leaves relatively little incentive for firms to increase the output.

Therefore the focus has shifted away from this trade-off and new consensus has emerged in the literature that price stability is key to long run growth prospects. Both theory and evidence suggest that monetary stimulus can only affect real economic activity in the short-run.

In the long run, however, there is no conflict between low inflation and full utilisation of economic resources. Ensuring price stability, in turn, requires effective management and anchoring of inflation expectations. With stable prices, economic decisions can be made with less...
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