2 A2658 D8 D 01

Monetary Policy Channels of Pakistan
and Their Impact on Real GDP and

Inflation

Karrar Hussain

CID Graduate Student and Postdoctoral Fellow
Working Paper No. 41, October 2009

Copyright 2009 Karrar Hussain and
the President and Fellows of Harvard College

at Harvard University
Center for International Development
Working Papers

Monetary Policy Channels of Pakistan and Their Impact on
Real GDP and Inflation

Citation and Context

This paper may be cited as: Hussain, Karrar. Monetary Policy Channels of Pakistan and Their Impact
on Real GDP and Inflation CID Graduate Student Working Paper Series No 40, Center for International
Development at Harvard University, October 2009. Available at
http://www.cid.harvard.edu/cidwp/grad/041.html

Professor Filipe Campante has approved this paper for inclusion in the Graduate Student and Research
Fellow Working Paper Series. Comments are welcome and may be directed to the author at Karrar
Hussain [karrar_ksg_harvard@ymail.com].

Acknowledgements
The author would like to express the deepest appreciation to Dr. Syed Zahid Ali, who has the attitude of a
genius economist: he was there at each and every step of this research in economics. In particular, his
recommendations and suggestions have been invaluable for this research. Without his guidance and
persistent help this paper would not have been possible.

2

Monetary Policy Channels of Pakistan and Their Impact on Real
GDP and Inflation

Karrar Hussain

Kennedy School of Government - Harvard University

__________________________________________________________________
This paper is an attempt to estimate the relative impact of monetary policy on key economic variables i.e. output and
inflation in Pakistan by covering the period from 1964-M1 to 2007-M12. For this purpose Vector Autoregression
(VAR) approach is used, which is based on error correction model (ECM).We considered five pertinent channels
through which monetary policy can affect economic activity of the country namely interest rate channel, exchange
rate channel, government expenditure channel and credit channel. The objective of this paper is to identify the
relative importance of each of these channels by employing Vector Autoregression (VAR) approach. We also
generate Impulse Response Functions to confirm the response of a shock in a variable upon itself and other
variables. Our study concludes that exchange rate is also a significant monetary policy instrument in Pakistans case
for both controlling inflation and minimizing output variance in the economy.
__________________________________________________________________
- Keywords: Outputgap, Inflation, Vector Error Correction
- Journal of Economic Literature (JEL) subject codes : C32, E31, E37, B41

3

TABLE OF CONTENTS

1. Introduction
2. Literature Review
3. Data Source and Methodology
3.1. Procedure to Convert Yearly Data into Monthly Data
3.2. Methodology
3.2.1. Ensuring Stationarity of the series
3.2.2. Regression Specification Involving St. Louis Equation
3.2.3. Different Specification of Vector Autoregression Approach (VAR)
3.2.4. Determination of Lags
3.2.5. Checking the Co-integration of Series
3.2.6. Vector Error Correction Model (VECM) and Granger Causality
3.2.7. Impulse Response Functions (IRF)
4. Results
4.1. Summary Statistics
4.2. St. Louis Equation Regression
4.3. Interest Rate Channel
4.4. Exchange Rate Channel
4.5. Credit Channel
4.6. Government Expenditure Channel
5. Conclusion and Policy Recommendations
6. References
7. Table Results
8. Description of Variables
9. Impulse Response Function (IRF) and Important Graphs
4

5

1. Introduction
This paper attempts to estimate the impact of
monetary policy on Pakistans economic activity.
Monetary policy is concerned with relationships
between changes in money supply and the level of
real output and (or) Inflation. We test for the
causality among macroeconomic variables by
employing the vector autoregressions (VARs)
approach. The objective is to identify the channels
through which monetary policy shocks play an
important role in our economic fluctuations. There
are four main channels through which monetary
policy simultaneously affects output in case of
Pakistan; namely the interest rate channel, asset price
channel, credit channel and exchange rate channel
1
.
In this paper we unfold the impact of three of these
channels i.e. credit channel (M1 and M2), interest
rate channel and exchange rate channel. Lastly we
confirm our findings by generating Impulse Response
Functions (IRFs) in order to reaffirm the impact of a
monetary policy shocks on other economic variables.
Before proceeding further, it is pertinent to mention
how each of above-mentioned channels affects output
and inflation in a country. Identifying the individual
importance of these channels helps us in checking
whether predictions of different theories regarding
monetary policy are consistent with the empirical
evidence. It also helps policy makers to predict
movements in the real variables and to understand
which channel is a better choice to achieve targets.
For example if interest rate is significant in
explaining how changes in money supply lead to

1
Agha, Ahmed, Mubarik & Shah (2005)
changes in output, given the output variance then the
central bank needs to focus on an interest rate target
2
.
The exchange rate affects output and prices both
through demand and supply side channels. A
depreciation of domestic currency increases the price
of foreign goods relative to domestic goods. Due to
increased import prices and production costs,
spending from foreign to domestic goods increases
thus causing increase in prices and aggregate
demand. On the other hand, a depreciation of
currency lowers export prices. This causes the net
exports to decrease leading to a fall in real income in
the economy. Thus the combined effects that occur
through the demand and supply channels determine
the net results of exchange rate fluctuations on real
output and price
3
.
In case of the interest rate channel, an increase in
nominal interest rate translates into an increase in real
rate of interest and user cost of capital. This leads to
changes in savings and investment decisions of
household and firms i.e. it is less attractive to take out
loans for financing consumption or investment. Thus
interest rate increase causes borrowing and spending
levels to decline thereby leading to decrease in
aggregate demand and thus the output level
4
.
The credit channel works through two separate
mechanisms. Firstly, in case of a contractionary
monetary policy the volume of bank reserves reduces
resulting in a decline in bank loans. This leads to a
decrease in aggregate spending since significant
number of firms and households rely on bank
financing. Secondly, money supply changes can also
influence output by inducing changes in interest rate

2
Agha, Ahmed, Mubarik & Shah (2005)
3
Kandil & Mirzaie (2000)
4
Transmission Mechanism, n.d.
i.e. an increase in interest rate due to a fall in money
supply reduces the value of assets i.e. stocks and
bond. This leads to shrinkage in the household
resources thereby decreasing consumption levels and
thus output
5
.
After carrying out Granger causality and VECM tests
we conclude that incase of Pakistan exchange rate is
an important monetary policy transmission channel
and the central bank can use this instrument to
control inflation in the country and can minimize the
variance.
The rest of the paper is organized as follows: Section
2 gives detailed literature existent on monetary policy
and VAR for United States in general and Pakistan in
particular. Section 3 outlines the data sources and the
methodology used to establish causal links between
the variables. Section 4 highlights the main findings
in case of each of the monetary policy channel
discussed and Section 5 concludes the paper with
policy recommendations for the future.
2. Literature Review
Milton Friedman and Anna Schwartz (1963) were the
first to observe that changes in monetary aggregates
lead to changes in real economic activity. Their
results were based on evidence of 100 years of
United States data stating that higher money growth
leads to increases in output above trend and lower
money growth leads to decreases in output
However, these correlations do not guarantee the
casual role of monetary policy on economic activity,
as the movements in monetary aggregates are not
exogenous.
Tobin (1970) was the first to notice that the
correlation implied by Friedman and Schwartz could
in fact reflect the opposite that output might be

5
Agha, Ahmed, Mubarik & Shah (2005)-SBP working paper
series
causing money. This reverse causation argument is
also been provided by King and Plosser (1984) who
argue that correlation between M1 or M2

and output
occur due to banking sector responding to economic
disturbances and not as a result of monetary policy
actions. On the same issue, Coleman (1996) predicts
that money is more highly correlated with lagged
output as opposed to future output.
A lot of literature on monetary policy focuses on the
importance of nominal income. M. Friedman and
Meiselman (1963) tested the impact of whether
monetary or fiscal policy was more important in the
determination of nominal income. They estimated the
following equation:
t
n
i
i t i
n
i
i t i
n
i
i t i
n
t t
u z h m b A a y p y + + + + = +

=

=

=

0 0 0
0

where all variables are expressed in log form,
nominal income is equal to the sum of output and
price level, A is autonomous expenditures, m is a
monetary aggregate, z is a vector of other variables
that help explain fluctuations in nominal income.
Their results indicated a much more statistically
significant relationship between output and money
that between output and their measure of autonomous
expenditure
6
.
Later on, policy analysis on the above equation was
carried out by a number of economists at the Federal
Reserve Bank of St. Louis so regressions of nominal
income on money are often referred to as St. Louis
equations. The original equation was first put forward
by Anderson and Jorden (1968) in the following
manner:

t
i
i t i
i
i t i t
u E e M m c Y + A + A + = A

=

=

4
0
4
0

6
Walsh (2003)
6

where Y is the current dollar GNP, M represents the
money stock, E is high employment federal
expenditures and u
t
is the error term assumed to be
homoscedastic. They carried out the regression
estimation with quarterly data from 1953-I to 1968-
IV. The coefficients were estimated based on Almon
lag technique required to lie along a fouth degree
polynomial with both end points restricted to zero
7
.
Their findings were in line with the above results by
Friedman and Meiselman.
However, the issue with St. Louis approach is that
since nominal income is the dependant variable a
change in money leading to a change in nominal
income cannot be accurately split between a change
in real output and a change in price level. This result
gave rise to common responses by Modigliani and
Ando (1976) and De Prano and Mayer (1965) among
others. They stressed that if m is endogenous in the
above equation then the policy responds to factors in
the error term resulting in inconsistent least square
estimates due to the correlation between u and m
8
.
Friedman updated the above form of St. Louis
equation for the period 1953-I to 1976-II and
concluded that lagged first differences in
expenditures lead to changes in GNP. Carlson,
commented that the error term variance is
heteroscedastic and as a result the estimated
coefficients in the above equation were inefficient.
He re-estimated the St. Louis equation by considering
rates of change rather than the first differences of the
variables of interest. He confirmed the original St.
Louis equations result that fiscal policy has no
significant impact on changes in nominal income.
Vrooman (1979) believed that such an approach was
incorrect and instead corrected Friedmans results by
employing the method of weighted least squares. His

7
Seeks and Allen (1980)
8
Walsh (2003)
results indicated that although the fiscal policy was
still ineffective there had been a considerable shift in
the linear combinations of the vectors of m
i
and e
i
.
Friedman also ascertained that the fiscal policy had a
greater impact when the number of lags was
increased to two years
9
.
Ray & Siklos (1986) re-examine the role of high
employment budget expenditures in the St. Louis
equation by relating the rate of change of nominal
income to the rate of change of money supply. The
specification used was given as follows:
t t t t
e L D g L C m L B a y ) ( ) ( ) ( + + + =

where the dot over the variables represents the log
change and e
t
comprises of the sequence of
independent and identically distributed random
variables. B(L), C(L) and D(L) represents infinite
degree polynomials (two-sided) in the lag operator L.
They used quarterly U.S. data from 1949-I to 1984-
IV. They use spectral method
10
in particular and the
time series method in general as opposed to classical
regression methods used by Anderson and Jordan
(1968), Carlson (1980) and others. Their main
findings maintain that both monetary and fiscal
policy have statistically significant partial coherences
with income at cycles of about 6 to 12 quarters.
Income lags monetary policy but leads fiscal policy.
Income is also significantly related to lead terms of
fiscal policy in the two-sided distributed lag model
11
.
Thus St. Louis equations relate nominal output to
money. In order to estimate the effects of output and
money Sims (1972) introduced the notion of
Granger causality
12
. He established that money

9
Vrooman (1979)
10
They estimate the St. Louis equation by using spectral estimates
of a two-sided distributed lag model.
11
Raj and Siklos (1986)
12
Variable X is said to Granger cause Y if and only if the lagged
values of X can predict Y.
7

Granger caused nominal GNP in a bivariate system
i.e. past behavior of money predicted future GNP.
The hypothesis stating unidirectional causality
between income and money was however rejected
13
.
Lawrence J. Christiano and Lars Ljungqvist (1988)
reinforced the result that money caused output when
industrial production was used as a measure for
output
14
.
In 1980, Sims found that output
15
variation predicted
by money was greatly reduced when interest rate was
added to the equation. Therefore, Sims concluded
that in the United States, short-term interest rate was
a better predictor of monetary policy than money
supply
16
. Later on, Litterman and Weiss (1985) also
concluded that nominal interest rate was a better
forecaster of output than money when it was added in
the vector autoregression containing money, output
and prices. However, this interpretation about the
ineffectiveness of the monetary policy was refuted by
King (1982) and Bernanke (1986) on empirical
grounds and by Bennett T McCallum (1983) on
theoretical grounds
17
. Also, Eichenbaum and
Singleton (1986) found that if regressions were
specified in log first differences instead of in log
levels then money appeared to be of lesser
significance. Stock and Watson (1989) however,
conclude that money helps predicting future output
even when prices and interest rate are included.
Moreover, Friedman and Kuttner (1992) have looked
upon the role of alternative interest rates in
forecasting output. They used various definitions of
money over different sample periods and predicted an

13
Sims (1972)
14
Bernanke and Blinder (1992)
15
Again using industrial production as a measure of real output
16
Walsh (2003)
17
unstable relationship existing in the United States that
deteriorated in the 1990s
18
.
Bernanke and Blinder (1992) carry out both Granger
causality tests on single equations and complete
vector autoregressions in order to find out the
predictive power of money and interest rate on nine
real variables including industrial production. They
use six lags each of CPI, M1, M2 real variable and
three different interest rates namely federal funds
rate, three-month Treasury bill rate and ten-year
Treasury bond rate. The sample period runs from
1959, 7
th
month to 1989, 12
th
month. Results indicate
that the federal funds rate dominates M
1
, M
2,
bill and
the bond rate in forecasting real variables where the
predictive power of M1 is nil
19
.
The question of whether it is anticipated or
unanticipated money that leads output was brought to
focus by Barro (1977, 1978). He suggested that
unanticipated part of money affected real variables.
Similar work done by Mishkin (1982) supported the
contrary i.e. anticipated money lead to output
changes. Cover (1992) estimates the difference in
positive and negative monetary shocks on output. He
concludes that negative shocks have significant
effects whereas positive shocks are usually small and
statistically insignificant
20
.
Sims (1992) examines VAR between money and
output separately in France, Germany, Japan, United
Kingdom and the United States. The variables
include industrial production, consumer prices, and
short-term interest rate as a monetary policy tool,
money supply, exchange rate and an index of
commodity prices. Sims orders the interest rate
variable first and finds out that changes in the interest
rate (i.e. innovations) affect the other variables

18
Walsh (2003)
19
20
Walsh (2003)
8

although this isnt the case vice versa. Also in all five
countries, monetary shocks (i.e. interest rate
innovation) lead to output following a hump-shaped
pattern. In case of a contractionary shock, output
patterns form a peak after several months and then
eventually die out. Also in all five countries a
positive interest rate shock led to an increase in price
level. This puzzling result is referred to as the price
puzzle.
Eichenbaum (1992) considers VAR on four variables
i.e. M1 as a measure of money supply, federal funds
rate as a measure of short-term interest rates, prices
and output. He establishes that a positive M1 shock
leads to an increase in the funds rate and a decline in
output where M1 shocks measure the impact of
monetary policy. This result is puzzling for two
reasons. Firstly, an expansionary monetary policy is
expected to increase both M1 and the output level.
Secondly, due to the inverse relationship between
money demand and nominal interest rate an increase
in M1 is expected to cause a decline in the interest
rate. Eichenbaum also used interest rate as a
monetary policy tool and established that no output
puzzle existed in this case i.e. a contractionary
policy shock (i.e. positive interest rate shock) gave
rise to a decline in output. However, a contractionary
policy shock gave rise to an increase in the price
level i.e. price puzzle. The commonly accepted
explanation for the price puzzle is that it reflects the
fact that the variables included in the VAR do not
span the full information available for interpreting the
response of the monetary policy tool being
considered
21
. From the study carried out by
Christiano, Eichenbaum and Evans (1996a) and by
Sims and Zha (1995) it is seen that by introducing
current and lagged values of commodity prices as

21
Walsh (2003)
variables in the VAR when interest rate is used as
monetary policy tool, the price puzzle often
disappears
22
.
An alternative explanation for the price puzzle has
also been provided by Barth and Ramey (2001) who
believe that rising prices following a monetary
contraction need not be a puzzle if monetary policy
operates not only through demand effects but also
through supply effects
23
. For instance, increase in
interest rates raises the cost of inventories and
thereby acts as a positive cost shock. This negative
supply side effect raises prices and lowers output.
This is known as the cost channel of monetary
policy
24
.
It should be kept in mind that a measure of policy in
a particular period may not reflect policy in another
period if the implementation of policy has changed.
Bernanke and Mihov (1998) maintain that funds rate
is the best predictor of policy in United states in pre-
1979 and post-1982 periods, whereas, non borrowed
reserves give more reasonable results for 1979-1982
period
25
.
In terms of literature existant on funds rate used as a
measure of United States monetary policy, Leeper,
Sims and Zha (1996) have also confirmed Sims
(1992) evidence on output following a hump shaped
pattern as a result of a contractionary interest rate
shock. They maintain that output response to a
contractionary policy shock is insignificant for most
of the first year after the shock, it then declines below
the baseline and the peak effect occurs after a lag of
two years. They also confirm the price puzzle when
interest rate is used as a monetary policy instrument.
Moreover, impulse response functions (IRF) depict

22
CEE (1998)
23
Giordani
24
Walsh (2003)
25
Bernanke and Mihov (1998)
9

that policy shocks occur with a long lag. They further
maintain that monetary policy shocks are irrelevant in
predicting business cycle fluctuations. However, this
result has been based on monthly data from 1960 to
1996 so one should bear in mind that during this
period the procedures used by Fed have been subject
to changes.
On the other hand, Christiano, Eichenbaum and
Evans (1998) conclude that monetary policy shocks
affect on output is contingent on the way the policy is
measured. They apply the Lucas Program that
focuses on the effects of monetary policy shocks by
employing the recursive assumption. This
assumption states that the monetary policy shocks are
orthogonal to the variables that the Federal Reserve
uses in their feedback rule
26
. First they estimate the
policy shock by fitted residuals in the Ordinary Least
Squares regression of the monetary policy variable on
the rest of the variables. Then they estimate the
response of a variable to a monetary policy shock by
the regressing the variable on current and lagged
values of the policy shocks. They use quarterly data
on the following variables namely log of real GDP,
log of implicit GDP deflator, change in index of
commodity prices, federal funds rate, log of total
reserves, log of non borrowed reserves plus extended
credit and log of M1 or M2.
Influenced by Bernanke and Blinder (1992) and
McCallum (1983) they find out the effect of federal
funds rate shock (using it as a monetary policy tool).
Funds rate policy shock account for 21% of the four-
quarter ahead forecast error variance for quarterly
real GDP. This figure rises to 38% of the twelve-
quarter ahead forecast error variance. However,
monetary policy shocks have very little effect on the

26
i.e. the rule which relates policymakers actions to the state of
the economy.
forecast error variance for the price level
27
. Their
study is also motivated by Eichenbaum (1992) and
Christiano and Eichenbaum (1992) and shows the
effect of innovations of nonborrowed reserves (using
it as a monetary policy tool) while innovations of
broader money show shocks to money demand.
Thirdly they examine the effect of using the ratio of
nonborrowed to total reserves as a monetary policy
shock, influenced by Strogins (1995) idea. Results
for all three policy shocks indicate that in case of a
contractionary or positive policy shock the federal
funds rate rises, monetary aggregates decline with lag
involved, price level initially stays stagnant, output
falls showing the famous hump shaped pattern
whereas the commodity prices fall.
Lastly, they also carried out the analysis using each
M0, M1 and M2 as the policy instrument. The
impulse response functions associated with M0 and
M1 were measured imprecisely. However, the point
estimates associated with M0 based policy shocks
were in line with simple neoclassical monetary
models. The results with M2 are similar to the ones
mentioned in case of the above three policy shocks.
The only difference is that after a lag, nonborrowed
reserves and M2 move in opposite directions.
A lot of literature on monetary policy shocks focused
on its effects on exchange rates. Eichenbaum and
Evans (1995) use contractionary U.S. monetary
policy shocks to examine its effects on real and
nominal exchange rates as well as foreign and
domestic interest rates. Their results show that a
contractionary shock to U.S. monetary policy causes
appreciation of U.S. nominal and real exchange rate,
decrease in the spread between foreign and U.S.
interest rates and leads to persistent deviations from
uncovered interest rate parity in favor of U.S.

27
Walsh (2003)
10

investments. Also a larger interest rate differential
induced by a contractionary monetary policy
increases due to expected future appreciation of the
dollar as opposed the theory under uncovered interest
rate parity.
Grilli and Roubini (1995) carry out the same study on
non-U.S. countries. They find that the foreign
countrys currency depreciates due to a
contractionary shock to foreign countrys monetary
policy. However, when they use the spread between
foreign short-term and long-term interest rate as a
monetary policy tool they establish that policy shocks
give rise to appreciation of foreign exchange rate and
a decline in output levels.
On the other hand, Cushman and Zha (1997), Kim
and Roubini (1995), and Clarida and Gertler (1997)
carry out the analysis on exchange rates without
considering the assumption that foreign monetary
policy only looks at predetermined variables when
setting its policy instrument
28
as in the above two
cases. Cushman and Zha assume that before setting a
short-term interest rate the Bank of Canada looks at
the money supply, exchange rate, U.S foreign interest
rate and an index of world commodity prices. Kim
and Roubini assume that the reaction function of the
central bank includes money supply, exchange rate
and the world price of oil. Clarida and Gertler assume
that the Bundesbanks reaction function includes
current values of an index of world commodity
prices, the exchange rate and German money supply
(excluding the U.S. funds rate). All of these three
papers conclude that contractionary monetary policy
shocks cause an appreciation of foreign interest rates
and increase the differential between domestic and

28
This means that these authors do not employ the recursive
assumption and monetary policy shocks cannot be recovered by
OLS regression. They would need other identifying assumptions
for their analysis.
foreign interest rate. This result is consistent with
Eichenbaum and Evans (1995) conclusion regarding
effects of policy shocks. Also these papers establish
that policy shocks cause a decline in output levels
and foreign monetary aggregates; a rise in interest
rates and affects foreign policy with a lag
29
.
In order to establish causality links between income,
money and prices, a lot of literature has been carried
out even in countries other than the U.S economy.
Barth and Bennett (1974) carried out Sims approach
in the Canadian economy and established bi-
directional causality between income and money,
whereas William, Goodhart and Gowland (1976)
applied Sims test procedure in the U.K and found
unidirectional causality from income to money as
opposed to Sims findings. They also established
unidirectional causality from money to prices.
Brillembourg and Khan (1979) used a longer data set
and found unidirectional causality from money to
income and prices in the U.S.
Dyreyes, Starleaf and Wang (1980) found
unidirectional causality from money to income in
Canada as opposed to Barth and Bannett (1974).
They also found bi-directional causality in U.S.
opposed to both Sims (1972) and Brillembourg and
Khan (1979). In U.K they found causality from
income to money in line with Williams, Goodhart
and Gowland (1976) findings
30
.
In case of developing countries Lee and Li (1983)
found bi-directional causality between income and
money and unidirectional causality from money to
prices in Singapore. Joshi (1985) found bi-directional
causality between money and income in India.
Khan and Siddiqui (1990) found unidirectional
causality from income (nominal GDP) to money (M1
and M2) and bi-directional causality between money

29
CEE (1998)
30
Hussain and Abbas
11

(M2) and prices in Pakistan for the period 1972-I and
1981-IV by employing the Sims procedure
31
. Abbas
(1991) found bi-directional causality between money
and income in Pakistan, Malaysia and Thailand
32
.
Sui-Ki Tsang tests the causality between money and
income in South Korea by employing three
approaches i.e. direct Granger approach using
autoregressive analysis, the Sims approach using
two-sided regression and the Haugh-Pierce approach
that investigates the correlation function of the
univariate residuals of the two series. He used
quarterly seasonally adjusted data from 1970-I to
1981-IV. The variables used are nominal GNP for
income and M2 for money supply. Results show that
the Haugh-Pierce test fails to establish any causality
link between the two variables. Both Sims and
Granger test establish causality running from money
to income in case of South Korea
33
.
All these studies examine the relationship between
two variables whereas an economic variable is
influenced by more than just one variable. Hence all
these results establishing causality remain
inconclusive. Ho (1982) carried out causality tests in
a trivariate case by taking into account money,
domestic and import prices in Hong Kong. He
established unidirectional causality from domestic
prices to money and observed significant impact of
import prices on domestic prices. However, the same
results were obtained when examined in a bivariate
case
34
.
Ibrahim (1998) examined causality between money
(M1 and M2) and prices (CPI), real industrial
production index and one year Treasury bill rate for
Malaysia over the period 1976-I to 1995-IV by using

31
Tahir (2003)
32
Hussain and Abbas
33
Tsang
34
Hussain and Abbas
seasonal data. Engle-Granger causality test was used
among two variables (money and output), three
variables (money, output and prices) and four
variables (money, output, price and interest rate).
FPE (Final Prediction Error) was used to determine
the optimal number of lags for each variable used.
Results showed that models with three and four
variables were cointegrated with M2. However, bi-
directional causality exists between M2 and real
industrial production and M2 and prices. Hence
monetary policy seemed to be ineffective in
Malaysia
35
.
Mudabber Ahmed carried out Granger causality tests
to examine the causality between money (M2),
interest rate, prices (CPI) and output (real GDP) in
selected South Asian Association for Regional
Cooperation (SAARC) economies namely
Bangladesh, Pakistan and India. Quarterly data from
1967-I to 1996-IV for India, 1972-I to 1997-II for
Pakistan and 1974-II to 1998-IV for Bangladesh was
used to conduct bivariate, trivariate and block
causality tests
36
for all three countries. In order to
choose the optimal lag lengths of each of the variable
the Akaike Information Criterion (AIC) and the
Bayesian Information Criterion (BIC) was used. The
results show that interest rate is a good policy
variable in Bangladesh and Pakistan while money
turns out to be a good policy variable in India. Bi-
directional causality exists between money and prices
in Bangladesh and Pakistan. Block causality tests
indicate that interest rate and money as a block cause
output and prices but output and prices do not cause
interest rate and money in Bangladesh. The situation

35
Tahir (2003)
36
Block causality tests are carried out by taking two non-policy
variables as a block such as income and prices or interest rate and
money. The test procedure is the same as that of multivariate
analysis. Instead of putting restrictions on single variables,
restrictions are placed on block variables.
12

is reversed in case of Pakistan and India. Thus we can
say that monetary policy is more obvious in
Bangladesh compared to Pakistan and India
37
.
The causal relationship between money and prices in
Pakistan was formally investigated by Jones and
Khilji (1988). They used monthly data, two measures
of money (M1 and M2) and prices (WPI, CPI) for the
period 1973-1985 and applied Granger causality tests
on these variables. Results showed impacts of money
lags on WPI and CPI lags on monetary aggregates
without any feedback. Also Bengali, Khan, and
Sadaqat (1997) used quarterly data from 19721990
and found bidirectional causality between money
measures (M1 and M2) and CPI
38
.
Fazal Hussain and Kalbe Abbas examine the causal
relationship between income and prices in both
bivariate and trivariate framework for Pakistan. They
use annual data from 1949-50 to 1998-99 for the
variables GNP at current prices, M2, and CPI with
base 1980-81. They apply the Unit Root Test (i.e.
Phillips-Perron (1998) test) to check for the
stationarity of the series. The causality between these
variables is examined through Granger causality test
and Error Correction Model (ECM). The analysis
suggests that long run relationship exists between
money, income and prices. Also it shows that money
effects income with a lag of three years. With regard
to causal relationship between money and prices,
there exists bidrectional causality between the two.
Masih and Masih (1997) tested bivariate and
trivariate causality between money and prices in
Pakistan for the period from 1971-I to 1994-IV. They
used CPI, spot exchange rate, industrial production
index, market interest rate and money (M1 and M2)
as the variables of interest. Johansen (1991)
technique was used for the multivariate analysis in

37
Ahmed
38
Hussain and Mehmood (1998)
order to test for the cointegration of variables. ECMs
were employed to test for causality. Results proved
that monetary policy was ineffective in Pakistan and
they supported their results by Variance
Decompositions (VDCs) and Impulse Response
Functions (IRFs).
Muhammad Tahir (2003) carried out a study to
estimate the effectiveness of monetary policy in
Pakistan from 1972-2002. Vector Error Correction
Model (VECM) derived from Johansens multivariate
co-integrating procedure were used to test the
effectiveness of monetary policy. Results showed that
exchange rate and money (M1 and M2) jointly
determined prices, interest rates and real output
variables. In the short run money supply and interest
rate do not cause real output and price level although
exchange rate causes output and interest rate and a
two-way causality exists between money (M1 and
M2) and exchange rate. Thus monetary policy proved
to be ineffective in the short run
39
.
Fazal Hussain and Tariq Mehmood (1998)
reexamined the causal relationship between money
and prices in Pakistan employing the cointegration
and ECMs. Two measure prices (WPI, CPI) and three
measures of money stocks (M0, M1, M2) were used
and analysis was carried out over the period from
July 1981 to June 1998. They found a long run
relationship between prices and M2. Also
unidirectional causality was established from money
to prices supporting the monetarists claim. These
results differed from earlier studies on Pakistan,
which showed bi-directional causality between prices
and money
40
.
Tariq Mehmood and Muhammad Farooq Arby
(2005) examined short run and long run relationships
among four macroeconomic variables in Pakistan

39
Tahir (2003)
40
Hussain and Mehmood (1998)
13

namely M2, call money rate as a measure of interest
rate, CPI for prices and Real GDP at factor cost as a
measure of output. To test for cointegration Johansen
and Juselius (1990) cointegration tests are carried out
and for examining short run causality ECMs have
been used. Annual data from 1993 to 2003 has been
used for the analysis. They establish that growth in
money causes real GDP growth but does not cause
inflation. Thus an attempt to control inflation through
monetary contraction may lead to contraction of real
economic activity rather than inflation. Moreover, in
their study interest rate turns out to be independent of
money, prices and output
41
.
3. Data Sources and Methodology
The dataset used for the regression analysis is largely
extracted from the IMF dataset compiled by the
United Nations Statistical Database. It covers a
period of 47 years from 1960-2007. The variables
used are as follows:
- Monetary aggregates (M1 and M2)
- Real GDP
- Exchange Rate in US dollars
- Money market interest rate
- Inflation i.e. change in Consumer Price
Index (CPI)
- Government Expenditure
In order to generate the series for Real GDP at 1999
base year, we calculate the GDP deflator
42
. This is
done by using the data series for GDP at current
prices, factor cost and GDP at constant prices, factor
cost and then dividing the original GDP series with
the GDP deflator of the year 1999. The data for CPI
has also been converted to the same base year
43
.

41
Mehmood and Arby (2005)
42
GDP Deflator = [Nominal GDP / Real GDP]*100
43
Year 2007 figures for money and GDP have been obtained from
Economic Survey whereas that for interest rate and inflation has
been taken from the State Bank of Pakistan.
To increase the number of observations and to fully
ascertain the impact of monetary policy shocks on
variables during the year, we have converted the
yearly data in time series into quarterly data. The
methodology used is as follows:
3.1. Procedure to convert yearly data into
quarterly and monthly data
We follow the Dentons (1971) method of obtaining
monthly data for a given year by using both annual
and quarterly values for that year by using the least
square approach
44
. Denton computes the proportional
Denton method of interpolation of an annual flow
time series by use of an associated "indicator series",
imposing the constraints that the interpolated series
obeys the annual totals. The method is described in
IMF Chapter 6, Benchmarking (2001) as "relatively
simple, robust, and well-suited for large-scale
applications." It may be particularly useful in cases
where, due to sizable statistical discrepancy,
quarterly series do not integrate to annual totals
which we can expect in case of Pakistan. The
indicator series only contribute their pattern to the
interpolation; thus it is quite feasible to use both
quarterly and annual flow series expressed at an
annual rate. The interpolated series will be at a
quarterly rate. Although the procedure is usually
applied to flow series (such as GDP), it may be
applied to stock series if they are differenced and
then integrated via generate sum (), after adding their
initial value
45
.
Following the same methodology, all series in the
paper have been converted to monthly estimates
before we proceed to the regression analysis
46
.

44
Bloem, dippelsman and Maehle (IMF-2001)
45
Baum (2001)
46
All variables are taken in log form unless otherwise specified.
Also all regressions are carried out in Stata 9.1 using inbuilt
commands for all tests of stationarity, cointegration, and VAR and
Granger causality.
14

3.2. Methodology:
The regression analysis of the dataset is as follows:
3.2.1 Ensuring Stationarity of the Series
We take first differences of the log forms of all series
and apply the unit root test on all of them i.e. Dickey
Fuller test. T-statistic with a value less than that at
5% level confirms that the series is stationary. For the
purpose of St. Louis Equation all the level form
series were made stationary using the Phillips-Perron
unit root test
47
.
3.2.2. Regression Specifications Involving
St. Louis Equations
St. Louis equations relate change in nominal GDP to
changes in money stocks, exchange rate management
and changes in autonomous expenditure. To see
whether monetary policy including exchange rate
management (because monetary policy becomes
endogenous if exchange rate is fixed) or fiscal policy
contributes more to a change in nominal GDP we
carry out sets of regression of different specifications.
These include:
- Nominal GDP
t
=
1
+
2
M
t
+
3
M
t-1
+
4
G
t
+
5
G
t-1
48

Here all variables are taken in level form
where M
t
refers to the monetary policy
instrument (i.e. M1) at time t and G
t
refers to
fiscal policy tool (i.e. Government
Expenditure) at time t. We have also
included exchange rate E
t
(since exchange
rate is fixed).
- ln (Nominal GDP
t
) =
1
ln(M
t
)

+
2

ln(M
t-1
)

+
3
ln(G
t
)

+
4
ln(G
t-1
)
49

47
This is because Phillips-Perron test cannot be applied to log
form so we used Dickey Fuller test for the log form series.
48
Following the original St. Louis specification.
49
Following specification suggested by Raj and Siklos (1986)
Here all variables are taken in log form and
the regression is estimated dropping the
constant term.
- Nominal GDPgap
t
=
1
+
2
ln(M
t
gap)+
3
ln(G
t
gap)
It is pertinent to mention that incase of regressions
involving St.Louis equations we use M1 as opposed
to M2. This is because M2 has a high correlation with
output so using that in regressions gives rise to the
econometric problem. Lastly in all specifications
exchange rate series was also included for more
detailed analysis.
3.2.3. Different Specifications for Vector
Autoregression Approach (VAR)
Our basic VAR model in a trivariate system can be
specified as follows:

t
t
t
z
y
x
= A (L) +
1
1
1
t
t
t
z
x
y
zt
xt
yt
u
u
u

Where x
t
represents output gap estimated and
computed by Hodrick-Prescott filter with the 139600
smoothing parameter (since frequency of the data
was high), y
t
is either inflation or natural logarithms
of consumer price index gap using the same
smoothing parameter and z
t
is the policy instrument
used i.e M1, M2, interest rate or exchange rate. A (L)
is a 3 3 matrix polynomial in the lag operator L and
u
it
is a time t serially independent innovation to the
ith variable. These innovations can either be
independently distributed shocks to x
t
, y
t
or to
policy.
50

50
Walsh (2003)
15

Our procedure involves taking one policy instrument
at a time and running the VAR with all possible dual
combinations of y
t
51
.

3.2.4. Determination of Lags
Models estimating causal links between variables are
very sensitive to the number of lags involved i.e. how
many past values should enter the equation. We use
Schwarzs Bayesian Information Criterion (SBIC) in
order to estimate our autoregressive model
(ARMA)
52
. Mostly, the model with the smallest
SBIC value is chosen. This method is preferred over
AIC although both give the likelihood value based on
goodness of fit and the number of parameters used to
obtain that fit (assuming constant is included in the
model)
53
. However, SBIC is favored since it has the
property of selecting the true model as T infinity,
provided that the true model is in the class of ARMA
models for small values of free parameters
54
.
3.2.5. Checking Cointegration of Series
Once we determine the optimal number of lags used
for each of the variables in a particular regression, we
need to ensure that the series are not cointegrated so
that the VAR is stable. If two or more series are
cointegrated, in intuitive terms this implies that they
have a long run equilibrium relationship that they
may deviate from in the short run, but which will
always be returned to in the long run
55
.
We use Johansens test for cointegration and this
method is preferred mainly because it is able to detect
more than one cointegrating relationship as opposed
to Engle-Granger approach. Also since the Johansen
method relies on the relationship between the rank of

51
Same number of lags are used for each set of the three variable
x
t
, y
t
and z
t
.
52
The two famous methods used to determining the optimal
number of lags are Akaikes Information Criterion (AIC) and
SBIC.
53
Verbeek (1997)
54
Hannan (1980)
55
Verbeek (1997)
the matrix and its characteristic roots it is more suited
for a multivariate system
56
.
3.2.6. Vector Error Correction Models
(VECM) and Granger Causality
If cointegration has been detected between series we
know that there exists a long-term equilibrium
relationship between them so we apply Vector Error
Correction Model (VECM) in order to evaluate the
short run properties of the cointegrated series. In case
of no cointegration VECM is no longer required and
we directly proceed to Granger causality tests to
establish causal links between variables.
The regression equation form for VECM is as
follows:

=

=

=

+ A + A + + = A
n
i
i t i
n
i
i t i
n
i
i t i t t
Z X Y e p Y
0 0 0
1 1 1
o | o

=

=

=

+ A + A + + = A
n
i
i t i
n
i
i t i
n
i
i t i t t
Z X Y e p X
0 0 0
1 2 2
o | o

In VECM the cointegration rank shows the number
of cointegrating vectors. For instance a rank of two
indicates that two linearly independent combinations
of the non-stationary variables will be stationary. A
negative and significant coefficient of the ECM (i.e.
e
t-1
in the above equations) indicates that any short-
term fluctuations between the independent variables
and the dependant variable will give rise to a stable
long run relationship between the variables. . If both
coefficients (of e
t-1
) are significant it implies bi-
directional causality from X to Y and Y to X
conditional on the presence of Z.
In case the coefficient does not fulfill the property of
being negative and significant; we conclude that no
stable long run relationship exists between the

56
Verbeek (1997).
16

variables. Moreover, the magnitude of the error term
coefficient indicates the speed of adjustment with
which the variables converge overtime.
In order to evaluate the short-term behavior between
the two series we look at the coefficients of the
lagged terms of AY
t
and AX
t
. For instance if the
lagged coefficients of AX
t
turn out to be significant in
the regression of AY
t
then X causes Y
57
.
Omitting the error correction term from the above
two equations gives us the Granger causality
equations
58
, required to investigate the causal links in
case of no cointegration among series.
3.2.7. Impulse Response Functions (IRFs)
In our analysis we apply a one-unit shock to the
monetary policy tool of interest and estimate the
Impulse Response Functions over a period of 48
months. IRFs on the following endogenous variables
are generated when money market interest rate and
exchange rate was used as the monetary policy
instrument:
- Real GDP gap, Inflation
- Real GDP gap, Inflation gap
In case of M1 and M2

representing the monetary
policy tool, IRFs capture the impact of both M1 (M2)
and

A M1

(A M2) on the above-mentioned
endogenous variables.

57
Hussain and Abbas
58
A variable x is said to Granger cause a variable y if, given the
past values of x and y are useful for predicting y.
4. Results
4.1. Summary Statistics
Before starting with Vector Autoregression results it
will be helpful to look at the simple statistics of
important variables which are as follows:
Variable Mean Std.Dev.
moneymarketRate 0.6499628 0.1973979
%changeinGovtExpenditure 0.0041774 0.0125688
%changeinM1 0.0115517 0.0077424
%changeinM2 0.0116244 0.0061891
%changeinExchangerate 0.0047726 0.0104796
%changeinRealOutput 0.0043692 0.0030998

The table above suggests that monthly average
growth rate of monetary instruments are higher than
the monthly average growth rate of real government
expenditure, over the period from 1964-M1 to 2007-
M12. For more details about the behavior of these
variables over time, the following graphs are
presented.
2
0
2
2
2
4
2
6
2
8
1965m1 1970m1 1975m1 1980m1 1985m1 1990m1 1995m1 2000m1 2005m1
time
lnM2 lnG
lnM1

-
.
1
5
-
.
1
-
.
0
5
0
.
0
5
.
1
1965m1 1970m1 1975m1 1980m1 1985m1 1990m1 1995m1 2000m1 2005m1
time
lncpigap outputgap

-
.
5
0
.
5
1
1965m1 1970m1 1975m1 1980m1 1985m1 1990m1 1995m1 2000m1 2005m1
time
lncpigap Money Market Interest Rate

17

4.2. St. Louis Regressions
Using level form:
Using the most generic form of the St. Louis equation
we come with the following sets of econometric
estimates for narrow money, government expenditure
and exchange rate as seen in Table 1.

The results with level form variables indicate that all
coefficients of M1 are significant whereas
government expenditure coefficient is insignificant
even at first lag of two months. Exchange rate
coefficients are also insignificant at both lags.
Using log forms:
Results for the percentage change in all four variables
given that the nominal income is dependent on other
three variables are presented in Table 1.
To the contrary, here we observe that, both narrow
money and government expenditure are statistically
insignificant when it comes to the explanation of
percentage growth of nominal income. Surprisingly,
all the variation in nominal income is explained by
exchange rate growth rate.
4.3. Interest Rate Channel
We start our trivariate analysis with interest rate
channel. Here, following the Johansen Methodology,
for checking the co-integration rank among the three
series we found that, the series are not co-integrated.
Co-integration tests are performed under the
assumption of a linear trend in the data, and an
intercept but no trend in the co-integrating equation.
With maximum lags set to thirty, the optimal lag
length was selected using different lag selection
criteria in the unrestricted VAR model. Sequential
modified likelihood ratio test, final prediction error
criterion and Akaikes information criterion all
selected fifteen lags in the unrestricted VAR model.
Finally, the null hypothesis of one co-integrating
relation among the variables (r=1) is rejected under
the Johansen test. Therefore we proceed with the
unrestricted VAR methodology to check the short run
causality among the four series. But in this technique
VAR stability conditions were given due
consideration due to the absence of co-integrating
factor. The results are presented in table 2 and 3.
The results show that, there is bidirectional causality
between output gap and inflation in the presence of
money market interest rate. After controlling for
output gap along with its lag, there is unidirectional
causality form interest rate to inflation.
Lastly, real GDP causes inflation but no causality
runs from interest rate to real GDP (Supporting the
Keynesian view) or inflation showing that money
market interest rate channel is not a good instrument
to act as a monetary policy tool in Pakistans case.
4.4. Exchange Rate Channel
The trivariate results for inflation, real income gap
and nominal exchange rate in US dollars term is
presented in the form of vector error-correction
model since all the series are cointegrated of order
two as shown in Table 4.
The table statistically signifies a few important
results. The three series under consideration are co-
integrated with rank 2. This implies that, long run
relationships among all these variables can be
explained by 2 co-integration equations. First, with
regards to inflation, the long run dynamics of the
system is stable i.e. inflation plays the role of
stabilizer in the presence of output gap and exchange
rate series. This is evident from the co-integration
equation of this table under the column of inflation as
dependent variable i.e. CointEq L1 and L2. In the
short run, there is bidirectional Granger causality
from exchange rate to output gap and also between
inflation and exchange rate implying that inflation is
18

exchange rate phenomenon and at same time
exchange rate movement can be forecasted by
inflationary movement in the economy. Lastly, due
to the unidirectional causality from inflation to output
gap in the presence of exchange rate it can be inferred
that this policy variable is inflationary on the average.
In order to confirm that, exchange rate is an
inflationary monetary policy instrument we
considered the growth rate of consumer price index
(cpi) gap using error correction model presented in
Table 5.
The table shows that both exchange rate and cpi gap
cause the movement in real GDP gap supporting the
notion of Walrasian Price Adjustment i.e. Walras
Law. Also, exchange rate causes inflation gap
confirming that purchasing power parity i.e. law of
one price holds incase of Pakistan in the long run.
These results indicate that due to the fact that,
exchange rate causing inflation gap both directly and
through real GDP gap simultaneously; it can be used
as a suitable monetary policy instrument for
controlling inflation in the country.
4.5. Credit Channel
Using M1 as a Monetary Policy transmission
channel
and narrow money (M1) as a money supply tool is
two in Table 6.

The above table shows that the three series under
consideration are co-integrated with rank 2.
Compared to the exchange rate, now in this case both
output gap and inflation have the power to stabilize
the dynamic system in face of exogenous change (in
the presence of narrow definition of money). In this
case also there is bidirectional causality between inf
and output gap implying that in face of exogenous
shock in M1, both output and inflation respond to the
system in a stabilizing manner. Lastly, there is
bidirectional causality between inflation and M1,
which implies that inflation is not only a monetary
phenomenon but also have the power to predict
future growth of money supply in the economy. Here
it is important to mention that money M1 has no
predictive power to forecast output gap and similarly
vice versa.
If instead of inflation, we consider consumer price
index gap, results does not change drastically,
implying that our previous analysis is robust.
Following are the results from this trivariate analysis
displayed in Table 7.
The above series are cointegrated with a rank of 2.
We show that Inflation has a stable long run
relationship with both Real GDP gap and M1
whereas the long run relationship of M1 with both
Real GDP and inflation is not stable which means
that money supply has no power to predict prices and
output gap in the long run. Also by observing the
causal links in the short run we see that no causality
exists between M1 and Real GDP gap, whereas
unidirectional causality runs from Real GDP to
inflation.
Using M2 as a Monetary Policy transmission
channel:
and broad money (M2) as a money supply tool is
two as seen in Table 8.

19

The above table shows that the three series under
consideration are co-integrated with rank 2.
Compared to the exchange rate and narrow money
M1, now in this case only inflation has the power to
stabilize the dynamic system in face of exogenous
change (in the presence of broad definition of money
M2 and output gap). In this case also there is
bidirectional causality between inf and output gap in
the short run implying that in face of exogenous
shock in M2, both output and inflation respond to the
system, but only inflation has the power to stabilize
the system. Lastly, there is bidirectional causality
between inflation and M2, which implies that
inflation is not only a monetary phenomenon but also
have the power to predict future growth of money
supply in the economy. Contrary to narrow definition
of money supply M1, here it is important to mention
that money M2 has the predictive power to forecast
output gap. The primary reason may that this
definition of money also includes saving deposits
which can affect or may be affected by income
through other aggregate demand variables.
If instead of inflation, we consider consumer price
index gap, results does not change drastically,
implying that our previous analysis is robust in this
case also. Following are the results from this
trivariate analysis in Table 9.
The above series are cointegrated with a rank of 2.
We show that Inflation has a stable long run
relationship with both Real GDP gap and M2
whereas the long run relationship of M2 with both
Real GDP gap and inflation is not stable which
means that money supply has no power to predict
prices and output gap in the long run. Implying that,
money is a pure source of inflation in the long run.
Also by observing the causal links in the short run we
see that, there exists unidirectional causality exists
from M2 to Real GDP gap, whereas unidirectional
causality runs from Real GDP to inflation.
The impulse response functions generated in case of
shocks to the monetary policy have been attached at
the end of the paper. It is observed that incase of M2
used as a monetary policy instrument neither output
puzzle
59
nor price puzzle
60
exists. Thus the IRFs
indicate that the major impact of policy shocks only
occurs with quite a long lag
61
.
4.6. Government Expenditure Channel
and real government expenditure is presented in the
form of vector error-correction model since all the
series are cointegrated of order two as shown in
Table 10.
The table statistically signifies important results. The
three series under consideration are co-integrated
with rank 2. This implies that, long run relationships
among all these variables can be explained by 2 co-
integration equations. First, with regards to inflation,
the long run dynamics of the system is stable i.e.
inflation plays the role of stabilizer in the presence of
output gap and government expenditure series. This
is evident from the co-integration equation of this
table under the column of inflation as dependent
variable i.e. CointEq L2. In the short run, there is
bidirectional Granger causality from government
expenditure to inflation and also between inflation.
Lastly, due to the unidirectional causality from
inflation to output gap in the presence of government
expenditure it can be inferred that this policy variable
is inflationary on the average.

59
i.e. an expansionary monetary policy shock (M2) gives rise to a
decrease in output level.
60
i.e. an expansionary monetary policy (M2) is followed by a
decrease in price level. Both these puzzles have been explained in
Section 2 above.
61
IRFs with respect to other monetary policy tools can be analyzed
in the same manner.
20

In order to confirm that, government expenditure is
an inflationary monetary policy instrument we
considered the growth rate of consumer price index
(cpi) gap using error correction model presented in
Table 11.
The table shows that government expenditure
through cpi gap cause the movement in real GDP gap
supporting the notion of Walrasian Price Adjustment
i.e. Walras Law again.
Lastly due to the fact that, government expenditure is
causing inflation gap directly (can) pose a serious
tradeoff in terms of binding constraints of the State
Bank of Pakistan. This also indicates that, this
variable can affect more severely the inflation
curbing objective of the State Bank in the presence of
fiscal dominance of the monetary policy, given that
government has a very limited resources.
5. Conclusion and Policy Recommendations
This paper is an attempt to unravel the various
channels of monetary policy transmission mechanism
not only in the short run but also in the long run for
the economy of Pakistan. We attempted to quantify
the lags associated with monetary policy shocks and
to investigate the strength of channels through which
these shocks were propagated. This paper discovered
that, the estimates for both inflationary measures
(including consumer price index gap using Prescott
filter) aggregate demand management policy tools
(based on Johansen full information maximum
likelihood technique) and output gap are co-
integrated and move together in the long run. The
results are robust to the lag orders. For the short
dynamics, we estimated the error correction models
in different specifications. The following conclusions
have been derived from the overall analysis.
Our finding maintains that the State Bank can also try
to curb inflation by also emphasizing on exchange
rate as the monetary policy tool in case of Pakistan.
This is because the effect of exchange rate could not
be accurately dissociated with inflation and output
considerations, given the possibility of supply side
effects of exchange rate. In that case, any
depreciation can lead to adverse supply shock given
that the country is heavily depended on intermediate
raw material for its imports. This is true in case of
Pakistan, especially the effect of high import bills on
production and inflationary pressure because of this
adverse supply shock cannot be ignored easily.
Secondly, this paper found that in Pakistans
economy, inflation is not only a monetary
phenomenon but it is also an exchange rate and
government spending phenomenon. Empirically, this
was shown using Johansen co-integration technique
which confirmed this notion. Compared to broad
money M2 and narrow money M1, exchange rate
takes almost one year more on the average, to effect
the inflation while broad money takes almost five
months to take the effect in terms of its transmission
into inflation.
Lastly, if we closely observe the graphs generated by
impulse response functions, we can also see that
inflationary pressure are much higher in case of
exchange rate management shock and government
expenditure shock compared to interest rate and
credit channel shocks. This also confirms that these
two channels are much inflationary compared to
money market and credit channel shocks.

21

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7. Table Results

Table 1
(OLSwithheteroskedasticityrobust
standarderrorsandcorrected
forseriallycorrelatedresidualsusing
thePraisWinsteniterativeprocess)

Dependent Variables Change in Y Change in Y % change in Y % change in Y

Lag
0 Change in M1 .201*
(0.088)
.196*
(0.088)

1 0.224*
(0.088)
0.219*
(0.091)

0 Change in Govexp .019
(0.268)
.008
(0.269)

1 0.346
(0.256)
0.337
(0.260)

0 Change in Exchange Rate .072

(0.254)

1 0.004
(0.241)

0 % change in M1

.0174
(0.021)
.0255
(0.026)
1

-.0208
(0.025)
0 % change in Govexp

.024
(0.014)
.036
(0.0322)
1

-0.018
(0.0304)
0 % change in Exchange Rate

-0.064*
(0.018)
-0.198*
(0.0693)
1

0.140*
(0.064)
DWStatistics 2.263311 2.26076 2.368597 2.356926
NoOfObservation 526 526 526 526

Notes: All the variables in regression equations are the natural logarithms of the first difference.

26

Table 2
Equation Excluded
chi2 Df Prob>chi2
outputgap inf_p 29.957 15 0.012
outputgap mmi 9.4028 15 0.856
outputgap ALL 45.195 30 0.037
inf_p outputgap 39.702 15 0.001
inf_p mmi 16.089 15 0.376
inf_p ALL 49.029 30 0.016
mmi outputgap 12.884 15 0.611
mmi inf_p 41.455 15 0
mmi ALL 63.179 30 0

Table 3
Equation Excluded
chi2 Df Prob>chi2
outputgap lncpigap 34.494 15 0.003
outputgap mmi 9.9225 15 0.825
outputgap ALL 49.859 30 0.013
lncpigap outputgap 35.182 15 0.002
lncpigap mmi 20.376 15 0.158
lncpigap ALL 50.198 30 0.012
mmi outputgap 13.257 15 0.582
mmi lncpigap 28.898 15 0.017
mmi ALL 50.13 30 0.012

27

Table 4 and 5 (*indicates significant at 5% level)
ErrorCorrectionModel outputgap Std.Err. inf_p Std.Err. lnexrate Std.Err.
CointEqL1 0.043465* 0.01466 0.011423* 0.00320 0.015278* 0.00611
CointEqL2 0.0632826* 0.02365 0.0222357* 0.00517 0.0047207 0.00985
outputgap
LD. 0.0041562 0.04632 0.0178867 0.01012 0.0201807 0.019292
L2D. 0.2247943* 0.045665 0.0115612 0.009979 0.0125198 0.019019
L3D. 0.2244288* 0.04635 0.0047815 0.010128 0.0150095 0.019304
L4D. 0.2122342* 0.04585 0.0023818 0.010019 0.0055265 0.019096
L5D. 0.0433977 0.046632 0.0060631 0.01019 0.0185354 0.019422
L6D. 0.0067811 0.046622 0.0032488 0.010188 0.0044592 0.019418
L7D. 0.0260183 0.046079 0.0095121 0.010069 0.0187991 0.019192
L8D. 0.0141972 0.046083 0.0209183* 0.01007 0.0280112 0.019193
L9D. 0.0444842 0.046397 0.021211* 0.010139 0.0493256* 0.019324
L10D. 0.0003024 0.046834 0.0325706* 0.010234 0.0379959 0.019506
L11D. 0.207747* 0.046965 0.0119579 0.010263 0.0172286 0.01956
L12D. 0.0302417 0.047384 0.0021909 0.010354 0.0051287 0.019735
L13D. 0.0746112 0.047111 0.0141851 0.010295 0.0646648* 0.019621
L14D. 0.0412105 0.047079 0.00057 0.010288 0.0488002* 0.019608
inf_p
LD. 0.2947165 0.212962 0.8294283* 0.046536 0.2339171* 0.088697
L2D. 0.0846563 0.249496 0.0101431 0.05452 0.1037477 0.103913
L3D. 0.2616082 0.195494 0.2067169* 0.042719 0.0854684 0.081421
L4D. 0.1315113 0.200607 0.1883139* 0.043837 0.0548134 0.083551
L5D. 0.0351174 0.204485 0.0156288 0.044684 0.0300098 0.085166
L6D. 0.1562352 0.204239 0.0070707 0.04463 0.0112739 0.085064
L7D. 0.2101526 0.204282 0.0285795 0.04464 0.0109119 0.085081
L8D. 0.259082 0.204596 0.0039888 0.044708 0.0011829 0.085212
L9D. 0.1882869 0.204675 0.0011988 0.044725 0.0360529 0.085245
L10D. 0.1831644 0.204653 0.0082709 0.044721 0.0185984 0.085236
L11D. 0.1194587 0.201652 0.0030193 0.044065 0.0055875 0.083986
L12D. 0.1853073 0.197901 0.6190396* 0.043245 0.6320396* 0.082424
L13D. 0.1347834 0.254569 0.52780388* 0.055628 0.6902746* 0.106026
L14D. 0.0760972 0.217331 0.021708 0.047491 0.1473142 0.090516
lnexrate
LD. 0.0947615 0.094774 0.0127622 0.02071 1.792698* 0.039472
L2D. 0.0787655 0.176199 0.0141348 0.038503 0.8379879* 0.073385
L3D. 0.0832913 0.172624 0.0321899 0.037722 0.140112 0.071896
L4D. 0.2261164 0.169856 0.0431767 0.037117 0.3184995* 0.070743
L5D. 0.1758439 0.173615 0.0206547 0.037938 0.1605024 0.072309
L6D. 0.1348987 0.174701 0.0021121 0.038175 0.0252061 0.072761
L7D. 0.0514418 0.174624 0.0032902 0.038159 0.0505572 0.072729
L8D. 0.0156103 0.174481 0.0049961 0.038127 0.0191566 0.07267
L9D. 0.0997338 0.17437 0.0052 0.038103 0.0173858 0.072623
L10D. 0.2149996 0.173359 0.0042572 0.037882 0.0532381 0.072202
L11D. 0.263719 0.169607 0.001804 0.037062 0.0445325 0.07064
L12D. 0.2317793 0.168709 0.0736031 0.036866 0.6577074* 0.070265
L13D. 0.1157955 0.162047 0.1427149* 0.03541 1.160338* 0.067491
L14D. 0.219749* 0.085685 0.0725301* 0.018724 0.5225367* 0.035687
Constant 0.0000296 0.000156 0.0000573 0.000034 0.00012718* 6.49E05
Co-Integration Relation 1:
t t t
u exrate Outputgap + ln .0006192 .003031
) .0008022 (

=
28

t t t
v exrate Inflation + = ln .0011426 .002653
) .0008991 (

ErrorCorrectionModel outputgap Std.Err. lncpigap Std.Err. lnexrate Std.Err.
CointEqL1 0.050942* 0.015057 0.008443* 0.004513 0.018045* 0.006464
CointEqL2 0.0005677 0.004102 0.008066* 0.001229 0.004156* 0.001761
outputgap
LD. 0.0004428 0.0461601 0.0139169 0.0138363 0.0194731 0.019817
L2D. 0.2252622* 0.0453975 0.019194 0.0136078 0.0059408 0.0194897
L3D. 0.2257294* 0.0461543 0.0052617 0.0138346 0.0146374 0.0198146
L4D. 0.2179123* 0.0457086 0.0024562 0.013701 0.0064312 0.0196232
L5D. 0.0481685 0.0463383 0.0005457 0.0138897 0.0181602 0.0198936
L6D. 0.0096012 0.0461246 0.0070861 0.0138257 0.0029575 0.0198018
L7D. 0.0315779 0.0460403 0.0038071 0.0138004 0.0235741 0.0197656
L8D. 0.0182302 0.0461108 0.0146182 0.0138215 0.0310275 0.0197959
L9D. 0.0507555 0.0463052 0.02466 0.0138798 0.0474085* 0.0198794
L10D. 0.0047929 0.0467332 0.0218269 0.0140081 0.0428824* 0.0200631
L11D. 0.200257* 0.0465062 0.0123102 0.0139401 0.0143813* 0.0199656
L12D. 0.0307193 0.0471133 0.0004507 0.014122 0.0070492 0.0202263
L13D. 0.0744717 0.0466195 0.0030625 0.013974 0.0687411* 0.0200143
L14D. 0.0468905 0.0466304 0.0017823 0.0139773 0.0479245* 0.020019
lncpigap
LD. 0.3066209* 0.1509504 1.364838* 0.0452468 0.0484711 0.0648048
L2D. 0.0944542 0.2538275 0.245081* 0.0760839 0.1203321 0.1089711
L3D. 0.3508882 0.2481375 0.354565* 0.0743784 0.0808574 0.1065283
L4D. 0.1112562 0.2509561 0.295492* 0.0752232 0.0400467 0.1077383
L5D. 0.0680709 0.2532305 0.0044003 0.0759049 0.0301571 0.1087148
L6D. 0.1502606 0.25148 0.0429419 0.0753802 0.0085648 0.1079633
L7D. 0.1870514 0.2516023 0.0330034 0.0754169 0.0302436 0.1080158
L8D. 0.2557706 0.2517162 0.0221015 0.075451 0.018127 0.1080647
L9D. 0.0063131 0.2518521 0.1745143 0.0754918 0.1125914 0.108123
L10D. 0.2586975 0.2533968 0.184024* 0.0759548 0.1334692 0.1087862
L11D. 0.1166319 0.2521737 0.204968* 0.0755882 0.0587014 0.1082611
L12D. 0.1245815 0.2489999 0.0846675 0.0746368 0.2922387* 0.1068985
L13D. 0.1180583 0.248384 0.1253703 0.0744522 0.6770098* 0.1066341
L14D. 0.0136647 0.1515555 0.0493887 0.0454282 0.2924759* 0.0650645
lnexrate
LD. 0.0902884 0.0903256 0.083868* 0.0270748 1.727534* 0.0387778
L2D. 0.048078 0.1627934 0.1012481* 0.0487968 0.7407886* 0.0698891
L3D. 0.0610715 0.1675228 0.0243573 0.0502144 0.1960961* 0.0719195
L4D. 0.2128834 0.16877 0.002684 0.0505882 0.3465968* 0.0724549
L5D. 0.1665536 0.1729648 0.0084514 0.0518456 0.1700147* 0.0742558
L6D. 0.1345817 0.1741025 0.0012222 0.0521866 0.0263049 0.0747442
L7D. 0.059002 0.174036 0.0037518 0.0521667 0.0514662 0.0747157
L8D. 0.0064175 0.1738994 0.0002438 0.0521257 0.0212838 0.074657
L9D. 0.096362 0.1737825 0.0069796 0.0520907 0.0238786 0.0746069
L10D. 0.2223128 0.1727548 0.0040298 0.0517826 0.0569003 0.0741656
L11D. 0.2764972 0.1688563 0.0067368 0.0506141 0.0360825 0.072492
L12D. 0.2418982 0.1679954 0.1071597* 0.050356 0.6386904* 0.0721224
L13D. 0.1184403 0.1614668 0.210178* 0.0483991 1.125445* 0.0693196
L14D. 0.221387* 0.0851988 0.1114025* 0.025538 0.5007601* 0.0365768
Constant 0.0000706 0.0001277 0.000078* 0.0000383 0.0001625* 0.0000548
t t t
u exrate Outputgap + ln .0002907 .0005347
) .0015645 (

=
29

t t t
v exrate cpigap + = ln .0034326 .0110149 ln
) .0038596 (

Table 6 and 7 (*indicates significant at 5% level)
ErrorCorrectionModel outputgap Std.Err. inf_p Std.Err. lnM1 Std.Err.
CointEqL1 0.068071* 0.008095 0.0043092 0.002462 0.0098676 0.012934
CointEqL2 0.0322813 0.017558 0.034079* 0.005341 0.0187494 0.028055
outputgap
LD. 0.0978092* 0.041667 0.0052038 0.012674 0.0398508 0.066575
L2D. 0.3006567* 0.040903 0.005586 0.012442 0.048608 0.065356
L3D. 0.2577512* 0.041805 0.0034991 0.012716 0.0500838 0.066796
L4D. 0.2043017* 0.043113 0.003926 0.013114 0.0755099 0.068887
inf_p
LD. 0.3213128* 0.134801 0.8635073* 0.041004 0.5760874* 0.215387
L2D. 0.1730783 0.174695 0.0164015 0.053139 0.2898533 0.27913
L3D. 0.479714* 0.17474 0.379954* 0.053153 0.2193425 0.279202
L4D. 0.0142227 0.139041 0.343214* 0.042294 0.2297226 0.222162
lnM1
LD. 0.0430517 0.027297 0.007424 0.008303 0.595316* 0.043615
L2D. 0.058132 0.031831 0.0000635 0.009683 0.5417034* 0.05086
L3D. 0.0301438 0.031867 0.0103414 0.009693 0.0761403 0.050917
L4D. 0.0482179 0.027249 0.0070098 0.008289 0.176081* 0.04354
Constant 0.0001867 0.000289 0.000428* 0.000088 0.0011006* 0.000463
t t t
u M Outputgap + 1 ln .0004878 .0155287
) .0008022 (

=
t t t
v M Inflation + = 1 ln .0002225 .0251654
) .0004683 (

Table 7
ErrorCorrectionModel outputgap Std.Err. lncpigap Std.Err. lnM1 Std.Err.
CointEqL1 0.0453553* 0.008184 0.0010217 0.002726 0.0098974 0.012602
CointEqL2 0.0021796 0.002955 0.005910* 0.000984 0.0068175 0.00455
outputgap
LD. 0.23711578* 0.039961 0.0067142 0.013311 0.0489631 0.061535
L2D. 0.3984313* 0.040283 0.0076786 0.013418 0.0337607 0.062031
lncpigap
LD. 0.2717512* 0.104922 1.562124* 0.034949 0.500468* 0.161565
L2D. 0.2308519* 0.105932 0.600547* 0.035286 0.542414* 0.163121
lnM1
LD. 0.0258648 0.0266 0.0023405 0.00886 0.558805* 0.04096
L2D. 0.0253268 0.026634 0.0096432 0.008872 0.3582568* 0.041013
Constant 0.000077 0.000283 0.0004941* 9.42E05 0.0004037 0.000435
t t t
u M Outputgap + 1 ln .0007383 .0155287
) .0012763 (

=
t t t
v M cpigap + + = 1 ln .0000877 .0708611 ln
) .0031065 (

30

Table 8 (*indicates significant at 5% level)
ErrorCorrectionModel outputgap Std.Err. inf_p Std.Err. lnM2 Std.Err.
CointEqL1 0.0688812 0.008081 0.0039821 0.002451 0.010892 0.011962
CointEqL2 0.032835 0.017499 0.034012* 0.005306 0.0172011 0.025901
outputgap
LD. 0.0922925* 0.041513 0.0068726 0.012589 0.1194331 0.061448
L2D. 0.2943156* 0.040809 0.005627 0.012375 0.0363365 0.060405
L3D. 0.2613361* 0.041748 0.0015471 0.01266 0.0891757 0.061796
L4D. 0.2105296* 0.043152 0.000832 0.013086 0.0453423 0.063874
inf_p
LD. 0.3055176* 0.135477 0.8674858* 0.041083 0.5964458* 0.200533
L2D. 0.1105788 0.175206 0.0124779 0.053131 0.1377498 0.25934
L3D. 0.460945* 0.173752 0.381033* 0.05269 0.3382699 0.257188
L4D. 0.0073027 0.138574 0.3483683* 0.042022 0.3447581 0.205117
lnM2
LD. 0.0537351 0.029628 0.0026354 0.008985 0.4036647* 0.043855
L2D. 0.0238608 0.031488 0.015794 0.009549 0.4540262* 0.046608
L3D. 0.0049689 0.031614 0.0199181* 0.009587 0.199768* 0.046796
L4D. 0.070030* 0.029547 0.0091888 0.00896 0.169188* 0.043736
Constant 0.0001911 0.000308 0.000360* 9.35E05 0.0010768* 0.000456
Co-Integration Relation 1: Outputgap
t t t t
u M Inflation + + 2 ln .0005292 19 - 8.67e .0155394
) .0007625 (

=
t t t
v M Inflation + = 2 ln .0002871 .0261807
) .0004519 (

Table 9
ErrorCorrectionModel outputgap Std.Err. lncpigap Std.Err. lnM2 Std.Err.
CointEqL1 0.0709252* 0.008291 0.0020696 0.002925 0.0042083 0.012182
CointEqL2 0.0003227 0.002988 0.006466* 0.001054 0.0111717* 0.004391
outputgap
LD. 0.0908795* 0.041231 0.002433 0.014546 0.1068748 0.060583
L2D. 0.2915418* 0.040769 0.0046591 0.014383 0.0355944 0.059905
L3D. 0.25588078* 0.041544 0.0048534 0.014656 0.0705642 0.061043
L4D. 0.2072057* 0.042772 0.0121193 0.01509 0.013269 0.062848
lncpigap
LD. 0.3685156* 0.124206 1.554256* 0.043819 0.6706905* 0.182504
L2D. 0.2714137 0.228247 0.481201* 0.080524 0.797195* 0.335379
L3D. 0.4779294* 0.228232 0.259423* 0.080519 0.1604539 0.335356
L4D. 0.4332863* 0.125284 0.1545704* 0.044199 0.0867779 0.184088
lnM2
LD. 0.0573918 0.029961 0.0081067 0.01057 0.386699* 0.044023
L2D. 0.0299615 0.031539 0.0109285 0.011127 0.4429003* 0.046342
L3D. 0.0078675 0.03156 0.0134699 0.011134 0.2071336* 0.046373
L4D. 0.072725* 0.029684 0.0180811 0.010472 0.150825* 0.043617
Constant 3.22E06 0.000323 0.0006241* 0.000114 0.0003612 0.000474
t t t t
u M Inflation Outputgap + + = 2 ln .0005418 17 - 1.39e .0113925
) .0007455 (

31

t t t
v M cpigap + = 2 ln .0003401 .0748676 ln
) .0025908 (

32

Table 10 (*indicates significant at 5% level)
ErrorCorrectionModel outputgap Std.Err. inf_p Std.Err. lnG Std.Err.
CointEqL1 0.069146* 0.008211 0.0035731 0.002483 0.0178398 0.014537
CointEqL2 0.032905 0.017538 0.033878* 0.005304 0.0417383 0.03105
outputgap
LD. 0.0974579* 0.041729 0.0071764 0.012621 0.0090474 0.07388
L2D. 0.3006641* 0.040971 0.0049756 0.012391 0.0403347 0.072538
L3D. 0.2587285* 0.041978 0.004853 0.012696 0.0326326 0.074321
L4D. 0.205896* 0.043236 0.0016642 0.013077 0.022656 0.076548
inf_p
LD. 0.3287777* 0.138423 0.8733982* 0.041866 0.5690242* 0.245076
L2D. 0.1558593 0.180021 0.0039246 0.054447 0.2061671 0.318724
L3D. 0.465105* 0.179823 0.375363* 0.054387 1.127095* 0.318373
L4D. 0.0404012 0.140676 0.3468233* 0.042547 0.76959* 0.249064
lnG
LD. 0.0140836 0.025172 0.0124245 0.007613 0.8869434* 0.044566
L2D. 0.0269724 0.032606 0.0125029 0.009862 0.4790064* 0.057729
L3D. 0.0128785 0.032562 0.0015882 0.009848 0.356864* 0.057651
L4D. 0.0165379 0.02491 0.0070321 0.007534 0.128250* 0.044103
Constant 0.0000714 0.000157 0.000217* 4.74E05 0.0002331 0.000278
Co-Integration Relation 1: Outputgap
t t t
u Gov + exp ln .0010564 .0265869
) .0020823 (

=
t t t
v Gov Inflation + = exp ln .0008144 .0325701
) .0012476 (

Table 11
ErrorCorrectionModel outputgap Std.Err. lncpigap Std.Err. lnG Std.Err.
CointEqL1 0.071457* 0.008416 0.0019136 0.00296 0.0138235 0.01502
CointEqL2 0.0021775 0.002983 0.006463* 0.001049 0.0050388 0.005323
outputgap
LD. 0.0980758* 0.041498 0.0036158 0.014594 0.032664 0.074056
L2D. 0.2985401* 0.040988 0.0049415 0.014415 0.0451455 0.073146
L3D. 0.2537974* 0.041832 0.0018088 0.014711 0.0144011 0.074651
L4D. 0.2026552* 0.042946 0.0111822 0.015103 0.0515478 0.07664
lncpigap
LD. 0.3973284* 0.127136 1.55616* 0.044711 0.3095867 0.226881
L2D. 0.2536009 0.233793 0.481557* 0.08222 0.0074235 0.417214
L3D. 0.518293* 0.233807 0.258519* 0.082225 0.945942* 0.41724
L4D. 0.4183146* 0.127852 0.1532912* 0.044963 0.6360897* 0.228158
lnG
LD. 0.0123777 0.025091 0.0048217 0.008824 0.8889902* 0.044776
L2D. 0.0244275 0.032284 0.0096262 0.011353 0.4845644* 0.057612
L3D. 0.009806 0.032245 0.0064919 0.01134 0.366772* 0.057542
L4D. 0.0134964 0.02485 0.0020964 0.008739 0.121547* 0.044347
Constant 0.0000626 0.000143 0.000208* 5.02E05 0.0002949 0.000255

t t t
u Gov Outputgap + exp ln .0010752 .025022
) .0020329 (

=
t t t
v Gov cpigap + = exp ln .0028092 .1004942 ln
) .0078442 (

33

8. Description of Variables

VariableName
Variable
Symbol
Inflation inf_p
Exchange Rate lnexrate
Discount rate mmi
Real GDP Y
Broad Money M2
Narrow Money M1
Output Gap outputgap
CPI gap lncpigap
Government Expenditure G

Note: In the graphs lnexrate refers to natural logarithm of monthly exchange rate (Rupee/US$)

34

9. Impulse Response Function (IRF) and Important Graphs
2
4
.
5
2
5
2
5
.
5
2
6
2
6
.
5
2
7
1965m1 1970m1 1975m1 1980m1 1985m1 1990m1 1995m1 2000m1 2005m1
time
lngdp_trcyc tr_ln_gdp
-
.
0
4
-
.
0
2
0
.
0
2
.
0
4
.
0
6
o
u
t
p
u
t
g
a
p
1965m1 1970m1 1975m1 1980m1 1985m1 1990m1 1995m1 2000m1 2005m1
time

-
1
0
1
2
3
1965m1 1970m1 1975m1 1980m1 1985m1 1990m1 1995m1 2000m1 2005m1
time
lncpi_trcyc tr_ln_cpi

35

-
.
1
5
-
.
1
-
.
0
5
0
.
0
5
.
1
l
n
c
p
i
g
a
p
1965m1 1970m1 1975m1 1980m1 1985m1 1990m1 1995m1 2000m1 2005m1
time

-.2
0
.2
.4
0 50
step
irf
a: mmi -> inf_p
-.5
0
.5
0 50
step
irf
a: mmi -> outputgap
-1
0
1
2
3
0 50
step
irf
a: inf_p -> outputgap
-.4
-.2
0
.2
0 50
step
irf
a: outputgap -> inf_p

0
.5
1
0 50
step
irf
a11: lnexrate -> inf_p
-.5
0
.5
0 50
step
irf
a11: lnexrate -> outputgap
-2
0
2
4
0 50
step
irf
a11: inf_p -> outputgap
-.4
-.2
0
.2
.4
0 50
step
irf
a11: outputgap -> inf_p

-.1
-.05
0
.05
0 50
step
irf
a1: lnM1 -> inf_p
-.06
-.04
-.02
0
.02
0 50
step
irf
a1: lnM1 -> outputgap
-.5
0
.5
1
0 50
step
irf
-.2
-.1
0
.1
0 50
step
irf

-.15
-.1
-.05
0
.05
0 50
step
irf
a: lnM2 -> inf_p
-.2
-.1
0
.1
.2
0 50
step
irf
a: lnM2 -> outputgap
-.5
0
.5
1
0 50
step
irf
a: inf_p -> outputgap
-.2
-.1
0
.1
0 50
step
irf
a: outputgap -> inf_p

-.15
-.1
-.05
0
.05
0 50
step
irf
a1111: lnG -> inf_p
-.1
-.05
0
.05
.1
0 50
step
irf
a1111: lnG -> outputgap
-.5
0
.5
1
0 50
step
irf
-.2
-.1
0
.1
0 50
step
irf

-1
0
1
2
3
0 50
step
irf
b11: mmi -> lncpigap
-.5
0
.5
0 50
step
irf
b11: mmi -> outputgap
-1
0
1
2
0 50
step
irf
b11: lncpigap -> outputgap
-2
-1
0
1
0 50
step
irf
b11: outputgap -> lncpigap

-2
0
2
0 50
step
irf
b: lnexrate -> lncpigap
-1
-.5
0
.5
0 50
step
irf
b: lnexrate -> outputgap
-2
-1
0
1
2
0 50
step
irf
b: lncpigap -> outputgap
-2
-1
0
1
2
0 50
step
irf
b: outputgap -> lncpigap

-.6
-.4
-.2
0
.2
0 50
step
irf
aaa: lnM1 -> lncpigap
-.06
-.04
-.02
0
.02
0 50
step
irf
aaa: lnM1 -> outputgap
-1
0
1
2
0 50
step
irf
aaa: lncpigap -> outputgap
-.6
-.4
-.2
0
.2
0 50
step
irf
aaa: outputgap -> lncpigap

36

-.6
-.4
-.2
0
.2
0 50
step
irf
b1: lnG -> lncpigap
-.1
-.05
0
.05
.1
0 50
step
irf
b1: lnG -> outputgap
-1
-.5
0
.5
1
0 50
step
irf
b1: lncpigap -> outputgap
-1
-.5
0
.5
0 50
step
irf
b1: outputgap -> lncpigap

-.6
-.4
-.2
0
.2
0 50
step
irf
aa: lnM2 -> lncpigap
-.2
-.1
0
.1
.2
0 50
step
irf
aa: lnM2 -> outputgap
-1
-.5
0
.5
1
0 50
step
irf
aa: lncpigap -> outputgap
-1
-.5
0
.5
0 50
step
irf
aa: outputgap -> lncpigap

37

2 A2658 D8 D 01

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Monetary Policy Channels of Pakistan

and Their Impact on Real GDP and

Dependent Variables Change in Y Change in Y % change in Y % change in Y

0 Change in Exchange Rate .072

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