A Dynamic Stochastic General Equilibrium Model for Pakistan: Methodology for Calibration, Operation and Forecasting

A small-scale DSGE model for Pakistan is developed to analyse monetary policy in Pakistan. The model includes a financial sector and distinguishes between high-income households who participate in the financial sector and low-income households who face borrowing constraints. In evaluating different monetary policy options, the model takes into account the constraint that the State Bank has to satisfy the long-term borrowing needs of the government, and thus cannot independently determine the long-run rate of inflation. The baseline model assumes that fiscal policy adjusts primary budget surplus to stabilize government debt to GDP ratio around a feasible target level. This model is used to examine macroeconomic adjustment to various shocks and to compare the macroeconomic performance of alternative monetary policy rules. In this regime, monetary policy can play an important role in stabilizing inflation and output. The paper also considers an alternative policy regime in which fiscal policy does not attempt to stabilize government debt. In this case, monetary policy is constrained further by the need to use interest rates to control the growth of government debt. Feasible monetary rules under this constraint are found to produce much larger variability in inflation.