Monetary Policy in Pakistan: Role of Inflationary Expectations, Credit Frictions and Exchange Market Interventions

Monetary policy in Pakistan is currently operating in an environment in which fiscal deficits and government debt are increasing, the government is continuously borrowing from State Bank of Pakistan, and there is concern that inflation and debt growth would not be controlled. To explore feasible monetary policy options in such an environment, the paper uses a DSGE model that allows for imperfect credibility, and distinguishes between two regimes that are relevant for Pakistan: weak monetary independence (fiscal policy determines the inflation target, but undertakes fiscal measures to stabilize government debt) and fiscal dominance (monetary policy is constrained to use interest rates to stabilize both inflation and government debt). In the weak monetary independence regime, imperfect credibility amplifies the inflation response to different shocks and leads to greater variability of Inflation. However, increased inflation variability is not too large if monetary policy pursues a sufficiently strong anti-inflation policy. Inflationary consequences of fiscal dominance are much more serious. Shocks, such as an increase in government expenditures, lead to much larger inflation rates under fiscal dominance even if there is full credibility. Inflation is much more variable under fiscal dominance. An important implication of our analysis is that inflation volatility can be avoided if fiscal authority takes the responsibility for