Articles on the Economy-Transmission Mechanism of Monetary Policy

Introduction to Transmission Mechanisms:

Monetary policy serves as a compass for a nation’s economic trajectory, influencing key indicators such as inflation, employment, and economic growth. The State Bank of Pakistan (SBP) wields monetary policy as a tool to maintain stability and foster sustainable economic development. In this article, we will explore the transmission mechanisms through which the SBP’s monetary policy ripples through the economy, impacting various sectors and facets of Pakistan’s financial landscape.

Interest Rates as the Vanguard:

At the forefront of the SBP’s monetary policy arsenal is the manipulation of interest rates. The central bank’s decisions regarding the policy rate, such as the key policy rate or the discount rate, set the tone for the overall interest rate environment in the economy. By adjusting these rates, the SBP seeks to influence borrowing costs for businesses and consumers. The State Bank of Pakistan provides funds to the banking system by charging a three-day reverse repo rate (also known as the policy rate or discount rate), which is the rate at which banks in Pakistan borrow from the SBP on an overnight basis. This rate was recently revised and increased from 9.5 percent to 10.0 percent to control inflation in the medium term.

Credit Channel: 

A crucial transmission mechanism is the credit channel, through which changes in interest rates affect borrowing and lending activities. When the SBP adjusts interest rates, it directly impacts the cost of credit. Lower interest rates encourage borrowing for investment and consumption, stimulating economic activity. Conversely, higher interest rates can cool down an overheating economy and curb inflationary pressures. Changes in official interest rates have an immediate impact on money-market interest rates and, indirectly, lending and deposit rates set by banks for their customers. Several studies revealed that lending rates on new loans are more sensitive to changes in money market rates than lending rates on outstanding loans. A 100 basis point change in KIBOR of different tenors results in a 91 to 96 basis point change in the lending rate on new loans. In terms of time, the full impact takes two to three months. In comparison to lending rates, the pass-through of changes in money market rates to deposit rates is not only slow but also incomplete. Due to a 100 basis point change in money market rates, the response of returns on new deposits is limited to only 60 basis points. Furthermore, it takes two to six months to see this impact.

Exchange Rate Dynamics:

The exchange rate mechanism plays a pivotal role in the transmission of monetary policy. Pakistan’s economy, being open, is sensitive to changes in exchange rates. The SBP may use monetary tools to influence the exchange rate, affecting exports, imports, and the overall balance of payments. A depreciation of the currency can boost exports but may contribute to inflationary pressures.

Asset Prices and Wealth Effects:

Changes in interest rates influence asset prices, including stocks and real estate. As interest rates decrease, the appeal of income-generating assets like stocks may rise, leading to increased demand. This, in turn, can contribute to a “wealth effect,” where individuals feel wealthier due to the appreciation of their assets, leading to increased spending.

Inflation Expectations: 

Managing inflation expectations is a crucial aspect of the SBP’s monetary policy. By signaling its commitment to price stability, the central bank aims to anchor inflation expectations. When individuals and businesses anticipate stable prices, it contributes to economic stability by influencing spending and investment decisions.

Banking Sector and Money Supply:

The transmission mechanism also operates through the banking sector. Changes in interest rates influence the cost of funds for banks, affecting their lending and deposit rates. Additionally, the SBP regulates the money supply through open market operations, influencing liquidity conditions in the banking system. 

Government Securities Market:

The SBP uses open market operations to buy or sell government securities, influencing the supply of money in the economy. This, in turn, affects interest rates and liquidity conditions. By managing the government securities market, the central bank can influence short-term interest rates.

Conclusion:

Understanding the transmission mechanisms of monetary policy is paramount for policymakers, economists, and market participants alike. The State Bank of Pakistan, as the steward of the country’s monetary policy, carefully navigates these mechanisms to achieve its objectives of price stability, sustainable economic growth, and financial stability. As global and domestic economic landscapes evolve, the effectiveness of these transmission channels remains a dynamic and intricate subject, highlighting the ongoing importance of monetary policy in shaping the economic destiny of Pakistan.

The empirical findings show that the Phillips curve is valid in Pakistan (A.W Philips initiated the idea of a trade-off between inflation and unemployment and showed evidence of a negative relationship between the unemployment rate and the changes in nominal wages for British data). The structure of the reduced-form Phillips curve reveals that expected inflation is significant for all periods. Current unemployment exceeds lag unemployment, implying that unemployment has been increasing at an increasing rate, causing a significant change in current inflation.

According to one study, the employment elasticity in Pakistan is 0.5 percent, and labor force growth is 3.5 percent, implying that we need at least a 7 percent increase in GDP to absorb this much labor force.