Articles on the Economy-Transmission Mechanism of Monetary Policy

Transmission Mechanism of Monetary Policy

Any country’s central bank provides funds to the banking system and charges interest. Given its monopoly on money creation, the central bank has complete control over the interest rate. 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 overnight basis. This rate was recently revised and increased from 9.5 percent to 10.0 percent in order to control inflation in the medium term.

According to the SBP policy document, inflation expectations are around the medium-term targets of 9.5 percent for 2013 and 8 percent for FY14, as envisaged in the government’s Medium Term Budgetary Framework (MTBF). Year-on-year CPI inflation was 10.8 percent in March 2012, and given current economic conditions, it is expected to remain in the double digits during FY13. In this article, we will look at how other variables change as policy rates change.

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 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.

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.