Inflation targeting and exchange rate pass through in Pakistan: Markov switching approach

Safia Minhaj,Muhammad Nishat

doi:10.54784/1990-6587.1028

Abstract

This study uses Markov switching model to empirically track the existence of exchange rate pass through and inflation trends in Pakistan from 1982 to 2016. The results reveal a direct relationship between pass through and inflation. Furthermore, interest rate and trade variables have a significant impact on inflation. According to the smoothed probabilities, switches between regimes were sudden and sporadic till 1990, after which long spells were observed during high and low inflation regimes.

Highlights

For most developing countries, relative price stability for long durations has become a significant challenge of great socio-economic importance
This paper further evaluates the impact of pass through of exchange rate (ERPT) on inflation before and after inflation targeting regimes
The main objective of this paper is to investigate the relationship between inflation targeting and exchange rate pass through effect in Pakistan

Summary

Introduction

Relative price stability for long durations has become a significant challenge of great socio-economic importance. A major cause of inflation regime fluctuation is the liberalization of financial markets and modifications in stabilization policies. Following the mid-1990s exchange rate crisis, Pakistan adopted rupee convertibility in 1993 and opened its domestic market to global financial flows with greater exchange rate flexibility. Policy-makers in Pakistan started targeting inflation with flexible exchange rate to benefit more from financial liberalization. This created a challenging situation for SBP because of heavy fiscal dominancy, lack of institutional credibility and extraordinary impact of exchange rate change on domestic inflation, a phenomenon that had already been observed in other economies (Nogueira and Reginaldo (2007)). This study is an attempt to find the evidence of exchange rate pass through (ERPT) in different regimes of inflation that is with and without inflation targeting during managed floating and free floating exchange rates in Pakistan

Objectives

Findings

Discussion

Conclusion