Abstract
This study uses vector autoregressive approach to estimate the relative importance of credit and interest rate channels in the monetary transmission mechanism of Pakistan by covering the period from 1991-Q3 to 2012-Q2. The purpose of the study is to explore the role played by monetary policy shocksin economic fluctuations. The results based on variance decomposition analysis and impulse response function demonstrate that for the combine sample period covering from 1991-Q3 to 2012-Q2 both the credit and interest rate channels seem inef ective and it was dif icult to distinguish which channel is more important during this period in Pakistan's case. The sample period was then divided into two subsample periods and both the channels were observed in two subsample periods. However, credit channel was dominant in the first sample covering 1991-Q3 to 2000-Q4 and interest rate channel performs a much greater role in transmitting policy shocks in the second sample period of 2001-Q1 to 2012- Q2. Hence, it is concluded that the role of both transmission channels changed during the last two decades. The role of the credit channel in transmitting monetary shocks has considerably weakened since the early 2000s, whereas interest rate channel is more important during this period. These results have important implications for policy design, supporting a greater emphasis on financial prices than the quantity of credit in order to accomplish the targets of monetary policy in Pakistan.
Highlights
Effective monetary policy is considered a strong tool for the stabilizing economy
This study utilizes VAR approach based on variance decomposition analysis and impulse response function to examine the effect of credit channel and interest rate channel on key economic variables i.e. output and inflation
This study attempted to estimate the relative importance of credit cannel and interest rate channel in the monetary transmission mechanism of Pakistan by covering the period from 1991:Q3 to 2010:Q2
Summary
Effective monetary policy is considered a strong tool for the stabilizing economy. Through monetary policy central bank influences the amount of lending and interest rate in the economy. The main intention of any country's monetary policy is to ensure stable prices and real income growth. From academic literature it is identified that monetary policy tends to change the real economic activities and the prices through transmission mechanisms. Monetary transmission mechanism is closely related to how adjustments in monetary policy variables impinge on real income (output) and prices (Taylor, 1995). The monetary transmission mechanism labeled the way in which the monetary policy impacts the cumulative demand and prices by manipulating the consumption and investment of the organizations, household and financial mediators. Transmission mechanisms are the key factors for monetary policy to recognize the direction of the real economy as well as to know the future prices (see Jiménez & Ongena, 2012; Ascarya, 2012).
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