Real interest rate volatility in the Pakistani economy: A regime switching approach

Fahad Javed Malik,Mohammed Nishat

doi:10.54784/1990-6587.1041

Abstract

This paper assesses the volatility of short term real interest rates in Pakistan using the Markov switching model and drawing on monthly data from January 1964 to March 2016. This model holds that if a random walk pattern is not visible in the real interest rate series, fluctuations are temporary and the interest rate will eventually converge around the mean value. The results reveal that real interest rates in Pakistan have exhibited high volatility since 1973 due to high budget deficits and other sources of instability in the economy.

Highlights

Interest rate is one of the most important policy variables, which is directly related to economic growth
The analysis investigated that stabilization of interest rate, output and price level due to demand shocks is not possible, in case of supply shocks output can be steadied by taking into account unanticipated interest rate fluctuations
If the random walk pattern is not visible in real interest rate series, fluctuation in the series is temporary and eventually it will be restored around the mean value

Summary

Introduction

Interest rate is one of the most important policy variables, which is directly related to economic growth. The central bank uses the Taylor’s rule to determine the short term interest rate in response to changes in inflation, output and other economic conditions This is translated into the long term interest rate which influences the investment and saving decisions in the economy. Pakistan has been highly vulnerable to changing policies throughout its existence due to frequently changing governments and varying economic agendas This has resulted in increased domestic and external borrowing and significant budget deficits prevalent in most developing countries as identified by Fry (1998). This study uses the most popular non-linear time series model known as Markov Switching model of Hamilton (1989) to assess interest rate volatility This model involves multiple structures that can characterize the time series behavior of different regimes of real interest rate in contrast to linear models.

Literature review

Econometric methodology and data

Model specification and econometric methodology

Empirical results

Conclusion