Sample Mid Questions:

why it is difficult to control inflation in Pakistan?

why monetary management in Pakistan is a challenging task?
Is inflation good for economy like Pakistan?
What are the main challenges for policy makers in Pakistan?
Is SBP an independent central bank?
Suggest few policy measures to Governor SBP for controlling inflation?

RANDOM INFORMATION:

WHAT IS INFLATION? DISCUSS ITS TYPES, CAUSES, MEASURES AND

EFFECTS.
Introduction:
Collective increase in the supply of money, in money incomes, or in prices refers to
inflation. Inflation is generally thought of as an undue rise in the general level of prices.
Definition:
Inflation is a situation whereby there is a continuous and persistent rise in the general price
level.
According to Meyer:
An increase in the prices that occurs after full employment has been attained.
Situation in Pakistan:
Today, inflation is one of the serious problems faced by Pakistan. Rate of inflation in
Pakistan is very high. According to economic survey 2009-10, its rate is 13.3 %, while it was
22.3 % in last fiscal year. According to ESP 2011-12, rate of inflation (CPI) is 10.8%.
Explanation:
All above definitions are showing that inflation is a condition in which prices rise and
money value decreases. Due to inflation the real value of money i. e., the purchasing power
decreases.
TYPES OF INFLATION:
Following are the main types of inflation, which are different from one another due to
their causes:
1)

Demand Pull Inflation

This is demand side inflation. It simply means that when there is an increase in aggregate
demand. Without any corresponding increase in aggregate supply the price level will rise.

2)

Cost Push Inflation

It is supply side inflation. If there is increase in prices it will results in fall in aggregate
supply. It is the reason of increase in cost of production.

3)

Structural Inflation

Sometimes prices rise in an expanding economy because the supply cannot keep up with
rising demand because of structural inflexibilities. This is also called the Structuralist
Argument for inflation.
4)

Imported Inflation
In such inflation local governments are helpless; it is due to an increase in the prices of
imported goods. To control it government may bans the imported items.

5)

Open Inflation
If there is no control over rise in prices, it will be determined by free forces of demand
and supply.

6)

Suppressed Inflation
If prices are subject to governmental control then their increase is made by the
government action.

7)

Ex-ante & Ex-post Inflation

Ex-ante inflation is the expected inflation and ex-post is the actual inflation. For example,
if people of Pakistan expect an inflation rate of 10% it will Ex-ante inflation but actual
inflation is 7 % it will be ex-post.

8)

Anticipated Inflation
If the actual rate of inflation is perfectly in accordance with the peoples expectations it is
called anticipated inflation.

9)

Unanticipated Inflation
If the actual rate of inflation is not according to the peoples expectations, it is called
unanticipated inflation.

10) Profit Inflation

Profit inflation is the result of the greed of businessmen. It usually occurs in such
economy, which are dominated by monopolies.
11) Deficit Inflation
Government has to borrow form banks and non-bank & internal and external resources in
case of deficit financing. It also caused inflation named as deficit inflation.
12) Devaluation Inflation
Devaluation also leads to inflation. Devaluation decreases the purchasing power of our
currency that results in inflation.
13) Ceiling Inflation

Inflation that occurs due to various prices ceiling enforced by government. Price ceiling
are set by government to maintain prices of certain essential goods at a determined level.
14) Income Inflation
If there is an increase in income of the people, it will increase the money supply in the
country that leads to income inflation.
DEGREES OF INFLATION:
Inflation contains the following degrees:
1)

Moderate Inflation
When the rate of inflation is very low, say in the range of 1% to 20%, it is moderate
inflation.

If its rate is less than 5 %, then it is creeping inflation.

If its rate is more than 5 %, then it is called trotting inflation.

2)

Galloping Inflation
When the rate of inflation exceeds 20 % it is called galloping inflation. The upper limit of
galloping inflation may roughly be defined as 1000 %.

3)

Hyper Inflation
If the rate of inflation is above 1000 %, it can be termed as hyper-inflation.
CAUSES OF INFLATION IN PAKISTAN
Causes of inflation are of two types:
A. INCREASE IN DEMAND:

1)

Increase in Money Supply

The major cause of increase in the price level is an increase in money supply. It may
be due to increase in currency or credit money. Increase in the stock of money induces people
to demand more and more of goods and services.

2)

Increase in Velocity of Money

According to the Fishers Quantity Theory of Money, if there is an increase in the
velocity of circulation of money it also leads to inflation.

3)

More Investment
Investments also play an important role in producing inflation. At the moment of
investment the economys stock of wealth and money expands and it result is in inflation.
4)

Non-productive Expenditures

Government of Pakistan has to make a lot of non-productive expenditures like

defence etc. Such unproductive expenditures lead to the wastage of economys precious
resources and also lead to inflation.
5)

Corruption & Black Money

Corruption and black money leads to increase in aggregate demand, which is cause of
inflation. These evils increase aggregate demand and import volume.

6)

Deficit Financing
Deficit financing is another cause of inflation. It increases the money supply and leads
to inflation.

7)

Foreign Remittances
Increase in foreign remittances is increasing the money supply in our country.
Increase in money supply leads to inflation.

8)

Foreign Aids
Foreign aids are also a source of mobilization of resources form rich countries to poor
countries. It is also a cause of inflation in Pakistan.

9)

Consumption Trends
Due to demonstration effect people of our country want to copy the styles of people of
rich countries. In this way there is an increase in consumption trends that leads to inflation.

10) Population Bomb

Population of Pakistan is increasing day by day. Increasing population is demanding
more and it creates inflation.
B. DECREASE IN SUPPLY:
11) Slow Agricultural Development
Low growth rate of agricultural sector caused in shortage of productivity. It results in
low supply and increase in price level.
12) Slow Industrial Growth
Our industrial sector is not at developed form due to use of backward techniques of
production. Its less production also creates shortage in market and caused in inflation.
13) Increase in Wages & Salaries
Now labour is demanding more wages and salaries. Increase in wages and salaries
leads to increase in cost that increases the prices. On the other hand due to more wages and
salaries there is an increase in income and it caused in inflation.

14) Increase in Prices of Imports

Increase in the prices of imports also leads to creation of inflation. If there is an
increase in the prices of oil and other imported raw material then it will cause to reduction in
supply.
15) Devaluation
The value of our currency is decreased due to devaluation. It makes imported goods
more expensive and it leads to shortage of supply.
16) Indirect Taxes
The imposition of indirect taxes is a reason for increase in prices. Sometimes
government imposes taxes on some particular commodities. In this case producer may start to
decline the production of those goods.
MEASURES TO CONTROL THE INFLATION
Following measures are suggested to control high inflation:
1)

Increase in the growth rate of output

2)

Government should control the supply of money through effective monetary policy

3)

Highly increasing unproductive expenditures must be control

4)

Government should check the corruption first to eliminate the inflation

5)

Control on population is also necessary to control inflation

6)

Reduction in budget surplus

7)

Reduction in monetary expansion

8)

Effective tax system will be helpful to control the inflation

9)

Improvement in balance of payment

10) Developments of agricultural and industrial sector will helps to control the inflation.
EFFECTS OF INFLATION
Following are GOOD EFFECTS of inflation, if rate is 2% to 4%:
1)

There is increase in production due to inflation.

2)

Inflation increases the employment opportunities in the country.

3)

Inflation enhances the process of economic development.

4)

There is more investment in country at the time of inflation.

5) Inflation increases the economic activities that may cause to inventions and innovations.
6)

Profit of the producers also increases when there is normal inflation.

Following are the BAD EFFECTS of inflation:

1)

It is a huge problem for employees, taking fixed salaries.

2)

It generates unfair distribution of income and wealth.

3)

Inflation reduces the saving of the population.

4)

It is a cause of unfavorable balance of trade and payment.

5)

Inflation increases the rate of interest .

6)

It creates a lot of social evils.

7)

It is difficult for consumers to purchases more goods.

8)

It generates very bad effects on the poor labour force.

9)

Inflation reduces the living standard and purchasing power of people.

10) It is harmful for creditors .

11) Inflation reduces the purchasing power .
Conclusion:
Inflation is everywhere in an economy. Its rate is high in developing countries and is
low in poor developed counties. Effective operation of monetary and fiscal policy is essential
to control the inflation.

The effectiveness of monetary policy in Pakistan

ARTICLE (December 09 2008): Alongside is the text of the speech of the Governor, State Bank of
Pakistan, at the Institute of Business Management on December 6. Economic policies aim to increase the
welfare of the general public, and monetary policy supports this broad objective by focusing its efforts to
promote price stability. Embedded in this objective is the belief that persistent inflation would
compromise the long term economic prospects of the country.
The objective of monetary policy in Pakistan, as laid down in the SBP Act of 1956, is to achieve the
targets of inflation and growth set annually by the government. In pursuit of this mandate, SBP formulates
the country's monetary policy that is consistent with these announced targets. In my remarks today, I plan
to provide perspective on:
First, why central banks focus on price stability?
Second, how the monetary policy transmission mechanisms work?
Third, what are the principal features of Pakistan's monetary policy framework?

 Fourth, selected thoughts on effectiveness of Pakistan's monetary policy framework

Finally, what measures are needed to improve the effectiveness of the monetary policy framework in
Pakistan?
These questions have been a subject of much debate lately, as monetary tightening - an inevitable policy
response for regaining macroeconomic stability - has aroused anxiety but better public understanding of
this question will help them to appreciate central bank's monetary policy stance.
WHY FOCUS ON PRICE STABILITY?
Before getting into other intricacies of monetary policy, it is useful to bring forth the importance of price
stability as an overriding objective of monetary policy. Actual inflation outcome in the economy is driven
largely by the level of output gap (the difference between what the economy is demanding and what it can
potentially produce) and inflation expectations.
When the output gap widens, the actual output is more than what the economy can sustain in the long run
with stable inflation. This reflects excessive demand for available resources in the economy, which pushes
up general prices. In order to stem the increase in resource cost and the general price level in the
economy, this gap needs to be narrowed or stabilised.
This can be achieved by either reducing the demand in the short run or increasing the productive capacity
over the medium to long run. Reducing aggregate demand, however, entails reduction in current output
and an increase in the unemployment level in the economy. The famous classical Phillips curve that
captures the trade-off between stabilising inflation and controlling unemployment was criticised by
Phelps and Friedman in the late 1960s.
They argued that if inflation expectations react to changes in actual inflation, then any trade-off between
inflation and unemployment would be short-lived at best. If wages are set once a year and for some
reason the output prices increase, then the producers have an incentive to increase their output by hiring
more workers.
However it is only possible if workers' expectations of inflation remain Unchanged during the period of
increase in output prices. If workers adjust their expectations in accordance with actual inflation and
demand higher nominal wages, it leaves relatively little incentive for firms to increase the output.
Therefore the focus has shifted away from this trade-off and new consensus has emerged in the literature
that price stability is key to long run growth prospects. Both theory and evidence suggest that monetary
stimulus can only affect real economic activity in the short-run.
In the long run, however, there is no conflict between low inflation and full utilisation of economic
resources. Ensuring price stability, in turn, requires effective management and anchoring of inflation
expectations. With stable prices, economic decisions can be made with less uncertainty and therefore

markets can function without concern about unpredictable fluctuations in the purchasing power of money.
On the other hand, high and unanticipated inflation lowers the quality of the signals coming from the
price system as producers and consumers find it difficult to distinguish price changes arising from
changes in the supply and demand for products from changes arising from the high level of general
inflation.
In the market economy, prices represent basic means of transmission of information; the increased noise
associated with high inflation lowers the effectiveness of the market system. High and unanticipated
inflation makes it impossible to plan for relatively longer outlook, creating incentives for households and
firms to shorten their decision horizons and to spend resources in managing inflation risks rather than
focusing on the most productive activities.
Ben Bernanke argued that the Fed's mandated goals of price stability and maximum employment are
almost entirely complementary: "price stability is an end of monetary policy; it is also o means by which
policy con achieve its other objectives." This argument has also been supported by Kenneth Rogoff
(1985) who advocated that the central bank should place larger weight on inflation stabilisation, in order
to increase the welfare of the society.
Therefore, the competing goals of growth and price stability, which may seem to be at odds with each
other, in fact boils down to a single objective ie price stability. In this backdrop, there is no surprise that
most of the central banks aim at maintaining low and stable inflation. Central banks place more weight
and demonstrate increased willingness on controlling inflation relative to output growth, and financial and
exchange rate stability.
It is important to acknowledge, however, that in practical policy making, adhering to revealed preferences
is rather difficult. The reason is that central banks do not operate in a vacuum and require co-ordination
with other policy making institutions, in particular the fiscal authority. In addition, the social and cultural
make-up of a country, and political economy considerations often require central banks to accommodate
conflicting policies.
In other words, sticking to an announced rule-based monetary policy can be difficult in practice;
'enlightened discretion' is preferred by most central banks. Thus, SBP's decision to focus on arresting the
persistent inflationary trends is tantamount to a pro-growth policy, not a growth retarding one.
MONETARY POLICY TRANSMISSION MECHANISM
The monetary transmission mechanism refers to a process through which monetary policy decisions affect
the level of economic activity in the economy and the inflation rate. Understanding the transmission
mechanism of monetary policy is crucial for appropriate design and efficient conduct of monetary policy.
As monetary policy actions affect policy variables with a considerable lag and with high degree of
variability and uncertainty, it is important to predict the possible impact and extent of monetary policy
actions on the real variables.

Thus, by its very nature, monetary policy tends to be forward-looking. It is also important to know which
transmission channels are more effective in terms of transmitting changes in monetary policy actions to
ultimate policy goals.
Since various financial sector developments particularly regarding introduction of new financial products,
technological changes, institutional strengthening, and expectations about future policy, etc can
potentially change economic effects of the monetary policy measures, there is a need to regularly update,
empirically test and reinterpret monetary policy transmission channels. The impact of monetary policy is
perceived to transmit in to the real economic activity through five channels.
The first channel and most widely studied and understood channel of monetary policy transmission
relies on the link between changes in the short-term nominal interest rate (induced by changes in the
policy rate) and the long-term real interest rate that ultimately affect components of aggregate demand
such as consumption and investment in an economy. As such, it is the changes in the long-term real
interest rates that have its impact on aggregate consumption, business investment and other components
of aggregate demand.
The second channel, known as the credit channel, involves changes in monetary policy that not only
affects the ability of firms to borrow money (by affecting their net worth) but also affects the ability of
banks to lend money. The strength of this channel depends on the degree to which the central bank has
allowed banks to extend loans and the dependence of borrowers on bank loans. These factors are clearly
influenced by the structure of the financial system and its regulation.
The third channel of monetary policy transmission focuses on asset prices (other than the interest rate)
such as the market value of securities (bonds and equities) and prices of real estate. A policy-induced
change in the nominal interest rate affects the price of bonds and stocks that may change the market value
of firms relative to the replacement cost of capital, affecting investment. Moreover, a change in the prices
of securities entails a change in wealth which can affect the consumption of households.
Fourth, a policy-induced change in the domestic interest rate also affects the exchange rate that in turn
affects the foreign financial flows, net exports and thus aggregate demand.
The strength of the exchange rate channel depends on the responsiveness of the exchange rate to
monetary shocks, the degree of openness of the economy, sensitivity of foreign private inflows and net
exports to exchange rate variations, and the net worth of firms and thus their borrowing capacity if they
have taken exposure to foreign currency. Moreover, exchange rate changes lead to changes in the
domestic price of imported consumption goods and imported production inputs affecting inflation
directly.
Since expectations influence the inflation dynamics, there is a fifth channel that is based on the
economic agents' expectations of the future prospects of the economy and likely stance of the monetary
policy.

According to this 'expectations channel', most economic variables are determined in a forward-looking
manner and are affected by the expected monetary policy actions. Thus, a consistent, credible, and
transparent monetary policy can potentially affect the likely path of the economy by simply affecting
expectations.
MONETARY POLICY FRAMEWORK IN PAKISTAN
Considering the economic and financial market structure in Pakistan, SBP has for sometime pursued a
monetary targeting regime with broad money supply (M2) as a nominal anchor to achieve the objective of
controlling inflation without any prejudice to growth.
The process of monetary policy formulation usually begins at the start of the fiscal year when SBP sets a
target of M2 growth in line with government's targets of inflation and growth (usually in the month of
May) and an estimation of money demand in the economy. The basic idea is to keep the money supply
close to its estimated demand level, as both a significant excess and a shortfall may lead to considerable
deviations in actual outcomes of inflation and real GDP growth from their respective targets.
Underlying this framework are two strong assumptions: first, there is a strong and reliable relationship
between the goal variable (inflation or real GDP) and M2; and second, the SBP can control growth in M2.
While containing the M2 growth close to its target level is the key consideration in the current monetary
framework, the composition of the money supply does matter and at times requires policy actions even if
these actions lead to a deviation in monetary growth from its target level.
To understand this point, it is necessary to know the major components of money supply and their relative
importance. Net foreign Assets (NFA) and Net Domestic Assets (NDA) of the banking system are the two
major components of money supply.
The NFA is the excess of foreign exchange inflows over outflows to the banking system, or in other terms
it is a reflection of underlying trends in the country's external Balance of Payment (BoP) position. It is
estimated by the projected values of all major external transactions such trade, workers' remittances; debt
servicing, foreign investment, and debt flows etc.
The NDA of the banking system, which primarily consists of credit to the government and the private
sector, reflects changes in the fiscal and the real sectors of the economy, If is estimated as a residual of
M2 and the NFA. Further break-up of NDA is estimated on the basis of projected credit needs of the
government and the private sector.
NOW coming to the importance of these components of the money supply, depletion in NFA is generally
considered as an unhealthy development. Sharp NFA depletion reflects worsening BOP position and a
pressure on exchange rate. In such a case, a higher NDA growth, though helps in expanding M2 to reach
ifs target level, may further deteriorate external accounts, sharper depreciation of local currency, and
higher depletion of country's foreign exchange reserves.
Although since FY07, only the indicative M2 growth target is being announced, SBP also takes into

consideration the causative factors for monetary expansion while pursing this target. Considering the
changes in monetary aggregates and other economic variables, the changes in monetary policy are
signalled through adjustments in the policy discount rate (3-day repo rate).
Further, the changes in the policy rate are complemented by appropriate liquidity management mainly
through Open Market Operations (OMOs) and if required changes in the Cash Reserve Requirement
(CRR) and Statutory Liquid Reserve requirement (SLR) are also made."
EFFECTIVENESS OF MONETARY POLICY IN PAKISTAN
Significance of various channels that transmit the monetary policy shocks in Pakistan to the real economy
has been analysed by few economists. Ahmad et al. (2005) found that credit channel is the most
'important conduit for transmitting monetary policy actions to the real economic activity. Evidence
confirms transmission through the active asset price channel and exchange rate channel.
According to this study, monetary policy shocks impact real output after a lag of 7 to 11 months. Tasneem
and Waheed (2006), on the other hand, investigated whether different sectors of the economy respond
differently to monetary shocks.
The presence of sector wise differences in the monetary transmission mechanism has profound
implications for macroeconomic management as the central bank then has to weigh the varying
consequences of its actions on different sectors. Investigating the transmission of changes in interest rate
to seven sub sectors of the economy, the authors found evidence supporting sector-specific variation in
the real effects of monetary policy.
They found that the interest rate shock on manufacturing, wholesale and retail trade, and finance and
insurance sectors transmit after a lag of 6 to 12 months. On the other hand, monetary policy shocks have
negligible impact on agriculture, mining and quarrying, construction and ownership of dwelling sectors.
Generally, historical evidence does reflect that Pakistan has been a high inflation and high interest
economy given its inherent structural weaknesses. The role and effectiveness of monetary policy appears
more visible in the 2000s when financial sector reforms started bearing fruits in terms of a more market
based money and foreign exchange markets.
Entering the 21sf century, the loose monetary policy stance in the face of low inflation, low growth and
low twin deficits, along with structural measures to open up the economy and alleviate some first round
constraints, triggered the economy on a long-term growth trajectory of above 7 percent.
Monetary policy stance was however altered as the inflationary pressures started to build up in 2005. At
the end of the fiscal year, the economy, which had been showing sustained steady growth since FY01,
registered a historically high level of growth (9 percent), average inflation rose sharply (9.3 percent) and
the external current account balance turned into deficit (-1.4 percent of GDP)
Coinciding with these developments, the fiscal module started to show signs of stress as the fiscal balance

was converted into a deficit and the stock of external debt and liabilities, which had been declining since
FY00 after the Paris Club rescheduling, began increasing. These indicators largely capture the high and
growing aggregate demand in the economy on account of sustained increase in peoples' income.
With the emerging domestic and global price pressures, SBP tightened its monetary policy after a
prolonged gap of a few years. The efforts to rein-in inflation, however, proved less effective due to a
rebound in international commodity prices and a rise in domestic food prices later on.
The rise in the international commodity prices, particularly oil, exacerbated the fight against inflation.
The international oil prices (Arabian Light) rose from US$27.1 at end 2004 to US$50.9 at end 2006,
whereas international food prices rose by 24, 24 and 21 percent during 2004, 2005 and 2006 respectively.
Realising the complications of monetary management and adverse global and domestic economic
developments, the implementation of SBP monetary policy during FY06 varied significantly from the
preceding fiscal years. In addition to the rise in the policy rate, the central bank focused on the short-end
of the yield curve, draining excess liquidity from the interbank money market and pushing up short-tenor
rates.
Consequently, not only did the overnight rates remain close to the discount rate through most of the year,
the volatility in these rates also declined. These tight monetary conditions along with the Government's
administrative measures to control food inflation helped in scaling down average inflation from 9.3
percent in FY05 to 7.9 percent in FY06, within the 8.0 percent annual target.
This was certainly an encouraging development, particularly as if was achieved without affecting
economic growth as the real GDP growth remained strong at 6.6 percent in FY06.
MONETARY POLICY TIGHTENING WAS STRENGTHENED FURTHER
For FY07, the government set an inflation target of 6.5 percent. To achieve this, a further moderation in
aggregate demand during FY07 was required as the core inflation witnessed a relatively smaller decline in
FY06, indicating that demand-side inflationary pressures were strong.
In this perspective, SBP further tightened its monetary policy in July 2006 raising the CRR and SLR for
the scheduled banks; and its policy rate by 50 basis points (bps) to 9.5 percent. Moreover, proactive
liquidity management helped in transmitting the monetary tightening signals to key interest rates in the
economy.
For instance, the Karachi Inter Bank Offer Rate (KIBOR) of 6 months tenor increased from 9.6 percent in
June 2006 to 10.02 percent at end-June 2007 and the banks' weighted average lending and deposits rates
(on outstanding amount) increased by 0.93 percentage points and 1.1 percentage points, respectively,
during FY07.
In retrospect, it appears evident that monetary tightening in FY07 did not put any adverse impact on
economic growth, as not only was the real GDP growth target of 7.0 percent for FY07 was met, the

growth was quite broad based. At the same time, the impact of the monetary tightening was most evident
in the continued deceleration in core inflation during FY07.
One measure of core inflation, the non-food non-energy CPI, continued its downtrend from YoY high of
7.8 percent in October 2005, to 6.3 percent at end-FY06, and to 5.1 percent by the end of FY07. However,
much of the gains from the tight monetary policy on overall CPI inflation were offset by the unexpected
rise in food inflation.
On the downside, however, broad money supply (M2) grew by 19.3 percent during FY07, exceeding the
annual target by 5.8 percentage points. Slippages in money supply growth largely stemmed from an
expansion in NFA due to the higher than expected foreign exchange inflows. Equally stressful was the
impact of Government borrowings from the central bank during the course of the year. The pressure from
the fiscal account was due to mismatch in its external budgetary inflows and expenditures.
With the privatisation inflows and the receipts from a sovereign debt offering at end-FY07, the
Government managed to end the year with retirement of central bank borrowings, on the margin. By endFYO7, SBP holdings of government papers were still around Rs 452 billion, despite a net retirement of
Rs 56.0 billion during the year.
Another major aberration in FY07 emanated from the high level of SBP refinancing extended, for both
working capital and long-term investment, to exporters. Aside from monetary management complexities,
these schemes have been distorting the incentive structure in the economy.
FY08 AND BEGINNING OF FY09 WAS EVEN MORE CHALLENGING
FY08 was an exceptionally difficult year. The domestic macroeconomic and political vulnerabilities
coupled with a very challenging global environment caused slippages in macroeconomic targets by a wide
margin.
AFTER A RELATIVELY LONG PERIOD OF MACROECONOMIC STABILITY AND
PROSPERITY, THE GLOBAL ECONOMY FACED MULTIFARIOUS CHALLENGES: (i) hit by
the sub prime mortgage crisis in U.S in 2007, the international financial markets had been in turmoil, the
impact of which was felt across markets and continents; (ii) rising global commodity prices, with crude
oil and food staples prices skyrocketing; and (iii) a gradual slide in the U.S dollar against major
currencies.
Combination of these events induced a degree of recessionary tendencies and inflationary pressures
across developed and developing countries. Policy-makers were gripped with the dual challenge of
slowdown in growth and unprecedented rising inflationary pressures. Central bankers faced a demanding
task of weighing the trade-off between growth and price stability.
With the exception of few developed countries, most central banks showed a strong bias towards
addressing the risk of inflation and responded with tightening of monetary policies. On the domestic
front, the external current account deficit and fiscal deficit widened considerably to unsustainable level

(8.4 and 7.4 percent of GDP).

The subsidy payments worth Rs 407 billion by Government, which account for almost half of the fiscal
deficit, shielded domestic consumers from high international POL and commodity prices and distorted the
natural demand adjustment mechanism. While the government passed on price increase to consumers, the
rising international oil and other importable prices continued to take a toll on the economy.
Rising demand has cost the country dearly in terms of foreign exchange spent on importing large volumes
of these commodities. Rising fiscal deficit and lower than required financing flows resulted in exceptional
recourse of the Government to the highly inflationary central bank borrowing for financing deficit. At the
same time the surge in imports persisted.
As a result, inflation accelerated and its expectations strengthened due to pass through of international oil
prices to the domestic market, increases in the electricity tariff and the general sales tax, and rising
exchange rate depreciation. These developments resulted in a further rise in headline as well as core
inflation (20 percent weighted trimmed measure) to 25 percent and 21.7 percent respectively in October
2008.
Considering the size of macroeconomic imbalances and the emerging inflationary pressures, SBP
remained committed to achieve price stability over the medium term and thus had to launch steeper
monetary tightening to tame the demand pressures and restore macroeconomic stability in FY09. SBP
thus increased the policy rate from 13.5 to 15 percent.
WHAT NEEDS TO BE DONE TO IMPROVE THE EFFECTIVENESS OF MONETARY
POLICY?
Apart from taking policy measures to address the emerging challenges, SBP also introduced structural
changes in the process of monetary policy formulation and conduct to make the monetary policy
formulation and implementation more transparent, efficient, and effective. Specifically, during the last
couple of years, SBP focused on
Institutionalising the process of policy formulation and conduct,
Stepping up movement towards a more market based credit allocation mechanism,
Developing its analytical and operational capacity,
Improving its capabilities to assess future developments to act proactively, and
Improving upon the communication of policy stance to the general public.
However, the following areas need attention and are key for effective monetary management.
1. Effectiveness of monetary and fiscal co-ordination would be helpful. Section 9A and 9B of the SBP Act

(amended in 1994) articulates the institutional mechanism for economic policy making and co-ordination
and defines the ground rules for both the process and the policy making. However, the track record of the
Monetary and Fiscal Policies Co-ordination Board (MFPCB), established in February 1994 that requires
quarterly meetings of the SBP and the government, has been less than satisfactory.
urthermore, the sequencing of economy-wide projections is done in isolation of the budget and monetary
policy making process, and the budget making process has not respected the monetary compulsions. With
rising spending and stagnating revenues, the budget assumes at the start of the year certain recourse to the
central bank rather than treat it as mere ways and means advances.
2. For effective analysis of developments and policy making, timely and quality information is extremely
important. However, due to weaknesses in the data collection and reporting mechanism of the various
agencies of the country, information is not available with desired frequency and timeliness. Also there are
concerns over the quality of data. Unlike many developed and developing countries, data on quarterly
GDP, employment and wages, etc is not available in case of Pakistan.
Moreover, the data on key macroeconomic variables (such as government expenditure and revenue,
output of large-scale manufacturing, crop estimates, etc) is usually available with substantial lags. This
constrains an in-depth analysis of the current economic situation and evolving trends, and hinders the
ability of the SBP to develop a forward-looking policy stance.
3. Unlike many countries, both developed and developing, there is no prescribed limit On government
borrowing from SBP defined in the SBP Act or the Fiscal Responsibility and Debt Limitation (FRDL) Act
2005. Besides being highly inflationary, government borrowing from SBP also complicates liquidity
management.
Borrowing from the central bank injects liquidity in the system through increased currency in circulation
and deposits of the government with the banks. In both cases, the impact of tight monetary stance is
diluted as this automatic creation of money increases money supply without any prior notice. Moreover,
access to potentially unlimited borrowings from the SBP provides little incentives to the government to
put the fiscal accounts in order.
Therefore, the foremost task to improve the effectiveness of monetary policy is to prohibit the practice of
government borrowings from the SBP. In this regard, appropriate provisions are required to cease or limit
government recourse to central bank financing through amendments in the SBP Act and the FRDL Act
2005.
4. Another issue is to make a clear distinction between exchange rate management and monetary
management. Currently, there is a general perception that the State Bank is bound to keep the exchange
rate at some predefined level and any movement away from this level is then considered as an
inefficiency of the SBP.
There is a need to understand that for an open economy, it is impossible to pursue an independent
monetary and exchange rate policy as well as allowing capital to move freely across the border. Since the

SBP endeavours to achieve price stability through achieving monetary targets by changes in the policy
rate, it is not possible to maintain exchange rates at some level with free capital mobility.
This can only be achieved by putting complete restrictions on capital movements, which is not possible.
SBP's responsibility is to ensure an environment where foreign exchange flows are driven by economic
fundamental and are not misguided by rent seeking speculation. 5. Finally, based on experience
particularly gained during the last two months is to differentiate between liquidity management and
monetary policy stance.
Recently, when the banking system experienced extraordinary stress due to shallow liquidity in the
system, rumour mongering heightened the general public anxiety over few banks' sustainability.
Consequently, the SBP had to intervene in the market by injecting ample liquidity through various
measures. In some quarters, these changes were deemed as a change in the bank's tight monetary policy
stance.
However, this was not the case and the bank had to clearly and repeatedly communicate that the existing
stance is being continued. Later on, the bank further tightened its monetary policy. It must be understood
that quite often, liquidity management can drive the market interest rates away from the direction desired
under the monetary policy stance. However, this has to be temporary and 'the interest rates are bound to
move in the policy stance direction.
To resolve this issue, the SBP is studying various options, including the introduction of a "Standing
Deposit Facility" to keep the interbank rate within a corridor.
In conclusion, it is imperative that above steps be taken urgently. Over the period, however, this needs to
be complemented with much deeper structural reforms to synchronise and reform the medium term
planning for the budget and monetary policy formulation process Several studies and technical assistance
have provided extensive guidance in this area, but the lack of capacities and short term compulsions have
often withheld such reforms.
What is important is to recognise that a medium term development strategy, independently worked out,
would help minimise one agency interest which has often been a source of co-ordination difficulties. It
would also help the budget making process more rule based than the incrementally driven process to
satisfy conflicting demands.

Monetary policy and inflation:

MAKING the half-yearly monetary policy statement, State Bank Governor
Shamshad Akhtar told a press conference last Thursday that the central bank
will maintain its (tight) monetary policy stance while effective
administrative measures are needed to control food prices.

The SBP appears to be saying it has done as much as it can to control

inflation and it is now up to the government to take corrective measures on
the administrative or supply-side to bring down food price inflation that has
led to Pakistans overall inflation rate to accelerate to a twelve-month high of
8.9 per cent in December. The Governor left the benchmark policy rate (3day Repo Rate) unchanged at 9.5 per cent.
The monetary policy statement of the State Bank of Pakistan (SBP) makes
two other important points: (a) inflation remains stubbornly high and is likely
to exceed the 6.5 per cent target for the current fiscal year, and (b) the
monetary policy continues to be supportive of the economic growth as
threshold level of inflation for a stable economic growth. in the range of 4-6
per cent..
The assertion that Pakistan, being a developing country, needs a high
inflation rate (6 per cent or so) to support a 6-8 per cent GDP growth is
seriously questionable and is not supported by hard evidence from the most
recent comparable GDP growth and inflation data of some major emerging
markets. Pakistan stands out with the highest inflation rate and the only
country in the group whose inflation rate (8.9 per cent) is more than its GDP
growth rate (6.6 per cent). This suggests that either there is something so
unique about the structure of Pakistans economy that the divergence of its
GDP growth and inflation data from the norm of even other developing and
oil importing countries (leave aside those of the developed markets) has a
valid and legitimate reason or the data itself is questionable.
However, even if we take data at its face value, the graph shows that most of
these developing countries are growing at around six per cent or more while
their inflation rate is around four per cent or thereabouts. The only exception
is India whose inflation rate is 6.7 per cent but then its current GDP growth
rate of 9.2 per cent is also significantly higher than Pakistans 6.6 per cent.
The monetary policy statement does acknowledge that the inflation is
relatively higher compared to its competitors and trading partners and this
higher domestic inflation has offset the gains emanating from nominal
depreciation of the rupee against other currencies. Is it making a case for an
accelerated depreciation of rupee in the coming months because the
monetary policy has failed to achieve the inflation target?
When most of major developing countries are recording healthy GDP growth
while keeping overall inflation (this includes food and energy inflation) under
five per cent, should not the government set five per cent inflation rate as
target for the next fiscal year? This assumes additional significance aside
from domestic economy and political considerations in an election year
since the relatively higher inflation is hurting competitiveness and exports
growth instead of supporting the declared policy objective of encouraging
economic growth.

Still, it is fair to say that the SBP, primarily through open market operations
and changes in the reserve ratios, has managed to bring down the overall
growth rate in the private sector borrowings. Based on the monthly average
loans outstanding of the scheduled banks, the loan growth during the six
months to December 2006 was 14.5 per cent compared to 25.3 per cent
growth during the previous year.
However, the impact of the overall tightening in the credit supply has been
somewhat diluted by a Rs34.7 billion increase in loans under Long-term
Financing for Export Oriented Projects (LTF-EOP) and R26.8 billion increase in
loans under Export Finance Scheme (EFS), both offered at concessional or
reduced rates.
The combined increase in loans under these financing schemes accounted
for 54 per cent of the Reserve Money (M0) growth during the first half of the
current fiscal year. Although there may be legitimate reasons for offering
export financing at concessional rates, the reports about the abuse of such
facilities abound with money being diverted to real estate and stock market
investments. Such schemes can offset the benefits of a monetary tightening
and derail the progress made in since late 2004. Given their large proportion
in overall money supply growth, it is fair to argue that their rapid build-up
may have adverse effects on the core function of the monetary policy, that
is, achieving low inflation in the next 12-18 months.
Notwithstanding this, the impact of the monetary tightening is visible in
rising interest rates and a deceleration in the principal indicator of the
money supply, that is M2, during the first six months of FY2006-07. The
three-month Karachi interbank offered rate (KIBOR) averaged 10.39 per cent
during December 2006 compared to 8.98 per cent during January 2006.
While raising interest rates is a perfectly legitimate response to building
inflationary expectations, there is an other side to it.
If real interest rates, that is, nominal interest rates minus inflation, are higher
compared to a countrys competitors, they can hurt growth, particularly
exports. Some policy makers argue that the local businesses and
industrialists should not just look at the lower nominal interest rates in India
because Pakistans inflation rate is higher. Simple enough, but a comparison
of the real interest rates between Pakistan and India reveals a somewhat
different and more complex picture.
Graph 2 shows real interest rates in Pakistan and India. The monthly
averages of 3-month KIBOR and 3-month MIBOR (Mumbai interbank offered
rate) and monthly inflation (CPI) rates were used to calculate the real rates.
The graph shows the real interest rates in Pakistan have stayed generally
higher during 2006 compared to Indias. Although it is difficult to quantify the
impact, higher real interest rates do contribute to higher cost of production
and hurt international competitiveness.

Moreover, the data has some difficult implications from a monetary policy
standpoint. The real interest rates in Pakistan depict a declining trend since
mid-2006 while those in India show an upward trend.
Declining real interest rates can portend a higher inflationary environment
18 months down the road, as monetary tightening takes at least that long to
make a dent in inflation. Here, it is relevant to note that the SBPs last
Thursday statement starts with a rather bold assertion that monetary policy
measures adopted in July 2006 augmented earlier tightening and reduced
core inflation (Non-Food Non-Energy NFNE) to 5.5 per cent by December
2006 from 7.4 per cent a year earlier.
Given the widely accepted view, acknowledged even by the SBP Governor,
that monetary policy takes 18 months or so to impact inflation rate; it is not
clear how the July tightening has caused headline inflation to drop in just 6
months? While this may be excused as a statement made more for public
consumption rather than on a serious note, more important issue is the
recent and growing trend of emphasising core inflation as opposed to overall
inflation that includes food inflation. Maybe it is just a better number to talk
about because it looks good.
On the other hand, one may argue that core inflation is also followed closely
in the developed economies such as the United States. However, there is a
major difference between Pakistans inflation (CPI) measure and those of the
developed world. Food inflation is the single largest component of Pakistans
CPI and constitutes 40 per cent of this index compared to only 17 per cent or
so in the U.S. and some other developed markets.
Together with energy, food inflation accounts for almost 48 per cent of the
CPI or overall inflation in Pakistan. Therefore, in Pakistans context, core
inflation (that is, Non-Food Non Energy inflation) is not as meaningful a
measure as in some other developed countries. While supply-side factors do
play a role in inflation, this should not detract the central bankers from
targeting the overall inflation rate as the primary focus of the monetary
policy. Monetary tools, such as margin requirements, do play a role in
commodity financing and should be used appropriately to respond to the
financing needs of essential items.
Moreover, while financial deregulation and innovation have made the money
supply harder to interpret in the developed markets, domestic money supply
control can be a relatively more effective tool of monetary policy in
economies like Pakistan where private sector access to foreign borrowing and
markets is fairly limited. The fact that a large sector of the economy is
undocumented has little to do with the effect of money supply growth on
inflation as has been well established in high inflation developing countries
like Brazil and Turkey.

The SBP maintains it is capable of skilful management of the often difficult

and complex objectives of meeting national growth priorities, liquidity and
demand management, and controlling inflation. As central bankers around
the world know too well from history, it is difficult to manage just one goal
low inflation let alone many.
Given the propensity of the borrowers in Pakistan to abuse concessional
credits and the difficulties in managing multiple and some times conflicting
near-term policy objectives, the SBP will be better off to make achieving an
inflation rate of five per cent or less as its core target for next 12-18 months.
That by itself will facilitate growth and price stability. Failure to achieve low
inflation will hurt growth and exports down the road as monetary policy
mistakes can take up to 18-24 months to show up in even higher inflation
numbers. But by then, elections will be over.

Freeing the state bank:

If there is one thing that the current government will strive at all costs to retain, it is control over the
State Bank of Pakistan (SBP). And if there is one thing that the International Monetary Fund wants, it
is to wrest control of the SBP from political control and create a truly independent entity. To that end,
the IMF has dropped the hammer on the federal government and given it two months to get its
financial house in order by giving complete autonomy to the SBP. This is a move that was neither
sudden nor unexpected and the government had been ducking and diving on this issue virtually since
it took office.

The federal government had proposed an amendment bill which sought to satisfy the IMF condition
of autonomy for the SBP, but the IMF was not satisfied with the proposed amendments that fell far
short of what it sought and had a number of structural weaknesses, particularly in relation to
autonomy the very thing that the IMF was seeking and the federal government was hoping to
avoid. The government is keen to retain control of the SBP because it allows what amounts to
interest-free borrowing, the proverbial licence to print money. As things stand, the SBP is subservient
to the federal government, and has weak internal governance and controls.
The government would be wise to accede to the requirements of the IMF. The devolution of control
has been an issue for many years and successive governments have resisted granting autonomy to the
SBP simply because it is an immediately accessible source of ready cash in a cash-strapped economy.

The IMF favours the government borrowing from private banks which have rather more stringent
terms of business than does an enfeebled SBP. Borrowing in the private sector is also likely to result
in greater transparency, something that Pakistans governments are perennially averse to. The federal
government now has till the end of August to demonstrate compliance a tight time frame. Our
financial managers cannot dodge and weave forever and this looks like the end of this particular road.
An independent SBP is maybe not a distant dream after all.

Parliament giveth with one hand and taketh away with the other. Or so it seems from the
comments made by members of the parliamentary committee on finance, who two weeks
back criticised the State Bank of Pakistan (SBP) for tightening monetary policy. It is
somewhat comical that the same legislature that has only this past week taken active
measures to curb a loose fiscal policy are now complaining about a monetary policy that is
too tight. A parliamentary panel passed a bill last week that would restrict government
borrowing from the central bank and would enhance the ability of the SBP to control
monetary policy. This action would suggest that they agree with the SBPs central diagnosis
that the administrations fiscal policy is flawed and needs to be institutionally kept in check.
But on the same day, they decide to criticise the SBP for acting against that very same
flawed fiscal policy and moving to protect the integrity of the rupees value. There is an
inherent contradiction in those two acts and one that the members of the committee would
do well to try and understand.
We believe that the SBP was right in its diagnosis of the governments fiscal policy as being
overly optimistic. We also believe that the central bank has, first and foremost, a mandate to
curb inflation. There are both monetary and fiscal means to do that, though the SBP only
controls the former and the finance ministry controls the latter. In this tug of war between
the finance ministry and the SBP, the central bank is clearly the more responsible actor. We
commend the parliamentary committees approval of proposals to strengthen the central
banks independence. But they must understand that the SBPs job, while often unpopular,
is necessary. Legislators would serve the country well by not second-guessing a policy that
they clearly seem to agree with.