Money and Banking
89had been greater on reviving economic growth rather than containing inflation. While thisfocus reverted to reducing inflation FY05 onwards, there was a conscious decision to lowerinflationary pressures
over a longer time (2-3 years), since attempts to hasten thepace of disinflation ran the risk of destabilizing the growth momentum of the economy.Thus, the targeted inflation reduction in FY06 was a very modest 1.3 percentage points.(2)
Moreover, recent research findings indicated that a significant impact of monetary tighteningon reducing inflation persists over almost 28 months. Thus, monetary tightening duringFY06 had to encompass both, the impact of the improvement in transmission of changes inpolicy rate, as well as the lagged impact of the hike in policy rates during FY05 (see
) on output and inflation in FY06. It was felt that the impact of aggressive policy rateincreases in FY06 would have been exaggerated by the lagged impact of earlier tightening,raising the risk of an economic slowdown.
Box 5.1: The lags involved in monetary policy transmission in Pakistan
Only a few studies have been conducted in Pakistan that have empirically estimated the relative strength of various channelsthrough which the monetary policy transmits to the ultimate objectives of growth and inflation. As such, the lags that areinvolved in transmission mechanism have also rarely been quantified. In this perspective, recent research at the SBPprovides useful insights on the response of the economy to a tightening of monetary policy.The estimation in the study has been done on monthly data from July 1996 to March 2004 using 6 months as optimal laglength in all of the VAR system. The study has concluded that during the first 6 months of a monetary shock, the aggregateprice level responds very little. However, 6 months onwards, the price level
declines persistently. In sharp contrast to this,the output responds very quickly and bottoms out after 7 months; later which it dissipates (see
).Another recent finding is the Khan and Schimmelpfennig (2005) which has attempted to figure out whether or not theinflation is a monetary phenomenon in Pakistan. Using the monthly data covering the period from January 1998 to June2005, they concluded that the inflation is found to be a monetary phenomenon caused mainly by the growth in money supplyand credit to private sector. According to their estimates, there is a lag of about 12 months, within which the broad moneygrowth and the private sector credit explains the inflation developments
Khan, Mohsin and Schimmelpfennig, Axel; Money or Wheat, SBP Research Bulletin, Vol.2, Number 1, 2006..(2)
Mubarik, Yasir Ali, Agha, Asif Idrees, Ahmed, Noor and Shah, Hastam, Transmission mechanism of monetarypolicy, SBP Working Paper no. 09 dated 2004.
Response of IPI to Changes in 6m T-bill
Response of Price to Changes in 6m T-billFigure 5.1.1: Impulse Response Function