A Model for Monetary Policy Analysis in Pakistan

Transcription

1 Working paper A Model for Moneary Policy Analysis in Pakisan The Role of Foreign Exchange and Credi Markes Ehsan U. Choudhri Hamza Malik March 2014 When ciing his paper please use he ile and he following reference number: S PAK-1

2 A Model for Moneary Policy Analysis in Pakisan: The Role of Foreign Exchange and Credi Markes Ehsan U. Choudhri and Hamza Malik* Carleon Universiy and Sae Bank of Pakisan March 2014 *We are graeful o Inernaional Growh Cenre for he suppor of his projec. 1

3 A Model for Moneary Policy Analysis in Pakisan: The Role of Foreign Exchange and Credi Markes Ehsan U. Choudhri (Carleon Universiy) and Hamza Malik (Sae Bank of Pakisan) Non-Technical Summary IGC has suppored an ongoing program o develop and use a Dynamic Sochasic General Equilibrium (DSGE) model for moneary policy analysis in Pakisan. Previous projecs have designed a DSGE model suiable for Pakisan used i o examine imporan moneary policy issues and made he model ready for operaion a he Sae Bank of Pakisan (SBP). The presen projec underakes imporan exensions of he model o explore he role of foreign exchange and credi markes in deermining he macroeconomic effecs of moneary policy. Moneary policy plays an imporan role in advanced counries in conrolling inflaion and sabilizing economic aciviy. Foreign exchange and credi markes in hese counries represen imporan channels for he ransmission of moneary policy effecs. In Pakisan credi markes are less developed and inernaional capial flows are less dominan in he foreign exchange marke. The projec incorporaes hese differences in he model and explores how hey influence he effeciveness of moneary policy. Mos cenral banks use conrol over ineres raes as he key insrumen of moneary policy. A lower policy ineres rae leads o a decrease in a variey of ineres raes. As coss and prices adjus slowly lower policy ineres rae also leads o a decline in he expeced real ineres raes (nominal ineres raes minus expeced inflaion). This decline increases aggregae demand and hus oupu and inflaion hrough hree imporan effecs. Firs he expeced real reurn on saving is reduced which increases consumpion by discouraging savings. Second he expeced real cos of borrowing is reduced which induces more invesmen. Third he real value of home currency depreciaes (as capial ouflows are simulaed by lower expeced real ineres raes) which improves he rade balance. In Pakisan credi markes do no operae smoohly and he lending raes do no fall quickly and adequaely in response o lower policy ineres raes. This feaure can weaken he effec of moneary policy on invesmen. Also he financial markes in Pakisan are no well inegraed wih global financial markes. One consequence of his lack of inegraion is ha SBP can inervene in he foreign exchange marke o sabilize he exchange rae wihou causing significan inernaional capial flows. Alhough his policy reduces exchange rae flucuaions i weakens he moneary policy effec on rade balance operaing via he exchange rae adjusmen. We incorporae hese feaures of he credi and foreign exchange marke in he DSGE model for moneary policy analysis in Pakisan (MPAP model) calibraed o Pakisan s economy. We inroduce ineria in he seing of he ineres rae on bank loans. The degree of his fricion is chosen o allow a low pass-hrough from he policy ineres rae o he bank lending rae which! 1!

4 is consisen wih he evidence. We add ransacion coss in inernaional borrowing and lending and hese coss are assumed o rise as he volume of borrowing or lending increases. This fricion is assumed o be sufficienly large o explain he small effec of exchange marke inervenion by SBP on inernaional capial flows. The model also allows for ineria in he formaion of inflaion expecaions. We underake simulaions of he MPAP model wih he above fricions o examine he dynamic effecs of moneary policy (wih exchange rae sabilizaion) on inflaion and he oupu gap (beween acual and poenial GDP). We also derive he dynamic effecs from a sandard model wihou hese fricions and flexible exchange raes o explore he exen o which moneary policy effeciveness in Pakisan is weakened by he fricions and exchange rae sabilizaion. We find ha hese facors make a significan difference and he impac of moneary policy on inflaion and he oupu gap in he MPAP model is roughly one-half of ha in he sandard model. One imporan moneary policy issue in Pakisan is how he policy ineres rae should respond o inflaion. Esimaes based on hisorical daa sugges ha he ineres rae response o inflaion has been weak in Pakisan. Since moneary policy effeciveness is diminished because of credi and foreign exchange marke fricions here may be a need for a more vigorous ineres rae response o inflaion o effecively conrol inflaion and reduce oupu variabiliy. To explore his issue we use he model o evaluae he macroeconomic performance of differen moneary policies wih differen degrees of ineres rae response and wih or wihou exchange rae sabilizaion. To evaluae he performance of each policy we use sochasic simulaion of he model (where he economy is subjeced o demand and supply and inernal and exernal shocks) o generae arificial series on key macroeconomic variables. These series are used o calculae indexes of variabiliy of inflaion oupu gap and real depreciaion as hree key indicaors of macroeconomic performance. The resuls of our simulaions sugges ha using moderae raher han weak response o inflaion would significanly lower inflaion variabiliy and would also make oupu more sable. Srong response would furher reduce inflaion and oupu variabiliy alhough he improvemen form moderae o srong response would no be as large as ha from weak o moderae response. Our resuls also show ha if moneary policy also aemps o sabilize real exchange rae movemens (via inervenion in he foreign exchange marke) i would achieve his goal a a cos of much higher inflaion and oupu variabiliy for each ype of inflaion response. Our model simulaions assume ha fiscal auhoriies adjus axes and/or expendiures o conrol deb levels. Wihou fiscal adjusmen o conrol deb he rae of borrowing would keep on increasing making i infeasible o conrol inflaion. If governmen does no conrol deb cenral bank could aemp o sabilize i. In a previous paper we explored a policy rule where SBP adjuss ineres raes o conrol deb as well as inflaion. This policy was found o lead o high and volaile inflaion and cause large welfare losses. Concerns regarding fiscal policy could also lead o credibiliy problems which would worsen economic condiions. An imporan policy! 2!

5 implicaion is ha macroeconomic performance and he abiliy of SBP o conrol inflaion can be improved considerably if fiscal policy akes he responsibiliy o sabilize deb.! 3!

6 1. Inroducion This paper discusses he resuls of a projec suppored by IGC which is par of an ongoing program o develop and use a DSGE model for moneary policy analysis in Pakisan. Previous projecs have designed a DSGE model suiable for Pakisan used i o examine imporan moneary policy issues and made he model ready for operaion a he Sae Bank of Pakisan (SBP). The presen projec underakes wo imporan exensions of he model needed o address pressing moneary policy issues. 1 One exension is he modelling of inernaional capial flows and SBP inervenion in he foreign exchange marke. The dynamics of inernaional capial flows have always played a significan role in influencing he balance of paymens posiion in Pakisan and as a consequence SBP s exchange rae and ineres rae policy. There is a need o examine he ineracion of SBP s foreign exchange marke inervenion wih he ineres rae policy in he conex of inervenion-induced foreign exchange losses. Anoher exension is he modelling of he credi marke o beer undersand he impac of he policy ineres rae on he bank loan rae and in urn on he behaviour of credi availed o he privae secor. This exension also allows us o examine he implicaions of excessive fiscal borrowing for he privae credi marke. In adding he wo exensions in he model we ake ino accoun wo feaures of he financial and credi markes in Pakisan. Firs he financial markes in Pakisan are no well inegraed wih global financial markes and here are imporan deparures from he ineres pariy relaion. To incorporae his feaure we inroduce a fricion in he form of ransacion coss in inernaional borrowing or lending. Large ransacion coss would allow exchange marke inervenion o have significan impac on he exchange rae and sabilize exchange rae 1 These exensions were idenified in meeings wih SBP saff for consulaion abou he developmen use and applicaion of he model. 2

7 movemens. Second he credi marke in Pakisan are less developed han advanced counries and he lending raes do no adjus quickly and adequaely o change in he policy ineres rae. We capure his feaure by inroducing adjusmen coss in he seing of he ineres rae on bank loans. Large adjusmen coss can accoun for low pass-hrough from he policy rae o he bank loan rae observed in low income counries (Mishra e al. 2010). Fricions in he credi and exchange markes and exchange rae sabilizaion weaken he effec of moneary policy on inflaion and oupu. To explore he role ha hese facors play in reducing he effeciveness of moneary policy we compare he exended model wih a sandard model wih flexible exchange raes and wihou he credi and exchange marke fricions. We find ha he oupu and inflaion effecs of an ineres rae change in he exended model are much weaker han he sandard model. One implicaion of hese resuls is ha he SBP may need o respond o inflaion more srongly o effecively conrol inflaion. We underake sochasic simulaions of he exended model o explore he appropriae ineres rae rule. Secion 2 discusses he exensions of he model and derives he new relaions for he exended model. Effeciveness of moneary policy in he exended model is examined in Secion 3. Secion 4 evaluaes he performance of alernaive ineres rae rules. 2. Exended Model Our previous research developed a dynamic sochasic general equilibrium model designed for moneary policy analysis in Pakisan (MPAP). The model has a modular srucure: i sars wih a basic version and hen adds various exensions and modificaions. 2 The basic version of he model (MPAP0) is based on he convenional New-Keynesian framework and 22 For a discussion of he basic version and is exensions see Choudhri and Malik (2013). 3

8 represens a fairly sandard model of a small open economy wih one household wo differeniaed goods (home and foreign goods) and wo inpus (labor and capial). A second version (MPAP1) allows for wo ypes of households: high-income ( H ype) household who can borrow or lend and low-income ( L ype) households who are liquidiy consrained. The hird version (MPAP2) also inroduces a compeiive banking secor ha ransforms deposis (by highincome households) ino loans (o firms) for financing invesmen. 3. The curren projec exends he model furher in wo direcions. Firs inernaional capial flows are deermined endogenously. Fricions in he form of ransacions coss are inroduced o accoun for a lack of financial inegraion beween Pakisan and advanced counries. Second he banking secor is assumed o operae under monopolisic compeiion. This seup allows he inroducion of ineria in he deerminaion of he ineres rae on bank loans which can explain low pass-hrough from he policy rae o he bank loan rae. In he remainder of his secion we explain he relaions based on he wo exensions. The complee model which incorporaes he new relaions in he model version MPAP2 is described in Appendix Endogenous inernaional capial flows To add his exension o he version wih wo households we assume ha high-income households can also borrow and lend inernaionally by holding foreign asses or liabiliies. We also assume ha inernaional borrowing or lending involves a significan ransacion cos ha increases in ne foreign asses. Assuming a coninuum of H ype households indexed by h (01) express he uiliy funcion and he budge consrain for a household of his ype as 3 We also consider a variaion ha incorporaes imperfec credibiliy of moneary and fiscal policy rules and adds a model in which inflaionary expecaions depend on credibiliy sock ha is deermined endogenously 4

9 s c ( h) cu ( h) d ( h) n ( h) UH ( h) E s Hs HC Hs HD Hs HN Hs c ( h) ( h) cu ( h) d ( h) b( h) sb ( h) cu ( h)/ (1 r ) d ( h) (1 r )( b ( h) * H H H H H 1 D 1 H s (1 r ) b ( h)(1 TC ) w n ( h)(1 AC ( h)) qi ( h) r l ( h) rek ( h) pr( h). * * H H WH L 1 H 1 where in period c ( h) and n ( h ) are he household s consumpion and labor supply; H H cuh ( h ) and d ( h ) are he (end of period) holding of real currency and bank deposis (in erms H of he composie good); ( h) represens (lump sum) real axes; b( h ) and b * ( h) are he real socks of domesic and foreign bonds and k ( h ) is he sock of capial (a he end of he period); i( h)[ k ( h) k ( h)] is real invesmen while l ( h ) is he (fixed) real value of household loans 1 H from banks; s is he real exchange rae; q is he price of insalled capial P / P 1 where P is he price of a uni of he composie good; r D r and r L are he real ineres raes on bank deposis governmen bonds and bank loans; re is he real renal rae for insalled capial; w ( h ) H is he real wage rae; and AC is he wage adjusmen cos; pr ( h ) represens he household's W share of real profis and TC is he ransacion cos for foreign bonds defined as 4 TC e b* e b* Noe ha ha TC is zero in he absence of inernaional borrowing or lending ( b * 0 ). If * b is posiive (negaive) TC is greaer (smaller) han zero and increases (decreases) as lending (borrowing) abroad increases. In his case home residens receive (pay) an ineres rae lower 4 This form of he ransacion cos funcion is based on Laxon and Peseni (2003) 5

10 (higher) han he foreign rae. Parameer deermines he slope of he ransacion cos funcion and an increase in makes he funcion seeper. In he presence of ne foreign asses in he household porfolio opimizaion by he household implies he following new condiion e * s (1 r )(1 TC) (1 r ) s e where s is he expeced value of s 1 a ime.to allow for ineria in he formaion of exchange e rae expecaions we assume ha s Es 1(1 ) s Combining he budge consrain of boh high- and low-income households wih he governmen s flow budge and he Sae Bank s balance shee relaions we can derive he following relaion deermining he accumulaion of foreign asses: b (1 r )(1 TC ) b ( ni c ) / s * * * H where ni represens ne income of H households and is defined as. ni p z p z s rm s dir i g c AC. In his definiion px and pd are he * * X X D D L real prices of he bundles expored and supplied o he domesic marke; zx and z D represen he demand for he wo bundles; be received by L households); * rm is he amoun of foreign remiances in dollars (assumed o * dir is he change in Sae Bank s holding of inernaional reserves; c L is he consumpion of L households; and AC represens he oal adjusmen coss. 6

11 The relaion deermining he consumpion of H households can be derived as follows. Firs assume for simpliciy ha r r move he above foreign asse relaion forward on * * period and hen use i repeaedly o subsiue for fuure values of * b o obain 5 b 1 c ni 1 c ni.... Nex use his * * * 2 (1 r )(1 TC) s 1 (1 r ) (1 TC)(1 TC 1) s2 * relaion o subsiue for b in he foreign asse relaion make use of he Euler condiion (implied by he household opimizaion) ha ch 1 c H (1 r) o eliminae fuure values of c H and derive c sumni b sumr * where sumni ni * ni * and s (1 r )(1 TC ) s (1 r ) (1 TC )(1 TC ) (1 r) (1 r) (1 r ) 1/ 1/ 1/ 1 sumr... s (1 r )(1 TC ) s (1 r ) (1 TC )(1 TC ) s (1 r ) (1 TC )(1 TC )(1 TC ) Variable 1 * * 2 * sumni represens he discouned value of H household s ne income sream while sumr is a conversion facor ha makes he produc of c and sumr equal o he discouned value of H household s consumpion sream. These above expressions are simplified as 1 1 sumni ni sumni * * 1 s(1 r )(1 TC 1) (1 r )(1 TC 1) 5 In deriving his series we use he ransversaliy condiion ha Lim 1 1 n TC r n1 * b s * n n (1 s) (1 ) 0. 7

12 sumr 1/ (1 r ) sumr 1 1 s (1 r )(1 TC ) (1 r )(1 TC ) * * Monopolisically compeiive banking secor Assume ha here is a coninuum of banks indexed by b (01). Each bank faces a demand funcion for i loans lb () b lb rl ()/ b rl B where B/( B1) 1 ( B1)/ B lb l 0 B () b db and r () b is he ineres rae on loans se by he bank. A fricion in he banking secor is L inroduced by he assumpion ha banks face adjusmen coss in seing he loan rae which are given by AC [1 r ( b)] B L B ( h) 1 2 [1 rl 1( b)] 2. Deposi creaion and producion of loans by a bank is deermined by he following liquidiy and monioring funcions: d b cr b b b 1 H () BD( ())( B ()) l () b n () b B BL HB where cr () b and b () b represen real values of cash reserves and governmen bonds held by B banks and n () b is he employmen of H ype labor (banks are assumed o employ only his HB ype of labor). The balance shee of he banks is given by cr () b b () b l () b d () b. B B H 8

13 The discouned value of bank profis is E s s H s cr b r b b r b l b AC (1 rds ) dhs ( b) whs nhbs ( b) s()/ s 1 (1 s) B s() (1 L s()) B s()(1 B s) where Hs denoes he marginal value of wealh for H households (he Lagrange muliplier associaed wih heir budge consrain) and w H represens he real wage rae for he H ype labor bundle. Banks maximize his value subjec o he liquidiy and monioring relaions and he balance-shee consrain. The opimal condiions in symmeric equilibrium are 6 cr B (1 rd ) d B 1/ E 1 H b (1 r ) (1 ) d B D B H B (1 r) B (1 ACB )[1 rl (11/ )] (1 rl )( rl / )( ACB / rl ) ( wh / BL ) ( ch 1 / ch ) (1 rl 1 )( lb 1 / lb )( rl / )( ACB 1 / rl ) where B is he shadow price associaed wih he balance shee consrain and we have made use of he condiion (implied by household opimizaion) ha H c H. Noe ha he adjusmen cos parameer B influences he shadow price and hus affecs he response of r o r. L 6 To derive hese condiions we use he following Lagrange expression: 1 crs()/ b s 1 rsb B s() b rl s() b lb s()(1 b ACB s) rd sbd scrs() b bb s() b s B E s H s whsbs l ( b) 1 Bs BDs crs() b bbs () b crs() b bbs () b lbs () b BL s 9

14 3. Effeciveness of Moneary Policy We firs use he exended model o explore how fricions in he credi and foreign exchange marke influence he effeciveness of moneary policy. Fricions in he credi marke are represened by adjusmen coss in seing he bank loan rae. The adjusmen cos parameer B deermines how he lending rae responds o he policy rae. We assume ha his parameer equals This value makes he shor run effec of he policy rae on he bank lending rae in he model consisen wih he evidence for low income counries (Mishra e al. 2010). In he foreign exchange marke fricions arise from ransacion coss in inernaional borrowing or lending. We assume ha he ransacion cos parameer equals 20. This value is sufficienly large o allow SBP inervenion in he foreign exchange marke (purchase or sale of inernaional reserves) o have a subsanial effec on he exchange rae. We also inroduce ineria in he formaion of exchange rae and inflaion expecaions by leing (he weigh on forward looking componen) equal o 0.5. Moneary policy is assumed o operae in an environmen ha we call weak moneary independence. The inflaion arge is no chosen by SBP bu is deermined by he governmen (hrough he fiscal auhoriy) and depends on is needs o generae sufficien revenue from money creaion. SBP however is free o choose a policy for implemening he inflaion arge. We assume ha he SBP policy can be represened by an ineres rae rule of he following general form: ln(1 R) ln(1 R ) (1 ){ln(1 R) (1 )ln( E / ) ln( y / y)} ln rr 1 rr r 1 ry R 10

15 where R is he nominal ineres rae se by SBP is he inflaion arge (deermined by he fiscal auhoriy) R is long-run nominal ineres rae consisen wih he seady sae real rae y is he seady sae oupu and R is he shock o he moneary policy rule. The governmen is assumed o ake responsibiliy for sabilizing is deb a a arge level and uses a ax rule which adjus axes (slowly) in response o deb growh. 7 Finally SBP is also assumed o follow a policy of sabilizing he real exchange rae by buying or selling inernaional reserves. We describe his policy by an inervenion rule of he following simple form: dirs ( s s ) 0 * ir ir where s is he real exchange rae in he seady sae. The key channel for he ransmission of he moneary policy effecs in he model is he real ineres rae. The real ineres rae equals he nominal ineres rae minus he expeced inflaion rae. A policy induced reducion in he nominal ineres rae lowers he real ineres rae direcly as well as indirecly by raising he expeced inflaion rae. The lower real ineres rae increases hree componens of aggregae demand. Firs as he real reurn o savings is less households increase consumpion. 8 Second a decrease in he bank loan rae in response o lower policy rae reduces he real cos of borrowing and hus increases invesmen. Third he real exchange rae appreciaes (he real value of home currency depreciaes) in response o a decrease in he real ineres rae (via he ineres pariy relaion). The exchange rae appreciaion increases rade balance. The fricions inroduced in he model make moneary policy less effecive by 7 Choudhri and Malik (2013) consider an alernaive policy environmen of fiscal dominance where he governmen does no follow he ax rule and SBP has o follow an ineres rae rule which also arges deb. This policy is shown o cause higher and more volaile inflaion. 8 In our model L household are liquidiy consrained and do no save. However heir consumpion would also increase via an increase in income brough abou by higher aggregae demand. 11

16 impeding hese effecs. Expecaion ineria dampens he effec on he expeced inflaion rae and he real ineres rae falls less (for a given reducion in he nominal ineres rae). Credi fricions make he bank lending rae less responsive o changes in he policy rae. Exchange rae sabilizaion policy (made possible by fricions in inernaional capial flows) blocks he effec operaing via he real exchange rae policy. To explore he effeciveness of moneary policy we examine he response of oupu and inflaion o a emporary decrease in he ineres rae. In he ineres rae rule he emporary rae decrease is represened by a negaive shock o moneary policy rule for one quarer equal o a 1% decrease in he annualized ineres rae. Esimaes of he ineres rae rule for Pakisan sugges ha he response o inflaion is weak and we se he inflaion coefficien ( r ) equal o We assume no response o oupu ( ry 0) and moderae ineres rae smoohing ( 0.5 ). To illusrae he role of various fricions and exchange rae sabilizaion in influencing moneary policy effeciveness we compare he exended MPAP model wih a sandard model wihou fricions and fully flexible exchange rae. In he sandard model we assume no adjusmen coss in he bank loan rae ( B 0 ) and negligible ransacion coss in inernaional borrowing or lending ( 0.01). 9 We also assume no exchange marke inervenion ( 0 ) in his model. ir r Figures 1 and 2 show he dynamic effecs (over 12 quarers) of he emporary ineres rae decrease on he oupu gap (percen change in oupu relaive o seady sae oupu) and inflaion (percen annual rae). The effeciveness of moneary policy in he MPAP model is significanly weaker han in he sandard model. Indeed firs-quarer impac of he ineres rae reducion on oupu and inflaion in he MPAP model is roughly half of ha in he sandard model. 9 A very small cos ensures convergence o a unique seady sae bu has a negligible effec on he dynamics. 12

17 Differences beween he wo models are furher explored in Figures 3 hrough 5. Figure 3 illusraes he effec of ineria in inflaion expecaions and shows ha he real rae does no iniially fall as much in he MPAP model as in he sandard model. The effec of adjusmen cos on he spread beween real bank loan rae and he real ineres rae is shown in Figure 4. In he MPAP model he spread rises sharply as he bank loan rae does no iniially fall as much as he ineres rae. The role of exchange rae sabilizaion is highlighed in Figure 5. In he sandard model he moneary policy shock causes a emporary real depreciaion of he rupee bu hese effecs are offse by he sabilizaion policy in he MPAP model. 4. Model Dynamics This secion examines he dynamic adjusmen of key macro variables o various shocks (oher han he moneary policy shock). Our model focuses on shocks o four variables: governmen expendiures oal facor produciviy (TFP) foreign impor prices and foreign remiances. All four variables are assumed o follow an AR (1) process (in logs) expressed as ln g (1 G)ln ggln g 1 xg ln Y (1 Y)lnYYlnY 1 xy * * * ln rm (1 RM)ln rm RM ln rm 1 xrm * * * ln( pm ) (1 M)ln( pm) Mln( pm 1 ) xm where Y represens TFP and a bar over he variable denoes seady sae value and xg xy x RM and M x are whie noise shocks. We use he daa since 2000 o esimae he 13

18 auoregressive coefficien and he sandard deviaion of he shock. 10 The values of hese parameers are shown in Table 1. Figures 6 hrough 9 examine he effec of a one sandard deviaion shock o each variable (in quarer 1) on oupu gap inflaion real ineres rae and real (rupee) depreciaion (over 12 quarers). In his analysis he real exchange rae is no sabilized ( ir 0 ) and he coefficiens of he ineres rae rule are assumed o be he same as in secion 2. A posiive shock o governmen expendiures increases aggregae demand and brings abou a emporary increase in boh oupu and inflaion and causes a emporary real depreciaion (see Figure 6). A posiive shock o TFP represens an increase in aggregae supply and while i also increases oupu and causes real depreciaion in he shor run i reduces inflaion emporarily (see Figure 7). A posiive shock o foreign remiances causes a emporary real appreciaion by increasing capial inflows which leads o lower oupu and inflaion in he shor run (see Figure 8). Finally a posiive impor prices shock divers demand from more expensive foreign goods o home goods which increases boh oupu and inflaion in he shor run alhough here is a emporary real appreciaion (see Figure 9). 5. Appropriae Ineres Rae Rule In his secion we examine how differen ineres rae rules would affec macroeconomic performance. As menioned above esimaes of ineres rae rules sugges ha he response of he ineres rae o inflaion is weak. Our analysis of he exended MPAP model also shows ha he effec of ineres rae changes on inflaion and oupu is smaller han in he sandard model and 10 Only annual series are available for governmen expendiures and TFP. These series were convered o quarerly series using a conversion procedure. Daa on TFP are preliminary. All series were derended using he Hodrick-Presco filer. 14

19 moneary policy in Pakisan may have been less effecive in conrolling inflaion and sabilizing oupu. We now explore he poenial for reducing inflaion and oupu variabiliy hrough he use a more vigorous response o inflaion in he ineres rae rule. We examine ineres rae rules wih and wihou inervenion in he foreign exchange marke o sabilize he exchange rae. To evaluae he performance of each rule we use sochasic simulaion of he model (wih he four shocks discussed above) o generae arificial series on key macroeconomic variables. These series are used o calculae sandard deviaions of inflaion oupu gap and real depreciaion as hree key indicaors of macroeconomic performance. The resuls are summarized in Table 2 for hree ypes of reacion o inflaion: weak moderae and srong. The weak response wih inflaion coefficien equal o 0.15 represens he curren pracice as suggesed by he empirical esimaes. The moderae response wih inflaion coefficien equal o 0.50 conforms o he value used in he sandard Taylor rule. For he srong response we le he inflaion coefficien equal o 1.0. The able shows ha using he moderae raher han he weak response o inflaion would significanly lower inflaion variabiliy (by abou 20%) and would also make oupu more sable. Srong response would furher reduce inflaion and oupu variabiliy alhough he improvemen from moderae o srong response would no be as large as ha from weak o moderae response. The able also shows ha if moneary policy also aemps o sabilize real exchange rae movemens (via inervenion in he foreign exchange marke) i would achieve his goal a a cos of much higher inflaion and oupu variabiliy for each ype of inflaion response. This resul can be explained by noing ha exchange rae sabilizaion makes ineres rae changes less effecive and hus inflaion and oupu would be less sable under his policy for a given inflaion response. 15

20 6. Concluding Remarks The presen paper discusses he exensions of he MPAP model o incorporae endogenous inernaional capial flows and an imperfecly compeiive banking secor. We have inroduced significan fricions in he foreign exchange and credi markes o capure key feaures of Pakisan s financial secors. We also inroduced ineria in he formaion of price expecaions. Our analysis shows ha hese fricions weaken he impac of ineres rae changes on inflaion and oupu gap and hus make moneary policy in Pakisan less effecive. We underake sochasic simulaions o explore wha would be an appropriae ineres rae response o inflaion in he presence of fricions discussed above. Esimaes of he ineres rae rule in Pakisan sugges ha he inflaion coefficien in he rule is low (i is around 0.15). The resuls of our simulaions sugges ha a sronger response (a significanly higher inflaion coefficien) would be desirable o sabilize inflaion and oupu. SBP generally inervenes in he foreign exchange marke o sabilize he exchange rae. Our simulaion resuls show ha exchange rae sabiliy is achieved a he cos of greaer variabiliy of inflaion and oupu: inflaion and oupu would be more sable if he exchange rae is allowed o flucuae freely. Our analysis in his paper assumes ha fiscal auhoriies adjus axes and/or expendiures o conrol deb levels. Wihou fiscal adjusmen o conrol deb he rae of borrowing would keep on increasing making i infeasible o conrol inflaion. If governmen does no conrol deb cenral bank could aemp o sabilize i. (Benigno and Woodford 2006 Kumhof e al. 2008). In a previous paper (Choudhri and Malik 2012) we explored a policy rule where SBP adjuss ineres raes o conrol deb. This policy was found o lead o high and volaile inflaion and cause large welfare losses. 16

21 Concerns regarding fiscal policy could lead o credibiliy problems which would worsen economic condiions. For insance governmen commimen o sabilizing deb may no be credible; here may be a concern ha he governmen would raise primary defici permanenly leading o higher long-run seignorage and inflaion; here may be doubs abou he cenral bank s abiliy o keep boh long erm deb and inflaion a arge levels. These consideraions sugges ha macroeconomic performance and he abiliy of SBP o conrol inflaion can be improved considerably if fiscal policy akes he responsibiliy o sabilize deb. 17

22 References Benigno P. and M. Woodford 2006 Opimal Inflaion Targeing under Alernaive Fiscal Regimes NBER Working Paper No Choudhri Ehsan and Hamza Malik 2012 " Moneary Policy in Pakisan: Confroning Fiscal Dominance and Imperfec Credibiliy" December mimeo. Choudhri Ehsan and Hamza Malik 2013 Moneary Policy in Pakisan: How can i Conrol Inflaion? March mimeo. Kumhof M. R. Nunes and I. Yakadina 2008 "Simple Moneary Rules under Fiscal Dominance" Board of Governors of he Federal Reserve Sysem Inernaional Finance Discussion Papers No Laxon Douglas and Paolo Peseni 2003 Moneary rules for small open emerging economies Journal of Moneary Economics Mishra Prachi Peer J. Moniel and Anonio Spilimbergo 2010"Moneary Transmission in Low Income Counries" IMF working paper WP/10/

23 Appendix 1. Complee Model H households c H sumni b sumr * 1 (1) 1 1 sumni ni sumni * * 1 s(1 r )(1 TC 1) (1 r )(1 TC 1) (2) sumr 1/ (1 r ) sumr 1 1 s (1 r )(1 TC ) (1 r )(1 TC ) * * 1 1 (3) ni p z p z s rm i g c AC (4) * X X D D L b (1 r )(1 TC ) b ( ni c ) / s (5) * * * 1 1 * Es 1 (1 r)(1 TC) (1 r ) (6) s TC e b* e b* 1 1 (7) cu H e c H 1r 1/ HC 1 r (8) d H ch r rd HD 1 r (9) AC 2 WH (1 ACWH )( 1) wh HN ( n ) ( ch ) ( wh ) wh (10) 1 n w w AC 1 r n w H 1 H H 1 WH 1 e H H 19

24 ( E ) ( ) 0 1 (11) e AC WH 2 WH w w H H (12) L households c w n (1 AC ( l)) srm cu / cu (13) * L L L WL L 1 L L cu L c Ec L L 1 1 e LC cl (14) (1 AC )( 1) w n c w AC 2 WL WL L LN L L L wl (15) 1 nl 1 wl wl 1 ACWL 1. e 1 r nl 1 wl AC WL 2 WL w w L L (16) Banks d cr b 1 H BD( ) ( B ) (17) l n (18) B BL HB cr b l d (19) B B H cr B (1 rd ) d e B 1/ H (20) b (1 r ) (1 ) d B D B H B (1 r) (21) 20

25 (1 AC )[1 r (11/ )] (1 r )( r / )( AC / r ) ( w / ) B B L L L B L H BL ( ch 1 / ch ) (1 rl 1 )( lb 1 / lb )( rl / )( ACB 1 / rl ) (22) AC B [1 rl ( b)] B 1 2 [1 rl 1( b)] 2 (23) Invesmen q i 1 I k. (24) Ere (1 ) Eq (25) rl q k 1 i (1 ) k (26) i l l (27) B H Demand z c c i g AC (28) H L AC ( p mc ) z AC ( p mc ) z AC AC w n AC w n AC (29) D D PD X X PX WH H H WL L L I z (1 ) z p (30) D D z z p (31) M M M p D 1 p (1 ) (32) z z ( p ) (33) * * * X X Firms 21

26 y n n k (34) H L 1HL Y HY L n ymc / w (35) HY H H n ymc / w (36) L L L n n n (37) H HY HB k (1 ) ymc / re (38) H L y ( f) z ( f) z ( f). (39) D X AC ( f) P D PD ( f ) 1 2 pd 1( f) 1 p 2 (40) AC ( f) P X PX ( f ) 1 2 px 1( f) 1 p 2 (41) AC (1 ACPD ) ( 1) pd mc p D ( pd mc ) p z (1 ) AC p ( p mc ) D 1 PD 1 D D 1 1 r zd pd PD D (42) AC (1 ACPX ) ( 1) px mc p X ( px mc ) p z (1 ) AC p ( p mc ) X 1 PX 1 X X 1 1 r zx px PX X (43) p s p (44) * M. M p s p (45) * X. X Fiscal and moneary policy 22

27 b g H L ( mb mb 1/ ) (1 r 1) b 1 (46) H H b b 1 b (47) mb (11 / ) g H L rb (48) mb cu cu cr (49) H L ln(1 R) ln(1 R ) (1 ){ln(1 R) (1 )ln( E / ) ln( y / y)} ln (50) rr 1 rr r 1 ry R e 1 r (1 R)/ (51) 1 R(1 r) (52) dirs ( s s ) (53) * ir Shocks ln g (1 G)ln ggln g 1 xg (54) ln Y (1 Y)lnYYlnY 1 xy (55) * * * ln rm (1 RM)ln rm RM ln rm 1 xrm (56) * * * ln( pm ) (1 M)ln( pm) Mln( pm 1 ) xm (57) Endogenous variables: AC AC AC AC AC AC b b b c c cr cu cu d dirs g i k l * * B PD PX WH WL B H L H L H B mb mc n n n n ni p p p p p r r r re q R R w * * H HB HY L D M M X X D L H wl y e s sumni sumr TC z zd zm zx B H H Y R. Exogenous variables: 23

28 bgmbl r rm x x x x * * H G Y RM M L. Parameers: H L rr r ry b G M R Y I WH WL P * * BL HC HD LC HN LN Y bcf gp M z( * z*). 24

29 Figure 1 Dynamic Response of Oupu Gap (%) o a Temporary Ineres Rae Decrease Figure 2 Dynamic Response of Inflaion (annual %) o a Temporary Ineres Rae Decrease 25

30 Figure 3 Dynamic Response of he Real Ineres Rae (annual %) o a Temporary Ineres Rae Decrease Figure 4 Dynamic Response of he Real Bank Loan Rae Spread (annual %) o a Temporary Ineres Rae Decrease 26

31 Figure 5 Dynamic Response of he Real Depreciaion (%) o a Temporary Ineres Rae Decrease 27

32 Figure 6 Dynamic Response o a (one s. d.) Shock o Governmen Expendiures 0.6 oupu gap (%) 0.15 real depriciaion (%) nominal ineres rae (%) 10.4 inflaion rae (%)

33 Figure 7 Dynamic Response o a (one s. d.) Shock o TFP 0.3 oupu gap (%) 0.15 real depriciaion (%) nominal ineres rae (%) 9.95 inflaion rae (%)

34 Figure 8 Dynamic Response o a (one s. d.) Shock o Foreign Remiances 0.4 oupu gap (%) 0.5 real depriciaion (%) nominal ineres rae (annual %) inflaion rae (annual %)

35 Figure 9 Dynamic Response o a (one s.d.) Shock o Foreign Impor Price 0.5 oupu gap (%) 1 real depriciaion (%) nominal ineres rae (%) 13 inflaion rae (%)

36 Table 1. Esimaes of Auoregressive Coefficiens and Sandard Deviaions Auoregressive Sandard Variable Coefficien Deviaion Governmen expendiures TFP Foreign Remiances Foreign Impor Price

37 Table 2. Macroeconomic Performance under Alernaive Ineres Rae Rules Sandard Deviaion Inflaion Oupu Gap Real Dep. (% per quarer) (%) (%) No Exchange Rae Sabilizaion Weak Response ( r 0.15 ) Moderae Response ( r 0.5 ) Srong Response ( r 1.0 ) Exchange Rae Sabilizaion Weak Response ( r 0.15 ) Moderae Response ( r 0.5 ) Srong Response ( r 1.0 )

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