Choice of Optimal Monetary Policy Rules for Pakistan within DSGE Framework

Abstract

An optimal monetary policy is crucial for the macroeconomic stability in terms of output and inflation. A general debate in macroeconomics is that monetary policy rules have a greater advantage over discretionary stance in order to enhance and improve the economic activity. The State Bank of Pakistan (SBP) has not ever stated itself to be following any sort of rule. Design of optimal rule results in complications that cannot be implemented easily. This study explores two monetary policy rules, namely the price and the quantity rule. For this purpose we have used the calibration analysis based on DSGE model for Pakistan, using quarterly data from 1992Q3 to 2017 Q2 the parameters of the Taylor rule and the money supply rule have been estimated by applying GMM technique. Counterfactual experiments by using money supply as a policy instrument have also been undertaken of the study that the quantity rule raises volatility in output gap and inflation. On the other hand, volatility in inflation and output gap has been found to be minimum in the Taylor rule, implying that the price rule outperforms over the money supply rule and it converges to steady state. This outcome supports the policy stance of the SBP that focuses on the price of money as a policy rule to control inflation and output variability.