Macroeconomic Effects of Financial Frictions: An Evidence from Pakistan Economy

Abstract

The core objective of this dissertation is to analyze the transmission mechanism of monetary policy in the presence of incomplete pass-through, the existence of the informal financial sector and time-varying financial frictions in Pakistan. These issues manifest some of the characteristics of the financial sector of Pakistan, which are pertinent for the effectiveness of the monetary policy. This study is a collection of three essays that utilize context-specific methodologies embedded in a Dynamic Stochastic General Equilibrium (DSGE) setting for both, closed and open economy frameworks. In the first essay, the monetary transmission mechanism has been analyzed in the presence of incomplete interest rate pass-through and cost-channel for exogenous monetary policy shock and endogenous movements in policy rate arising because of other financial, nominal, and real shocks in the economy. The study found that the degree of interest rate pass-through depends on the nature of the shock hitting the economy; while the cost channel exists only for monetary and financial shocks. A weak tradeoff has been recorded between the degree of pass-through and the cost channel of monetary policy. Interestingly, for some shocks banks have been found to shelter firms from monetary policy shock by smoothing retail rates but for other shocks, they do not do so. Instead, banks have pursued profit motives even within the economic stabilization goals of the monetary policy. In the second essay, the interaction between formal and informal financial sectors has been analyzed in the face of domestic and foreign monetary policy shocks. The welfare and resource distribution in the financial sector is also examined to ascertain the interlinkages between these sectors. The study finds that the presence of the informal financial sector significantly hampers the effectiveness of domestic monetary policy and mitigates the impact of the foreign monetary shock. It has also been found that welfare and resource distribution occurs due to informal financial activities. The third essay investigated the finance-growth nexus by constructing a financial liberalization index incorporating time-varying financial frictions, which is a manifestation of the de-jure financial liberalization process. For examining the impact of financial liberalization on growth, the Solow-Swan growth model has been extended to include the financial liberalization index. By incorporating the de-jure financial liberalization index, the growth-finance linkages confirmed that financial deepening and inclusiveness provide momentum to economic growth in both, the short- and long-run. Moreover, the impact of time-varying financial frictions is also examined. The empirical findings have confirmed that moving towards a more liberalized financial system by reducing rigidities and expediting an effective reform process offers optimistic prospects for economic growth and stabilization in Pakistan