New Keynesian structural var model of oil prices with direct role of money for Pakistan

Abstract

Pakistan is an oil-intensive economy and the dependence of both its industry and household productivity and use is linked strongly to international prices. The disparity between production levels and needs is very large. Oil imports constitute 36 percent of Pakistan’s total import bill. This study takes a lead in the literature through incorporating oil prices in the New Keynesian environment with direct role of money. Specially, it focuses on the prime objective of understanding the dynamics of oil prices on the economy of Pakistan. Two step Structural VAR model is adopted wherein we followed the methodology of Keating (1990) to identify rational expectation restrictions. As such, New Keynesian model and SVAR models are compatible which is supported by Gali (1999) along with others. The literature review and the preliminary analysis of the Pakistan’s economy play complementary role in analyzing the simulations and the sources of variations. The results portray that high oil prices lead to low output growth along with inflationary effects on the economy. Given the uncovered interest parity condition, as interest rate increases domestically relative to interest rate in world market, exchange rate depreciates. In this setup, the government has to stabilize the economy by keeping exchange rate and exchange rate volatility stable. Thus, fiscal and monetary policies can play their role for the stability of exchange rate. Also the monetary authority should contribute to lessen the deteriorating influence of oil price shocks.