Monetary Policy Reaction Function in Open Economy Version: Empirical Evidence in Case of Pakistan

Abstract

Aftermath the globalization and financial liberalization the purpose of monetary policy deviates from economic growth to economic stabilization. Therefore monetary authority adjusts its policy rate in response to systematic changes in macroeconomic activities and business fluctuations. The rule which is followed to stable an economy at development path is called Taylor’s rule. This study empirically investigates monetary policy reaction function in case of Pakistan by applying Taylor’s rule (1993) nevertheless Johansan co integration test is employed for its open economy version. The monthly data from the period of January 2003 to December 2008 has been collected for the analysis. It is found that the coefficient of output gap and exchange rate gap are significant while coefficient of inflation gap is insignificant. The results depicted that inflation does not play significant role due to the monetary policy as such in the frame work of Pakistan’s economy. Therefore inflation targeted monetary policy does not suggest for Pakistan. To analyze the stability of coefficient Rolling Window technique was employed as it is found that monetary authority adopted inflation targeted monetary policy after 2002 which was not suitable as this study has shown.

Keywords: Taylor’s rule, inflation gap, output gap, exchange rate gap