BANKING SYSTEM INNOVATIONS

AND MONETARY POLICY: AN

EMPIRICAL STUDY OF PAKISTAN
By
Rabia Shakir1
Syed Muzammil Hussain2

1. Lecturer, Department of Economics, University of Karachi email rshakir@uok.edu.pk

2. Research Student, Department of Economics, University of Karachi

OUTLINE

Objective of the Study

Review of Literature

Theoretical Aspects

Choice of Variables

Methodology

Results

Conclusion

OBJECTIVES OF THE STUDY

To examine the role of monetary policy and

transmission mechanism with respect to the recent
Innovations in Banking System of Pakistan.
Increased consumer financing has led to demand
pull inflation in recent years which is in contrast to
the monetary policy objective of lowering inflation.
An attempt is made to provide an intuitive
explanation of this contrast in monetary policy
measure that encourages inflation, through an
indirect transmission mechanism.

REVIEW OF LITERATURE

Akhtar (1983) discussed financial advancements

and their impacts on monetary policy in global
scenario.
Lown (1987) contributed significantly to this issue
and discussed monetary policy with respect to the
financial innovations in a more rigorous manner.
Malik (2007) in his paper found that a simple
Output-inflation Taylor rule is insufficient to
attain the monetary policy objectives in the
current scenario of Pakistan.

THEORETICAL ASPECTS

Banking Innovations in Pakistan.

Transmission Mechanism through Credit
Channel of Monetary Policy
Consumer behavior and consumer financing

BANKING INNOVATIONS IN
PAKISTAN

Beginning of Banking in Pakistan

Nationalization of Banks

Privatization of Banks

Transformational reforms after Privatization

The post-reform era, 2006 present

Long journey to go

TRANSMISSION MECHANISM OF
MONETARY POLICY
Monetary
Policy

Central
Bank

Channels

Interest Rate
Credit
Exchange Rate
Asset Price

Output

Growth
&
Price
Stability

TRANSMISSION MECHANISM

2
4
1
3

SOME QUICK FIGURES OF CONSUMER

FINANCING IN PAKISTAN

Consumer Financing Share by

Sector(SBP, 2006)

Amount of Consumer Financing

(SBP, 2006)

Cont

CHOICE OF VARIABLES

We have taken four variables which are:

1.

Real Gross Domestic Product (Dependent Variable)

2.

Consumer Price Index to measure price levels

3.

Real lending rate as proxy for interest rate

4.

Broad money as proxy for money supply

(Independent Variables)

ECONOMETRIC FRAMEWORK

The Empirical framework used in this paper is based on Keynesian IS-LM model and
monetary theory.

The Functional Form of our model is as follows:

RGDP = f (CPI, RLR, M2)
Where,
RGDP = Real gross domestic product (constant price, LCU)
CPI = Consumer Price Index (2010=100)
RLR = Real lending rate (percent per annum)
M2 = Broad money (billions LCU)

The econometric model followed in this study can be written as:

RGDP = 1 CPI - 2 RLR + 3 M2 + 0
Where 1, 2 & 3 are the coefficients of independent variables and 0 is the
stochastic error term. The expected signs of 1 & 3 are positive, whereas the
sign of 2 is expected to be negative as suggested by the theory (Hasanov &
Omay, 2011).

METHODOLOGY

Methodology employed in this research consists of

three steps

First, to check the stationarity of the data

Second, Causality Test

Last, testing Cointegration followed by vector

error correction model (VECM)

RESULTS
AUGMENTED-DICKEY FULLER - UNIT ROOT TEST
Variables

Trend and

Order of

Intercept

Integration

1.76941
-5.52907*

-0.71351
-5.50785

I(1)

4.9591
-3.3185**

4.8931
-6.7578*

I(1)

-2.7487***
-4.4339*

-2.7538***
-4.3627*

I(1)

1.63045
-6.9209*

-0.0773
-6.8766*

I(1)

Intercept

RGDP
Level
1st Difference
M2
Level
1st Difference
RLR
Level
1st Difference
CPI
Level
1st Difference

*& ** indicates rejection of null hypothesis at 1% & 5% respectively based on Mackinnon

critical values

GRANGER CAUSALITY TEST

Dependent variable: D(RGDP)
Excluded

Chi-sq

df

Prob.

D(CPI)
D(RLR)
D(M2)

14.94269
7.582075
9.458250

2
2
2

0.0006
0.0226
0.0088

All

18.92071

0.0043

Source: Authors Computation 2015

JOHANSEN-JUSELIUS COINTEGRATION TEST RESULTS (TRACE)

Hypothesized
No. of CE(s)

Eigenvalue

Trace

0.05

Statistics

Critical Value

Prob. **

None *

0.789442

88.32217

47.85613

0.0000

At most 1 *

0.518823

38.46634

29.79707

0.0039

At most 2

0.375229

15.05767

15.49471

0.0581

At most 3

0.000182

0.005824

3.841466

0.9384

* denotes rejection of the hypothesis at the 5 %

Source: Authors Computation 2015

NORMALIZED COINTEGRATING COEFFICIENTS

RGDP

CPI

RLR

M2

1.000000

-3.398197*

793.0407*

0.025390*

(0.31670)

(114.484)

(0.00483)

* and ** denotes rejection of the hypothesis at the 5 % and 10% respectively

Source: Authors Computation 2015

ERROR CORRECTION ESTIMATES

Dependent Variable: RGDP
Method: Least Squares
D(RGDP(-1))

Coefficient
0.165773

Std. Error
0.22651

t-Statistic
0.73187

D(RGDP(-2))
D(CPI(-1))

-0.437011***
-0.187756

0.24217
0.15404

-1.80456
-1.21889

D(CPI(-2))

-0.511667**

0.20333

-2.51644

D(RLR(-1))

70.84949**

26.4963

2.67394

D(RLR(-2))

31.07324

23.0534

1.34788

D(M2(-1))

-0.000624***

0.00223

-1.79782

D(M2(-2))

-0.001367

0.00290

-1.47225

ECM t-1

-0.073723***

0.04104

-1.79628

ECM t-2

-0.327835**

0.12167

2.69437

R-squared

0.783890

Adjusted R-squared

0.675835

Durbin-Watson stat

2.360009

* and **denotes rejection of the hypothesis at the 5 % and 10 % respectively

Source: Authors Computation 2015

CONCLUSION

Our analysis illustrates that monetary policy has significant

impact on output through interest rate channel.

In our analysis, increase in money leads to decrease in output.

(Mallet & Keen, 2012)

However negative association of money is found with economic

growth which is opposite to monetary theory.

If we study the behavior of consumer in our economy, it makes

sense, because economy of Pakistan is consumption oriented.

Cont

The analysis of data shows that when supply of

money increases in the economy, real lending rate
decreases. (Mishkin, 2006)

As a result, households consume more because

credit is available at low cost. Therefore, they save
less and spend more.

Decrease in savings lead to a decrease in

investment and eventually output gets affected.

DIRECTION FOR FURTHER

RESEARCH

Other Channels of Transmission Mechanism can be

studied

By change in the length of data for instance taking

monthly or quarterly data rather than the yearly data

These estimations can be further strengthened with

an in-depth study of consumer behavior theories