The relationship between the Monetary policy and Inflation: a case study of Pakistan

Abstract

Many attempts have been made to figure out the real reasons for inflation in every economy. Inflation is considered to be monetary phenomenon in long run. Monetary policy tools such as interest rate and money supply are considered to be one of major determinants. In this paper we will study the relationship of Monetary Policy with Inflation with special focus on Pakistan. The study will analyze the State Bank of Pakistan’s monetary policy and tools it is using to control the inflation. The literature review describes the view about inflation and economic policy from different economists around the world and from Pakistan. The methodology of research consists of regression and correlation models where we test the relationship of inflation specifically with monetary components and then with addition of non-monetary components i.e wheat price, fuel price and exchange rate. This Two-model approach is to figure out the real effect of monetary components on inflation in Pakistan. In analysis part, the study tests the relationship of money supply and interest rate with inflation, based on past ten years data to figure out the trends and relationship of different variables with inflation. Whereas, different regression models and different correlation tests show variance in results, the highlight of the outcomes from this study is the failure of monetary policy to control the inflation, whether for absolute relationship of inflation with monetary policy or relative relationship of inflation with other determinants. Finally we conclude the study with recommendations to improve the monetary policy in order to control the inflation.