INTRODUCTION

Monetary policy is a process by which the central bank of a country controls the supply of money
in a country, often targeting the rate of interest for promoting economic growth and stability or in
other words sustainable growth. (Eric M. Leeper, 1996). The basic goal of monetary policy is to
gain the stable price or stable inflation and low unemployment. Monetary theory provides insight
into how to craft optimal monetary policy. It is referred to as either being expansionary or
contractionary, where an expansionary policy increases the total supply of money in the economy
more rapidly than usual, and contractionary policy expands the money supply more slowly than
usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment
in a recession by lowering interest rates in the hope that easy credit will entice businesses into
expanding. Contractionary policy is intended to slow inflation in hopes of avoiding the resulting
distortions and deterioration of asset values.
Monetary policy focus on the interest rate on which banks and other financial institutions do
borrowing and lending in the economy and it also focus on the supply of money in the economy
by which inflation and unemployment is controlled. Monetary policy use certain on its tools to
get the above mentioned targets, its targets also includes foreign exchange rates in the country
that affects the balance of payment accounts of the country. (Robert H.Frank,2004). Where
currency is under a monopoly of issuance, or where there is a regulated system of issuing
currency through banks which are tied to a central bank, the monetary authority has the ability to
alter the money supply and thus influence the interest rate (to achieve policy goals). The
beginning of monetary policy as such comes from the late 19th century, where it was used to
maintain the gold standard.

LIMITATION OF MONETARY POLICY

"Pakistan a CRT-5 country, is itself the site of military and terrorist activity. Its fundamental lack
of political stability is a challenge to its economic and financial outlook.” Due to this status,
function of monetary policy would face lack of transparent via the absence of political stability;
hence this situation would facilitate to the people who are on the power to force policies that serve
their interests, so these polices will lead to inequality in distribution wealth and income, under the
name of monetary policy. This was argued by Dr. Ayub Mehar "macroeconomic indicators have
been showing the significant improvement in the economy of Pakistan in the recent past regime.
The painful situation is that the effects of macroeconomic growth have not been transferred to the
lower income segment of the society." Moreover, the central bank in most developing countries is
independent and relies in government which is in this case face instability in itself. In conclusion,
"Political instability is also one of the major hurdles to improve the BOP situation of the country.
This situation is very much disappointing internationally as well as internally."
Second, beside the political instability of LDC, many of them have a lack of institutional quality
as well as great levels of corruption. In addition there is a scarce on papers that study the
implication of the corruption for the strategy of monetary policy. One of the studies was done by
Journal of International Economics and its result show how positively relationship between
corruption and inflation, where this assist to reduce the feasibility of monetary policy in
developing countries like Pakistan “First, the optimal inflation target is higher for a country with
poorer institutional quality. Hence, an inflation target of 1–4%, that is common among advanced
industrialized countries and might be called “international best practice,” is generally not
something to be emulated by developing countries. Second, pegged exchange rate, currency
boards, or dollarization are often prescribed as ways to solve the lack of credibility problem.
However, these monetary regimes are typically not very credible themselves and are likely to fail
(often associated with a currency crisis) in countries with weak institutions.”

Does Monetary Policy Play Effective Role in Pakistan

“Inflation is politically costly for the government (Haque and Qayyum, 2006). High and
persistent inflation is a regressive tax which adversely impacts the poor (Baily, 1956, and Fisher
and Modigliani, 1978a, 1978b). The poor are extremely limited in their options to protect
themselves against inflation; they are normally asset-poor, while most of their saving is in the
form of cash. Inflation erodes cash savings and protects the rich who hold real assets (Fisher and
Modigliani, 1978a). Given the well-known costs of inflation, policy now in all countries is
inflation-averse. Studies have also found that high and volatile inflation has been detrimental to
growth and financial sector development. Resource allocation is inhibited as inflation obscures
relative price changes and thus inhibits optimal resource allocation.
Knowledge about the factors that drive inflation is important to formulate appropriate policy to
control inflation. Unquestionably, empirical evidence points to “inflation being always and
everywhere a monetary phenomenon” [Friedman (1963)]. However, there still remains some
debate on whether supply-side factors could cause inflation without 1 Professor and Registrar at
the Pakistan Institute of Development Economics (PIDE).”
HOW MONETARY POLICY AFFECTS POVERTY: NEXUS AND CONSEQUENCES

“During the recent years the responsibility of economic development has largely been shifted on
corporate sector from the governmental agencies. The responsibilities of every types of
development are being shifted from bureaucrats to the technocrats. The political roles and
pressures of the armed forces, business leaders, international consultants, technocrats, and
community leaders are being re-shaped. In the present transitory condition, the role and
responsibilities of civil servants are also being changed. The financial markets experiences in the
Far Eastern and South American countries in recent past have shown that the problems of
corporate sector are not only the problems of investors, speculators and stockbrokers, they are
also the problems of a common man. The financial problems in corporate sector cannot be
segregated from the problems of unemployment, income distribution, poverty and development.
In the present scenario, it seems that the poor are being virtually penalized for the end of cold
war. ‘Globalization’ is one of the prescriptions recommended by the builders of macroeconomic
models to solve the problem of poverty. It is a common phenomenon in all over the globe that all
privileges and rights and positives of the globalization are only for richer segment of the
societies. The poor do not have power to utilize the facilities of education, entertainments,
information technology, migration, immigration, and mobility. Immigration and education are
considered as modes of the reduction in poverty; they are
creating further gaps.”
Measuring the Stance of Monetary Policy for Pakistan’s Economy
“Economic literature and theory has a characteristic feature that it puts no barriers to its ever
changing dimensions if required by the time. Conduct of monetary policy is nevertheless a
different issue, which has mostly been under different transitions keeping intact the essence of
original economic theory with it. Pursuit of the price stability has always remained a desirable
and most primary goal and objective of monetary policy but the intensity that has been brought in
with the regimes of inflation targeting reveals a subtle commitment to the cause of economic
stability. This targeting is led by the idea of output being hampered if the inflation surpasses its
threshold level (Khan and Sinhadji, 2001), (Mubarik, 2005).”

Monetary and Fiscal Policy Coordination

“The objectives of macroeconomic policies are to ensure that the economy achieves
noninflationary, stable growth. By this we mean purposeful manipulation of policy instruments
such that fluctuations in employment, production and prices are minimized and potential growth
in real output is realized. There are two major groups of policy instruments; one is related to
monetary conditions and the other to fiscal conditions. Monetary instruments are employed by
the central bank and fiscal instruments are employed by ministry of finance. The objectives and
implications of policy measures taken by the two institutions often conflict with each other. Thus
it is imperative to have a mechanism of coordination between the two authorities for the better
functioning of overall economy.”

Monetary Policy Objectives in Pakistan:

An Empirical Investigation “Since the seminal work by Taylor (1993) on using monetary policy
rules in a practical way,
researchers have been trying to explore the policy reaction function for different countries. One
practical issue in the Taylor rule is the monetary policy objectives considered in the rule.
According to this rule there are only two objectives of monetary policy: output and inflation. In
practice central banks have objectives other than these two like interest rate smoothing and
exchange rate stabilisation. This issue becomes more important in developing countries where
exchange rate is not flexible and governments depend heavily on seignorage revenues due to
limited effort to generate revenues from other sources and heavy budget deficits. So if these
countries use Taylor rule as practical guide for monetary policy then the rule would be
incomplete in the sense that it does not address the issues faced by the monetary authorities. So
the point here is that before suggesting any rule to a central bank, one should be very clear on
monetary policy objectives in the country.In estimating response of the central banks to different
variables, researchers miss-specify the reaction function.”