In this chapter the theory building is done for making the economic model and also the econometric technique is discussed for estimation of the model. The study setting and variable selection is also discussed.
4.1 MONETARY POLICY
Johnson defines monetary policy "as policy employing central bank's control of the supply of money as an instrument for achieving the objectives of general economic activity". It consists of those actions undertaken by a central bank in pursuit of macroeconomic stability. Full employment, Price stability, Economic growth and balance of payments are the main objectives of monetary policy.
The instruments or tools of monetary policy are of two types Qualitative and Quantitative in nature.
Qualitative control includes change in margin requirements, regulation of consumer credit, moral persuasion, publicity, direct action
Quantitative control includes, open market operations, the reserve ratio, the discount rate, Foreign Exchange Interventions
4.2 ROLE OF MONETARY POLICY IN ECONOMIC GROWTH
Economic growth implies the expansion in productive capacity or capital stock in the economy so that increase in real national output or income is attained. Economic growth can be speeded up by accelerating the rate of saving and investment in the economy. This requires the following steps:
Increase in the aggregate rate of saving in the economy,
Mobilization of these savings so that they are made available for the purpose of investment and production,
Increase in the rate of investment
Allocation of investment funds for productive purposes and priority sectors of the economy.
Proper monetary policy can help in producing favorable effects on the above requirements of economic growth. Such as a high interest rate policy can promote savings.
4.3 ECONOMIC GROWTH
Economic growth can be defined as a persistent increase over a long period of time in the national income of an economy. The process of economic growth is a complex phenomenon that is influenced by numerous economic, political, social and cultural factors. In words of Professor Nurkse, "Economic development has much to do with human endowments, social attitudes, political conditions and historical accidents. Capital is a necessary but not the sufficient condition of progress". But some economist believed that the capital is the only requirement for growth and therefore the greatest emphasis is laid on capital formation to bring about economic development.
4.4 THEORIES FOR GROWTH
The theories of economic growth Harrod-Domar growth model, Neoclassical theory of growth, Mahalanobis Model of growth, Wage-Goods Model etc paid stress on the investment pattern and the accumulation of the savings for the growth and stabilization of an economy. And both the saving and investment decisions of an economy depend on the rate of interest in the economy.
4.5 OPEN ECONOMIES
Pakistan is considered as a small open economy. And the open economy can be expressed by the equation
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Or
E:\noreen\desktop\new\CHAPTER 3_files\image006.png
Where the C (consumption), I (investment), G (government spending) shows the internal or domestic expenditure or sectors while (X-M) or NX shows net exports that shows the external or foreign sector.
4.6 THE MODEL FOR OPEN ECONOMIES
The model that is being explained is the Mundell-Fleming model. And for the explanation of this model new tools of analysis are used.
IS Curve shows the various combination of interest rate (i) and national income (Y) at which goods market is in equilibrium.
LM Curve shows the various combination of interest rate (i) and national income (Y) at which the demand for money is equal to the given and fixed supply of money, so that money market is in equilibrium.
BP Curve shows the various combination of interest rate (i) and national income (Y) at which the nation's balance of payment is in equilibrium at a given rate of exchange.
The following diagram shows the equilibrium in the goods and money markets and in the balance of payments. The IS, LM and BP curves show the various combinations of interest rates and national income at which the goods market, the money market and the nation's balance of payment respectively are in equilibrium.
FIGURE 4.1 MUNDELL-FLEMMING MODEL
The IS curve is negatively inclined for the quantities of goods and services demanded and supplied to remain equal because lower rates of interest (and higher investments) are associated with higher incomes (and higher savings and imports). The LM curve is positively inclined for the total quantity of money demanded to remain equal to the given supply of money because higher incomes (and a larger transaction demand for money) must be related with higher interest rates (and a lower demand for speculative money balances). The BP curve is also positively inclined for the nation to remain in balance-of-payments equilibrium because higher incomes (and imports) require higher rates of interest (and capital inflow). All markets are in equilibrium at point E, where IS, LM and BP curve cross at ie and Ye.
RESEARCH DESIGN
4.7.1 Type of Study
As our research question is "Whether the monetary policy is playing a significant role in the macroeconomic stability and economic growth of Pakistan?" So in order to analyze that we will use the hypothesis testing technique as it usually explain the nature of certain relationship, or establish the among groups or the independence of two or more factors in a situation. And we formulate the following hypothesis:
HO : Monetary policy promotes economic growth in Pakistan
HA : Monetary policy does not promote economic growth in Pakistan
Type of investigation
The study is both causal and co-relational in nature. As the goal of causal study is to check the cause and effect relationship between variables and here we are interested in checking the effect of monetary policy on economic growth of Pakistan
And the study is co-relational in nature as co-relational study helps in mere identification of the important factors associated with the problem. And here in the study we have to check the impact of monetary policy through different monetary channels on growth of Pakistan.
4.7.3 Study settings
The non contrived study settings will be used for this research.
Data type and source
The secondary data will be used from the following sources
Economic surveys
SBP reports and working papers
Pakistan development reviews
Different economic journals
Newspapers
Internet sites etc
4.8 ROLE OF MONETARY POLICY IN THE ECONOMY AND THE RESEARCH MODEL
The following diagram best shows the working of monetary policy how monetary policy handles the aggregate demand through various channels and affects the aggregate output and price level.
For building up the research model we use the transmission mechanism or channels of monetary policy through which it affects economic growth and the equation that we have discussed in open economies. The three channels of monetary policy that affects growth are given as under:
interest rate channel
exchange rate channel
credit channel
Interest rate channel
The effect of monetary policy that work through real interest rates on the economy is called interest rate channel of monetary policy.
Working
When money supply decreases it increase the real rate of interest that cause a reduction in the aggregate demand (spending by consumers and firms) and declining aggregate demand leads to falling output and prices.
Exchange rate channel
The affects of monetary policy working through change in the real exchange rate are called the exchange rate channel.
Working
Under the exchange rate a higher real exchange rate reduces the demand for home country net export as it makes the domestic goods more expensive for foreign customers and makes foreign goods cheaper for domestic residents. All else being equal this reduced demand for net export reduces aggregate demand depressing prices and output.
Credit channel
Monetary policy affects credit demand and supply by affecting them it affects aggregate demand output and price level. These affects are called the credit channel of monetary policy.
4.9 THE EQUATION
Consider the equation that is given under heading open economies.
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It is known that
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G = G0 (autonomous)
NX (net export) = e - g EX (exchange rate)
Now by substituting these values in the above equation we have
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⇾E:\noreen\desktop\new\CHAPTER 3_files\image013.png
⇾ E:\noreen\desktop\new\CHAPTER 3_files\image014.png
⇾ E:\noreen\desktop\new\CHAPTER 3_files\image015.png
⇾E:\noreen\desktop\new\CHAPTER 3_files\image016.png
⇾E:\noreen\desktop\new\CHAPTER 3_files\image017.png
So the equation is of the form
⇾ E:\noreen\desktop\new\CHAPTER 3_files\image018.png
Now by adding up the price level in this equation as it is the major goal of monetary policy to stable the price level because by stabilizing the price level the aggregate demand can be controlled.
Here in this equation one of the most important instrument of monetary policy is not considered the money supply as a variable affecting the growth as in the Keynesian economics we have studied that the money supply is demand driven so by indirectly the price level is controlling the money supply by controlling the demand.
So the final equation of our model is of the form
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Where;
GDP growth = gross domestic product (the GDP growth rate is taken as the indicator of macroeconomic stability and growth of economy).
EX = the real exchange rate (EX is taken as the measures taken as the exchange rate channel of monetary policy).
r = the real rate of interest is taken as the measure under the interest rate channel of monetary policy to check how it affects the growth of GDP.
P = the price level is taken as the most important variable as the major goal of monetary policy is to stabilize the price level and through price level stabilize the output and growth in the economy
ï¡= the intercept of the equation
ï¢ = the coefficient of real rate of interest
ï¤ = the coefficient of real exchange rate
ï§= the coefficient of price level
4.10 LIST OF VARIABLES
GDP = the GDP shows the annual real GDP growth
CPI = the annual inflation rate indicating price level
RER = the real exchange rate estimated by the dividing the multiplicative answer of nominal exchange rate and CPI of Pakistan over the CPI of United States.
REER = the real effective exchange rate calculated in terms of the weighted average of basket of goods in different currencies.
Consumption = C = HFCE (house hold final consumption expenditure annual growth)
Investment = I = total investment annual growth rates
Net export = net export annual growth rate
Exports = Exports of goods and services annual growth rates
Imports = Imports of goods and services annual growth rates
Savings = Gross domestic Savings (% of GDP)
Capital Formation = Gross Capital Formation annual growth rates
FDI = Foreign direct investment, net inflows as percentage of GDP
Trade = Trade as percentage of GDP
4.11 ECONOMETRIC TECHNIQUE
As the data that is being used for the explanation of variables of the research model is of time series in nature and we know that the following are Time series econometric models:
ARIMA Models and the Box-Jenkins Methodology
Modeling the Variance: ARCH-GARCH model
Cointegration and Error-Correction Models
Vector Autoregressive (VAR) models and causality Tests
If there exist contemporary relationship between variables that say two or more variables are jointly dependent then we use the VAR models. VAR assumes that all the variables are endogenous and there is no priori distinction between endogenous and exogenous variable.
Suppose that the 1Ã-m row vector Yt denotes the tth observation on a set of variables. Then a vector autoregressive model of order p, or VAR (p) for short can be written as
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4.12 METHODOLOGY
In this study firstly the Stationarity of variables is used to estimated for this unit root test are applied after that VAR analysis is used for the overall estimation of the research model. And then Granger-Causality test is used for the individual analysis and graphical techniques are used.
4.12.1 Stationarity Analysis and Unit Root Tests
Most macroeconomic time series are trended and therefore in most cases are non-stationary. And there is a problem with non-stationary data or trended data is that OLS regression procedure can easily lead to incorrect conclusions. The assumption of CLRM requires both Yt and Xt to have a zero mean and constant variance i.e. to be stationary. In the presence of non-stationarity the results obtained from regression are not reliable and totally spurious and these regressions are called spurious regressions. The general rule of thumb for detecting spurious regression is R2 > DW-statistic.
4.12.1a What is unit root?
Consider the AR(1) model:
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Where et is a white noise process and the Stationarity condition is |φ| < 1. In general we have three possible cases.
|φ| < 1 and therefore the series is stationary.
|φ| > 1 where in this case the series explodes.
φ = 1 where in this case the series contains a unit root and is non-stationary.
4.12.1b Testing for unit roots
For testing that is there any unit roots in the series the Augmented Dickey-Fuller test for unit roots will be used.
4.12.1c The Augmented Dickey-Fuller (ADF) test
Dickey and Fuller (1979, 1981) devised a procedure to formally test for non-stationarity. The key insight of their test is that for non-stationarity is equivalent to testing for the existence of a unit root.
As the error term is unlikely to be white noise, Dickey and Fuller suggested an augmented version of the test which includes extra lagged terms of the dependent variable in order to eliminate autocorrelation. The lag length on these extra terms is either determined by the Akaike Information criteria (AIC) or Schwarz Bayesian Criterion (SBC).
The three possible forms of the ADF test are given by the following equations:
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This procedure is the most sensible way to test the unit root when the form of data generating process is unknown.
4.12.2 Vector Autoregressive (VAR) Models
It is quite common in economics to have models where some variables are not only explanatory variables for a given dependent variable, but they are also explained by the variables that are used to determine. In those cases we have models of simultaneous equations, in which it is necessary to clearly identify which are endogenous and which are exogenous or predetermined variables. The decision regarding such a differentiation among variables was heavily criticized by Sims (1980).
According to Sims (1980), if there is simultaneity among a number of variables, then all these variables should be treated in the same way. In other words there should be no distinction between endogenous and exogenous variables. Therefore, once this distinction is abandoned, all variables are treated as endogenous. This means that each equation has the same set of regressors which leads to the development of VAR models.
In VAR there is an issue regarding the condition of Stationarity of the variables. Sims (1980) and Sims, Stock, and Watson (1990) were of the view that there is no need of differencing even if there exist unit root in the variables. They argue that the goal of VAR is not to determine the parameter estimates but to analyse the interrelationship among the variables. The major cause of being against differencing is that it "throws away" information concerning the co movements in the data (such as the possibility of cointegrating relationship). So, there is no need to detrend the data.
4.12.2a Testing Hypothesis
In principle there is nothing to prevent from incorporating a large number of variables in the VAR. it is possible to construct an n-equation VAR with each equation containing p lags of all n variables in the system. An n-equation VAR can be represented by
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Where: Ai0 = the represents the intercept term
Aij(L) = the coefficients with 1degree in the lag operator L
Since all equations have the same lag length with individual coefficients of Aij(L) are denoted by aij(1), aij(2),…, the polynomials Aij(L) are all of same degree. The terms eit may be correlated and are White-noise disturbances.
The VAR of the research model can be expressed as under
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4.12.2b The Impulse Response Function
The impulse response function is a practical way to visually represent the behavior of the series in response to the various shocks.
4.12.2c Cholesky Decomposition
Decomposing the residuals in the triangular fashion is called choleski decomposition. Cholesky decomposition constrains the system such that a εyt shock has no direct effect on Zt there is an indirect effect in that lagged values of Yt affect the contemporaneous value of Zt. The decomposition forces a potentially important asymmetry on the system since a shock εyt has contemporaneous affect on both the series included Yt and Zt.
4.12.2d Stability test
The stability test check the results for robustness and also look for evidence of structural breaks and other misspecification problems in the VAR.
4.12.3 Granger causality test
Granger causality test determines the impact of past information in one variable on the current value of the other, and determines if there is a relationship between the two variables over the long run. The two variables are considered independent if there is no pair-wise causality in the indicators.
