Monetary Policy and Economic Growth in Pakistan: ARDL Evidence from 1971–2018

Abstract

This research intends to explore the effect of monetary policy on the economic growth of Pakistan using time series annual data from 1971-2018. The variables of interest for the analysis are the key monetary and macroeconomic indicators such as interest rate, exchange rate, total reserves, gross fixed capital formation, inflation, labour force with gross domestic product as the indicator of economic growth. Before applying the ADF approach to investigate both long and short run relationship between the variables, the augmented Data of the Dickey-Fuller unit root test has been used to determine the stationarity properties of the variables. The ARDL bounds test results show that there is a long-run cointegrating relationship between monetary policy variables and economic growth in Pakistan. Results from the long run analysis reveal that interest rate and exchange rate have a statistically significant negative effect on economic growth suggesting that an increase in borrowing costs or appreciation of exchange rate negatively affects investment expenses, the production costs and macroeconomic stability. It indicates that the growth is positively and significantly influenced by gross fixed capital formation, thus underscoring the role of capital formation in achieving sustainable development in the economy. The long-run effect of total reserves, labour force and inflation are statistically insignificant, but the latter negatively affects growth in the short run. The error correction model corroborates a quick adjustment to the long-run equilibrium. The study advocates for a balanced and growth-oriented monetary policy for the monetary authorities, including controlling inflationary pressures, SAR and exchange rates, reducing overall interest rates and coordinating monetary and fiscal policies to engage in investment and sustainable economic growth in Pakistan.

Keywords: Monetary Policy; Economic Growth; Interest Rate; Exchange Rate; Gross Fixed Capital Formation.