Exchange Rate Flexibility and the Monetary Policy Framework in Pakistan

Iqbal M. Zaidi ()
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Iqbal M. Zaidi: IMF, Washington, D.C.

SBP Research Bulletin, 2006, vol. 2, 115-140

Abstract: This paper focuses on the choice of exchange rate regime and the implications of alternative monetary policy frameworks for Pakistan. It notes that, in the context of international capital mobility, there is ample evidence sustaining a fixed exchange rate in the face of terms-of-trade or international financial market shocks is very difficult. Furthermore, a forced abandonment of a fixed exchange rate has proved to be quite disruptive for some countries. In light of the discretionary nature of the existing monetary policy in Pakistan, there may be a case—especially in the context of a flexible exchange rate policy—for pursuing an inflation objective more directly. Inflation targeting can help to make monetary policy more transparent by focusing attention on an explicit goal, thereby increasing the public’s understanding of the central bank's strategy to deliver the target. More specifically, an inflation target for the State Bank of Pakistan (SBP) will help to provide an anchor for inflation expectations in the economy, and the announcement of a clear path for the medium-term inflation outlook will reduce the size of inflation "surprises" and their associated costs in terms of output fluctuations. While recognizing that there might be considerable merit in adopting an alternative monetary policy framework, it should nevertheless be stressed that the authorities would need to take some important steps to improve the central bank’s capacity to conduct such a policy, including enhancing technical skills at the SBP. The most crucial amongst the requirements for successful inflation targeting would be the continuous criterion that the authorities must ensure that there is no return to fiscal dominance of monetary policy.

Date: 2006
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