Monetary Policy

 










Frequently Asked Questions
Additional Educational Material
Glossary of Key Economic Terms



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Understanding Money


What is money?
Money is any asset or a good that is readily acceptable for making payments against the purchase of goods and services or settling debt obligations. For example, currency notes, coins, and cheques drawn against bank deposits are the most common forms of money used by an average Pakistani to carry out their day-to-day transactions. Recently, payments through credit and debit cards are gaining popularity. However, their acceptability is restricted to main cities and towns only.

Money can also be thought of as a special asset or good that could perform three basic functions viz. medium of exchange, unit of account, and store of value. For this reason, it is sometimes stated that money is what money does.

How is money created?
Money is usually created when SBP either buys domestic assets, mainly government securities, and foreign exchange from the banking system or directly lends to the government or financial institutions. For example, when SBP buys government securities through its open market operations from the interbank market, it gives banks equivalent rupee liquidity in return; which banks use to create more assets, such as loans to private and public sectors. The money thus created is called base money, seed money,high powered money, or reserve money.

Since most of the loaned funds are later re-deposited into the banking system and banks keep only a fraction of deposits in cash in tills or reserves with the SBP, it allows banks to make further lending and create additional money by multiplying the base money. Deposits and assets of banks are expanded and therefore broad money increases in the system.


How is money supply measured in Pakistan?
There are several ways to measure money supply in an economy depending upon different degrees of liquidity that different types of monetary assets have. Money supply is generally measured as a sum of currency in circulation and deposits of general public in different financial institutions.

In Pakistan, M2 is the most widely used definition of broad money. From liability side, it is measured as a sum of currency in circulation; total deposits of non-government sector, including residents’ foreign currency deposits; and other deposits with SBP. And from asset side, M2 is a sum of net domestic assets and net foreign assets of the banking system (i.e. SBP and scheduled banks).

In addition, data from liability side of a narrower definition of money as M1 and a broader definition of money as M3 are being regularly complied and published by SBP. M1 is defined as a sum currency in circulation, demand deposits with banks, and other deposits with SBP. M3 is measured as M2 plus public deposits or investment in national saving schemes, deposits with post offices, and non-bank financial institutions.

Why is it important to monitor growth in money supply?
There exists a strong and positive correlation between inflation and monetary growth in Pakistan in a long term perspective. A number of empirical studies concluded that high inflation is associated with high monetary growth in the country in the long-run. Therefore, to achieve the objective of maintaining low and stable inflation, it is essential to monitor the growth in money supply as an important indicator for monetary policy.

There is no defined level of monetary growth that is suitable for all time. Rather it depends on overall economic conditions in the country, in particular levels and trends in inflation and economic growth.

How does SBP influence money supply in the system?
SBP mainly influences the broad money growth by changing its monetary policy rate, conducting open market operations and foreign exchange SWAPs, and modifying cash reserve requirements for the scheduled banks. A cut in the policy rate, followed by appropriate liquidity management, transmits to bank lending rates with a lag and may induce demand for credit and broad money in the economy. Similarly, with low reserve requirements, banks are able to loan more money, which may increase the overall supply of money in the economy.

Interest Rates in Pakistan

How does SBP influence long-term interest rates and bank’s lending and deposits rate?
SBP signals its monetary policy stance through changes in its policy rate known as the SBP reverse repo rate. SBP aims to keep the overnight interbank repo rate within the 250 basis points corridor set by the SBP reverse repo rate as its ceiling and SBP repo rate as its floor with effect from 11 th February 2013.

SBP influences long-terms rates by exploiting their relationship with short-term rates. In general, the long-term interest rates reflect the average expected future level of short-term interest rate plus a term premium to compensate for uncertainties. Changes in the policy rate influence the long-term interest rate through its impact on short-term interest rates, term premium, and inflation expectations. Demand and supply of loanable funds also play a vital role in determination of interest rates in the market.

Lending rates of banks are linked to a benchmark rate known as Karachi Interbank Offered Rate (KIBOR), which is published by Financial Market Association of Pakistan. SBP has mandated banks to benchmark their lending to the corporate sector to KIBOR, so that the pricing mechanism is transparent.

Deposit rates are largely market driven; nonetheless, State Bank of Pakistan has set a minimum rate on saving deposits (which are approximately one-third of total deposits) to safeguard the interest of depositors and to avoid a high lending-deposit spread.
Understanding Inflation


What is inflation? How is inflation measured in Pakistan?
Inflation is a sustained rise in general price level in an economy over time. It also indicates a decline in the purchasing power of money over time; i.e. a certain amount of money buys less and less over time than it used to do earlier. For example, the price of one kg of wheat, one kg of basmati rice and one litre of milk was Rs24 in July 1991, which has increased to Rs.226 in May 2013. This shows that the purchasing power of money has significantly declined during 1991-2013.

Pakistan Bureau of Statistics (PBS) compiles and publishes data of various measures of general price levels in Pakistan; including consumer price index (CPI), wholesale price index (WPI), sensitive price indicator (SPI), and GDP deflator. CPI, WPI, and SPI are compiled on monthly basis, while the data on GDP deflator is published on annual basis. SPI data is also available at weekly frequency.

CPI is the most commonly used measure of general prices to analyze inflation in the country. Inflation targets are set in terms of an annual change in CPI on average basis for a fiscal year. The CPI records weighted average change, with respect to a base year, in the prices of a ‘basket’ of goods and services— such as food, housing, fuel, transport, clothing, furniture, education, medicines and entertainment etc — that a ‘typical Pakistani consumer’ purchases. The weight attached to a particular item in the CPI basket, e.g. milk, is derived as ratio of average spending by the households on purchase of milk to average expenditure of the households. Family budget survey, periodically conducted by PBS, provides the basis of selecting items and their respective weights in the CPI basket.

Details on the methodology of data compilation of price indices are available on PBS website.

What causes inflation in Pakistan?
There are several factors that can affect inflation on a temporary or a permanent basis. For instance, a relatively higher growth in aggregate demand of goods and services than of its supply; upward adjustment in administered prices such as utility prices; rise in international commodity prices such as oil; supply-side disruptions due to natural calamities such as floods and earthquake; depreciation of local currency vis-à-vis other currencies; etc are some of the factors that can spur inflation at least in the short-run.

A large number of empirical studies find growth in money supply as one of the most important determinants of long-term inflation in Pakistan. This is in line with theoretical underpinnings and empirical results for inflation in many other countries. This is why inflation is often described as “too much money chasing too few goods”. In other words as the money supply in an economy exceeds the amount needed for financial transactions, aggregate demand outpaces the production of goods and services. As an outcome, inflation increases and the purchasing power of a local currency unit declines.

In the studies on inflation in Pakistan, fiscal deficit, government borrowings from SBP, exchange rate depreciation, international commodity prices are some other factors that are found to play a significant role in determining long-term inflation in the country.

Why is high inflation bad?
High inflation makes maintaining a standard of living difficult because it erodes the purchasing power of money in terms of amount of goods and services one could buy. It also undermines the use of money as a store of value. High inflation can severely affect the normal working of an economy and is usually detrimental for sustained economic growth. At times, high inflation is also accompanied by increased volatility in prices of goods and services. It creates uncertainties and affects the decisions of households and businesses to consume, save, or invest.

It particularly discourages investment, which has negative implications for sustaining higher economic growth over long-run. Uncertainty about future prices makes businesses hesitant to make investment decisions. This is because volatility in inflation makes it difficult for businesses to anticipate the prices of the products they plan to produce now and which would make their way into the market in future. Similarly, high and volatile inflation confuses consumers about spending now or postpone it to some latter date. Ultimately, it reduces overall spending in the economy that starts hurting economic activity in the short run.

Higher domestic inflation compared to inflation in countries which are our trading partners or competitors also erodes competitiveness of our exports and imports, thus negatively affecting the trade deficit – the gap between receipts against export of goods and payments against imports, all expressed in foreign currency. Higher inflation increases the prices of raw material as well that pushes up domestic cost of production. This makes our exports costly relative to our competitors in our export destination countries. Therefore, growth in exports slows down leading to widening of trade deficit.

Prolonged inflation also affects income distribution in the country negatively, particularly affecting the poor by redistributing wealth to the riches that have non-money assets, such as land or gold.

Why shouldn’t SBP attempt to bring inflation down to zero?
Some inflation is always necessary for incentivizing the businesses to invest and produce more, creating employment opportunities for the new entrants in the labor market. There are at least four reasons cited against targeting ‘zero’ inflation

First, as widely believed, there is an upward bias in the measurement of CPI inflation and targeting ‘zero’ inflation might run the risk of deflation in the economy. In other words, after adjusting for the impact of improvement in quality of goods and services over time, the rate of increase in adjusted price level might even decline on average across the economy.

Second, given downward rigidity in wages, no inflation would lead to a rise in real wages making adjustments in the labor market difficult. Low inflation, however, might allow some flexibility and wages might not rise in relative terms.

Third, bringing inflation down to zero is costly in term of required contraction in economic activity and employment in the economy.

Fourth, as nominal interest rates cannot be negative, keeping inflation at zero make the monetary policy ineffective when interest rates fall close to zero. A central bank cannot stimulate economic activity during recession unless there is some inflation so that reducing interest rate could turn the real interest rates negative and thus encourage people to spend more.

Understanding Monetary Policy

What monetary policy can and cannot achieve?
There is a general agreement among economist that monetary policy can stimulate economic activity only in short-run and under certain condition, i.e. economy is operating below its potential level and inflation is low. It is widely experienced that attempts to increase growth beyond what an economy can sustain, with its given resources and technology, through expansionary monetary policy result in high and volatile inflation; which have negative repercussions for long-term economic growth.

Given limited influence of monetary policy on growth in the long-run, what monetary policy actually strives is to align demand in the economy close to its productive capacity. For instance, when economy is in recession and working below its productive capacity, a n expansionary monetary policy would tend to increase aggregate demand in the economy. For instance, the expansionary monetary policy increases incentives for households and businesses to borrow more by reducing their cost of borrowing from commercial banks. Through this way, demand for goods and services increases in the economy, and firms respond to this increased-demand by increasing their production and thus requiring more raw material, labor and machinery. However, if money supply continues to increase, and thus demand for goods and services, the prices start to rise at a faster pace and result into higher inflation.

In short, monetary policy has a lasting effect on inflation but only a transient impact on economic growth.

What is the role of monetary policy in promoting economic growth?
Both literature and central bank practices show that the best contribution monetary policy can make to sustainable growth and employment generation over the long run is by keeping inflation low and stable. By maintaining price stability, monetary policy reduces uncertainty about prices changes and provides an economic environment that allows the economy to expand in line with its production capacity. The literature also shows that low and stable inflation is pre-condition for securing growth prospects over the medium and long term.

If monetary policy can stimulate economic activity in a recession, why not use it all the time?
There is a certain level of growth an economy can achieve in the long run utilizing all of its available resources, which is referred to as the long run growth potential of the economy. When an economy operates below its long run growth path, it means that the economy is not utilizing its full potential and some resources are idle. Under such a situation, loose monetary policy could boost domestic demand and push growth towards the long run growth path. However, any attempt to expand growth beyond the long run path only results in inflation without any significant increase in output and employment in the economy.

Why doesn’t SBP simply print enough money to pay off national debt?
Printing money to pay off the national debt will cause inflation and effectively reduce the value of domestic money. This is because it will add to money supply in the economy without a matching increase in production of goods and services. This could even lead to hyper inflation, which has negative repercussions for economic growth and overall well being of the people. Furthermore, the increase in money supply of rupee against other currencies would also cause the rupee to depreciate.

Germany is a classic example where large scale printing of money was done to pay off their restitution payments after the First World War. This led to rampant inflation from 1922-24 and left the Deutcshe Mark worthless: people literally used notes to lit fires. Recently, Zimbabwe is faced with a similar situation.

What can monetary policy do in case inflation is caused by supply shocks only?
Monetary policy can prevent effects of the supply shocks affecting a particular segment of the CPI basket to become wide spread and broad based over time. For instance, a supply shock leading to a sharp increase in food prices, due to increase in international commodity prices, floods, droughts, etc., might make it difficult for factory workers in managing to fulfill bare needs of their families of average size. Therefore, the labor union would press the factory management for increasing their wages and salaries. This results in increased cost of production and as businesses usually pass these on to consumers, prices of the goods they produce rises further. This is known in the literature as the ‘second round effect’. Thus, inflation may further go up.

An increase in interest rate (if necessary) can stop potential second round effects of such supply shocks on inflation. Depending on credibility of the central bank, the increase in interest rate in the first place would help in calming the expectations of rise in prices of other commodities of CPI basket. With the expectation of compensation in terms of fall in prices of ‘other segment of the CPI basket’, there will be lesser pressures on wages and salaries, thereby, contributing to decline in inflation in future.

Why does SBP focus on price stability?
Research shows that keeping inflation low and stable creates a favorable environment for sustaining high growth and generating employment opportunities in the long run. It also helps in preserving the domestic value of money and fostering confidence in national currency. These reduce uncertainties about future movements in prices of goods and services and facilitate consumers and businesses to make long-term financial decisions with more confidence. Thus price stability supports long-term investment, which is critical for employment generation and efficiency and productivity in the economy. Moreover, low and stable inflation help businesses to maintain competitiveness in both the local and international markets. It also protects the purchasing power of low and fixed income segments of society, whose savings are in cash rather than real assets.

  •  
    SBP Policy Rate
    16.00% p.a.
     
    SBP Overnight
    Reverse
    Repo (Ceiling) Rate
    17.00% p.a
     
    SBP Overnight
    Repo (Floor) Rate
    15.00% p.a.
  •  
    Weighted-average Overnight Repo Rate
    As on 02-Dec-22

    15.27% p.a.
     
    KIBOR
    As on 05-Dec-22
    Tenor BID OFFER
    3-M 16.66 16.91
    6-M 16.72

    16.97

    12-M 16.75 17.25
     

  • MTBs
    Tenor Rates
    3-M 16.9999%
    6-M 16.8000%
    12-M 16.8401%
    (as on Nov 30, 2022)

    PIBs (Fixed Rate)

    Tenor Cut-off Rates
    3-Y Bids Rejected
    5-Y 13.3500%
    10-Y Bids Rejected
    15-Y No Bid Received
    20-Y No Bid Received
    30-Y No Bid Received
    (as on Nov 29, 2022)

    PIBs (Floating Rate Quarterly)

    Tenor Cut-off Price
    2-Y Rs. 98.9379
    3-Y Bids Rejected
    (as on Nov 30, 2022)
    PIBs (Floating Rate Semi Annual)
    Tenor Cut of Price
    5-Y Bids Rejected
    10-Y Bids Rejected
    (as on Nov 30, 2022)
    GIS (FRR)
    Tenor Cut-off Rental Rate
    5-Y Bids Rejected
    (as on 01-Dec-2022)
    GIS (VRR)
    Tenor Cut-off Price
    5-Y Bids Rejected
    (as on 01-Dec-2022)
  • PIB Auction
    (Fixed Rate)
    21-Dec-22


    MTB Auction

    14-Dec-22

    PIB Auction
    (Floating Rate)
    Semi-Annual

    14-Dec-22
    PIB Auction
    (Floating Rate)
    Quarterly

    14-Dec-22
    GIS VRR

    12-Jan-23
    GIS FRR

    12-Jan-23
    As on 25-Nov-22
    SBP’s Reserves
    7,498.7
    Bank’s Reserves
    5,879.5
    Total Reserves
    13,378.2

  •  
    As on 05-Dec-22
     
    M2M
    Revaluation Rate
    223.9082
     
    Weighted
    Average Rate
    Bid: 223.7161
    Offer:

    224.1322

     

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