THE IMPACT OF INTEREST RATE AND EXCHANGE RATE TRANSMISSION CHANNELS ON INFLATION IN PAKISTAN
A small open economy, like Pakistan, usually face obstacles in achieving stability in the level of prices because of the nature of the economy’s high degree of vulnerability to the external economy shocks and issues related to weak policy. Hence, the present paper is aimed at analyzing the effectiveness or otherwise of the monetary transmission channels of interest rate and the exchange rate in controlling inflation in Pakistan for the period January 1991 to December 2017. The VECM results show that the rate of interest plays a key role in transmitting monetary signals. Long run relationships were observed due to the presence of 3 cointegrating equations. Further the error correction term for interest rate indicates that it corrects 4.1924% of the deviations in disequilibrium per period of time, although VECM results were not significant for the exchange rate. However, both the Impulse Response Functions and Variance Decomposition indicate interest rates and rate of exchange as monetary transmission channels, for inflation. The impact of exchange rate is within a lag whereas the rate of interest takes longer lags to transmit the required policy results.
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