‘Annex VI. From boom-bust to stabilization: monetary policy and business cycles in Pakistan’ published in the October 2024 report by International Monetary Fund (IMF) titled ‘Article IV consultation and request for an extended arrangement under the Extended Fund Facility [EFF]…’ which ‘investigates the association between monetary stimulus, growth, and inflation’ concludes firstly, ‘…that discretionary monetary policy induces boom-bust inflation cycles and significantly hinders economic growth’, and secondly ‘…underscores the merits of strengthening the role rules play in the monetary policy framework.’
Moreover, the annexure references two articles—‘An Empirical Assessment of Monetary Discretion: The Case of Pakistan’, and ‘Assessing the Role of Money versus Interest Rate in Pakistan.’ In the first paper, published in 2016, and which is in line with the conclusions drawn for Pakistan in the annexure, policy of monetary discretion overall remains out of favour, since ‘in the long run monetary discretion is significantly biased against inflation without creating real growth gains…’, while in ‘the short-term direct impact of monetary discretion on inflation and real growth is mixed…’
In the second paper, which was published in 2020, while analysing three sub-periods (1974-1995), (1995-2009), and (2009-2015) to see ‘…if the SBP should place an increased emphasis on interest rate compared to the broad money…’ indicated that ‘…the full sample from 1974 to 2015 as neither money nor interest rate has a significant role in explaining inflation in Pakistan…’
The paper indicated that on the contrary, seen phase-wise, during the first phase when purely monetary targeting was adopted shows ‘…the role of money in explaining inflation is both significant and quantitatively large as against interest rate…’ that during the transition period (or second phase) of shifting towards using interest rate increased its significance in controlling inflation, and that during the third phase of using interest rate as policy instrument to controlling inflation ‘…both money and interest rate played a significant role in explaining inflation…’
An important outcome of the study is the discovery of presence of ‘price puzzle’ since ‘…interest rate and inflation are positively related’, and highlights that this puzzle ‘…is non-trivial as it renders the interest rate instrument ineffective [vis-à-vis the broad money instrument in conducting monetary policy], which is the main policy tool currently used by the SBP. We, therefore, suggest that money should not be deemphasised.’
The above line of thinking by IMF, and proponents of Monetarist school of thought is that they basically use the lens of monetary policy to look at inflation. This, in turn, also forms the core of Neoliberalism, where the underlying thinking can be understood by what was stated by Milton Friedman, which is ‘inflation is always and everywhere a monetary phenomenon.’ It is because of this thinking that what can be explained both empirically, and logically, based on the ground realities in developing countries in particular, and including Pakistan – not to mention even in developed countries, greater number of policy thinkers are asking for a more broad lens to tackle inflation, given in the short-run there is a strong case that the surge in inflation during the Covid pandemic, for instance, had significant causal footprint of global aggregate supply shock, while in the long run in the wake of frequent financial crises, and boom-bust cycles even in developed countries, especially in the wake of the neoliberal assault– that inflation is not only a monetary phenomenon, but at least equally a fiscal phenomenon.
Moreover, while the IMF understands, and internalizes the role of fiscal policy in influencing aggregate demand, where it employs fiscal austerity measures – through the benchmark whereby country having to run primary surplus (or fiscal austerity) in the ongoing EFF programme with Pakistan– to reduce aggregate demand, but does not focus on employing fiscal policy, which otherwise has significant influence on aggregate supply. This is because it sees no significant role of aggregate supply in determining inflation in any meaningful way, and due to this thinking it also does not see, albeit apparently, the otherwise important role of use of monetary policy in significantly influencing inflation through the channel of aggregate supply; and has only been focussing mainly on aggregate demand to influence inflation.
It is because of this reason that positive relation of interest rate and inflation is seen as a ‘price puzzle’ by IMF, when the significant role of cost-push-, and imported inflationary channels clearly explains this positive relationship. Moreover, this also glaringly indicates that the frequent boost-bust cycles in terms of macroeconomic stability, including inflation, and balance of payments, and also economic growth cannot be stopped in favour of greater sustainability is because of this neoliberal, or Monetarist school of thought’s thinking forming the basis of IMF programmes, and overall policy prescription.
Hence, throughout the Article IV, and EFF programme document, which forms this report (and therefore, can simply be called the ‘Report’), including ‘Annex VI’, there is no mention of the otherwise important role of fiscal policy in determining inflation, including the important relevance of cost-push and imported inflationary determinants of inflation. In addition, economic institutions are also given little importance in IMF programmes, which mainly focus on bringing in certain structural changes at the sectoral level because of lack of understanding and hence internalization of an otherwise important role of aggregate supply in reaching price stability, and the need for decreasing transaction costs – information asymmetry, and search related costs –that have a strong bearing on both the aggregate demand and supply-sides, and which, in turn, are reduced through better performing economic institutions.
The Report (including Annex. VI), and the two papers overall favour role of rule-based policy over discretionary policy by central banks, including that by State Bank of Pakistan (SBP). The lack of seeing inflation as a consequence of cost-push and imported inflation – and not just due to possible rise in aggregate demand – appears to have a strong bearing behind this thinking. This is because rule-based policy sees only a significant role of monetary policy in determining inflation, which is why ‘Taylor Rule’ or Taylor-type rules all see a predominant role of interest rate in determining inflation.
Hence, when inflation is above target, ‘Taylor Rule’ calls for increasing interest rate more than the inflation rate – and vice versa, when inflation is below the target rate – which is what generates the so-called ‘price puzzle’ because higher interest rate increases the cost of capital, and also puts stress on the domestic currency – making imports expensive, and increasing the cost of debt repayment – especially when foreign exchange reserves are low, and the country has high debt distress – which is the case of many developing countries, including Pakistan, and which is why in the first place they approach IMF which, in turn, viewing the inflation problem purely through the lens of monetary policy contributes to perpetuating the problem of boom-bust cycle, creating, in turn, a positive relationship between interest rate and inflation.
(To be continued)
Copyright Business Recorder, 2025
The writer holds a PhD in Economics degree from the University of Barcelona, and has previously worked at the International Monetary Fund. His contact on ‘X’ (formerly ‘Twitter’) is @omerjaved7
Comments