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Pak Economy: Monetary policy, economic growth and inflation

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The approach to implement a pro-growth strategy has not been addressed by the central bank. The trade-off between inflation and growth can be avoided if the economy can improve its supply-side performance. As the pace of the economy slows down, the unemployment rate rises

By Dr. Noor Fatima

Traditionally, monetary policy is an instrument of macroeconomic stabilisation; however, the matter to ponder upon is whether it has actually helped in lowering inflation and promoting growth in developing economies. The outcome in this context is not promising for Pakistan, which is trapped in the predicament of high inflation and low growth. A central bank is responsible to control the money supply and maintain financial stability through various tools of monetary policy. The State Bank of Pakistan (SBP) by following tight monetary policy stance has hiked the discount rate to curtail inflation. But, this policy has failed to deliver the desired results in the country as inflation has reached an uncontrollable level.

Normally a tight monetary policy approach is workable in a rapidly growing economy to obstruct the rise in prices. In Pakistan’s scenario, we need to broaden the economic base and adopt a growth-oriented policy. The present economic growth has slowed down due to tight monetary policy which has caused a drag on the process of economic recovery.  As a matter of fact the increase in discount rate should restrain the government borrowing level, but such is not the case in Pakistan.

In fact the unprecedented rise in government borrowing of Rs266 billion up to November 19 out of a total expansion in reserve money supply of Rs308 billion is responsible for persistently high inflation.

This has ultimately widened the fiscal deficit, whereas, the private sector is denied of borrowing funds due to high interest rates. In reality, the scenario should have been the opposite as private sector facilitates economic activities, thus giving an impetus to employment level and tax revenues. When government borrowing expands, it ultimately fuels inflation and fiscal deficit. For this reason, the core purpose of tight monetary policy i.e. to reduce prices is neutralised.

The approach to implement a pro-growth strategy has not been addressed by the central bank. The trade-off between inflation and growth can be avoided if the economy can improve its supply-side performance. As the pace of the economy slows down, the unemployment rate rises. If the money in circulation does not keep up with business activities and the private sector is unable to gain access to credit due to high interest rates, the tight monetary policy dampens growth. The ultimate goal of monetary policy should be to keep the inflation rate at a controllable level and promote investment so that more employment opportunities are generated.

In the final analysis, monetary policy can not be expected to directly contribute towards increasing long-term growth, but it can foster sustainable growth by maintaining an environment of price stability. Because inflation is primarily a monetary phenomenon, monetary policy is the only tool that can effectively manage price stability in the long run. Therefore, if we take the main objective of monetary policy i.e. to keep the prices steady, the recent SBP decisions pertaining to the issue have been absolutely futile. The question is how can price stability be ensured? The SBP has to be independent from the government or international donors’ interference in this regard and formulate and implement tough policy measures to ensure price stability with the combination of an appropriate fiscal policy.

The effectiveness with which monetary policy can perform a stabilising role, is limited by the fact that economic problems are persistent and more of a structural nature. For instance, if a private businessman is reluctant to invest in a country because of structural impediments implying not many profitable opportunities are available, then monetary policy would not be effective in restoring the confidence of the investor.

The financial challenges faced by the economy today demand an independent central bank keeping the objectives of price stability, financial stability and growth in mind. Naturally no one expects the SBP to perform miracles in the present state of affairs of the country. But the fact remains that the monetary policy can make an important contribution to revitalise growth. To this end, an effective fiscal consolidation strategy, based on growth-enhancing measures, can boost the confidence of private investors.

In Pakistan it is a well known fact that the monetary and fiscal policies do not support each other. Achieving macroeconomic objectives becomes very difficult under such conditions. From an economic point of view, the objectives of fiscal policy are the same as monetary policy i.e. achieving high growth and employment, ensuring price stability and strengthening balance of payments position. Hence, it is evident that both the monetary and fiscal policies need to complement each other for stabilisation.

In view of the SBP decision to raise the discount rate for the third time this year, especially when the economy is bound to face rising power and food costs, increased interest rates will curtail private investment and suppress growth. The decision will have absolutely no effect on price-hike as inflation is predominantly driven by a rise in food prices and the removal of power subsidies. Furthermore, tight monetary policy is not very effective in an economy such as Pakistan because of dependence on interest rates. Industries with debt on their balance sheets will only pass on the rise in cost to the consumer, further fuelling inflation. Therefore, the time has arrived for the fiscal managers to immerse themselves into serious rethinking as to how effective the tight monetary policy stance has been so far to tackle the problem of inflation and promote growth.

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