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Pakistan Institute of Development Economics, Islamabad

Taylor Rule and the Macroeconomic Performance in Pakistan


Author(s): Wasim Shahid Malik and Ather Maqsood Ahmed
Source: The Pakistan Development Review, Vol. 49, No. 1 (Spring 2010), pp. 37-56
Published by: Pakistan Institute of Development Economics, Islamabad
Stable URL: http://www.jstor.org/stable/41260992
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ThePakistanDevelopment
Review
49: 1 (Spring2010) pp. 37-56

TaylorRule and theMacroeconomic


Performancein Pakistan
WasimShahid Malik andAther Maqsood Ahmed
A near-consensus
is thatpolicyruleshave greater
positionin modernmacroeconomics
economicperformance.
For developingcountriesin
advantageover discretionin improving
rulesappearto be feasibleoptionsas pie-requisites
since more
particular,
simpleinstrument
sophisticatedtargetingrules are generallylacking.Using Pakistan'sdata, this studyhas
to estimatetheTaylorruleand use it as monetary
to simulatethe
attempted
policystrategy
the
economy.OurresultsindicatethattheStateBankofPakistan(SBP) has notbeenfollowing
deviationfromit.On theotherhand,
Taylorrule.In fact,theactualpolicyhas beenan extreme
counterfactual
simulation
confirms
thatmacroeconomic
couldhavebeenbetterin
performance
termsof stability
of inflation
and output,had theTaylorrulebeenadoptedas monetary
policy
The studyalso establishesthatfurther
valuesof the
strategy.
gainsarepossibleiftheparameter
ruleareslightly
modified.

JEL classification:
E47, E31, E52
Counterfactual
Simulation
Performance,
Keywords:TaylorRule,Macroeconomic
1. INTRODUCTION
A near-consensus
is thatpolicyruleshave
positionin modernmacroeconomics
in improving
economicperformance
greateradvantageover discretion
[Taylor(1993)].
Throughseminalpapers,KydlandandPrescott(1977) andBarroandGordon(1983) have
convincinglyshown thatdiscretionary
However, the
policies are time inconsistent.
adverseoutcomecan be avoidedif privateagentspursuea punishment
policyof higher
that
of the monetaryauthority
inflationary
expectations
may cause loss of reputation
of theCentralBank
[Barroand Gordon(1983a)]. Alternatively,
ensuringindependence
bias [Sargentand Wallace (1981), Rogoff(1985), Alesina
mayalso reduceinflationary
andSummers(1993), andWalsh(1995) amongothers].
Interestingly,
despite this overwhelmingsupportinitiallyfor money growth
and
later
for
inflation
it was notclear how a rulecould be used in
targeting
targeting,
practicalpolicy formulation
process untilTaylor (1993) presenteda state-contingent
interest
raterulethatis both,practicableand simple.1It calls forchangesin theshortWasim ShahidMalik (wmalikll@yahoo.com)is AssistantProfessor
of Economicsat Quaid-i-Azam
Islamabad.AtherMaqsood Ahmed(dr.athar@nbs.edu.pk)
is Professorof Economicsat NUST
University,
BusinessSchool,Rawalpindi.
Authors'Note: The authorsare thankful
to theparticipants
of PIDE SeminarSeriesand the'Readers
Forum'oftheStateBankof Pakistanforusefulcomments
and suggestions.
As instrument
rulesaresimple,robust,easilyverifiable
and strictandthereis fundamentally
no roleof
to theserulesis a good and feasiblemonetary
policy-maker's
judgmentin timeto timedecisions,commitment
fordevelopingcountries.Comparedto this,targeting
rules(attributed
to Svensson)are even
policystrategy
butnotsimple.
thoughoptimaland flexible,

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38

Malikand Ahmed

terminterest
rate(monetary
in responseto deviationof outputfrom
policyinstrument)
trendor potentiallevel and thatof inflation
fromthetargetwithequal weightgivento
boththeseobjectivesin thepolicyreactionfunction.
Taylorarguesthatadoptionof the
rule
not
has
the
of
macroeconomic
it also
simple
only
potential improving
performance,
avoidsthetimeinconsistency
thattheruledoes notsuffer
maintains
problem.He further
fromenforcement
problembecauseof itseasy verifiability
by agentsoutsidethecentral
bank.In thiscontext,
commitment
to thisrulebecomestechnically
feasible.
The purposeofthepresentstudyis to revaldate
theTaylorrulebyestimating
itfor
Pakistan.It needsto be establishedwhether
or nottheStateBankofPakistan(SBP) - the
- has been followingsuch a policyrule forthesimplereasonthat
MonetaryAuthority
Pakistanhas experiencedcycles in inflationand real economicactivity.
historically
Inflationreachedits peak of 23 percentin 1974, and touchedthe lowestlevel of 2.4
therealoutputgrowth
variedbetween8.7 percentin 1980 and
percentin 2002. Similarly,
-0.1 percentin 1997.2 Besidesthisinconsistent
macroeconomic
Pakistan's
performance,
fromweakinstitutional
set-up.Notonlythattheindependence
of
economyalso suffered
the centralbank was continuously
it
also
had
to
withstand
fiscal
challenged,
regular
therewas a
pressureswhichlargelyweakenedthemonetary
policystance.Furthermore,
constant
formaintaining
oftheexchangerate.
struggle
stability
Given these weaknesses,one would have argued that adoptionof a simple
instrument
rule- like theTaylorrule- mighthave been a naturaland feasibleoption.
Giventhisperspective,
thesecondobjectiveof thestudyis to assess themacroeconomic
on
the
basis
of variability
of inflationand output.For thispurpose,the
performance
has
been
withand without
simulated,
economy
Taylorrule,as monetary
policystrategy.
simulations,the study also investigateswhetherthe
Finally, using counterfactual
valuesof theTaylorrule(theweightson outputand inflation
and
parameter
stabilisation,
the inflationtarget)are optimalforPakistanor some modification
is neededto have
better
results.
The paperproceedsas follows.In Section2, thetwo typesof monetary
policy
rulesandthetargeting
rules,namelytheinstrument
rules,are definedandexplained.The
forestimation,
and counterfactual
simulationis presentedin
methodology
backcasting,
Section3. An exhaustivediscussionofempiricalfindings
is thesubjectmatter
of Section
4. The finalsectionsummarises
themainfindings
andoffersinsights
forfurther
research.
2. MONETARY POLICY RULES
- expressedalgebraically,
A monetary
policyrulecan be definedas a description
and/or
of
how
the
instruments
of
numerically,
graphically
policy,such as monetary
base or thediscountrate,changein responseto economicvariables[Taylor(1999b)].
Policyrulesare similarto constantgrowthraterulesformoneysupply.However,in a
broader sense, feedback rules such as money supply response to changes in
and/orinflation
etc. are preferred
unemployment
policyrules.As indicated,thereis a
near-consensus
thatpolicyruleshave greateradvantageover
amongmacroeconomists
discretion
in improving
economicperformance.
This,however,requiresthattheruleis
2Itmaybe recalledthata country
cannotgraduatefromlow-incometo middle-income
statusunlessit
a long periodof high and sustainedgrowthwherethe stabilityof pricesis also ensured[Fischer
registers
(1993)].

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Performance
TaylorRuleand Macroeconomic

39

adoptedand followedfor a reasonablylong periodof time to reap the benefitsof


and the credibility
associatedwiththerule.The literature
relatedto rules
stabilisation
betweensimple instrument
rules [proposedby
versusdiscretiondebate distinguishes
rulesdue largelyto Svensson
McCallum(1988); Taylor(1993) andothers]andtargeting
(1997, 2002, 2003). The choicebetweenthetworeducesto suchconcernsas simplicity,
technicalfeasibility,
result-orientation
and therole
robustness,
reliability,
practicability,
in
We
with
ofpolicy-maker's
a
brief
review
of thetwo
judgment decision-making. begin
rules.
Instrument
Rules: Instrument
rulesare state-contingent
reactionfunctions
thatlink
thepolicytool withperformance
indicators
of theeconomy[Meltzer(1987), McCallum
(1988), Taylor(1993), and Hendersonand McKibbin(1993)]. These rulesare simpleto
followand requirelittleamountof information.
Thesearerobustand technically
feasiblein
thesensethatcommitment
to ruleis easilyverifiable.
Of different
theone thathas
variants,
attracted
mostoftheattention
an
during1990shasbeentheTaylor(1993) rule.Tayloroffered
instrument
ruleto conductmonetary
the
for
federal
funds
policyoperations
bysetting target
rate(operational
realfundsrateplusthecurrent
inflation
and
target)
equaltoan 'equilibrium'
to
it
a
of
to
the
deviation
of
current
adding
weighted
average monetary
authority's
response
inflation
fromthetargetand percentage
deviationof thereal GDP froman estimate
of its
or full-employment
level.He considered
it to be an 'optimal'policyas itrelatesa
potential
toreasonable
andperforms
wellina variety
of
plausibleinstrument
goalvariables
reasonably
macroeconomic
models.3Therulecanbe described
the
by following
equation:
+ <2(, -*)
i, = r* +7C, + CLxyt

(1)

wherer* is thelong-run
realinterest
inflation
rate(Taylor
rate,ntis thecurrent
equilibrium
takesthisas lastfourquarters
inflation
the
current
71*
average
including
quarter), is thetarget
inflation
trend.The
rate,and ytis thedeviationof outputin periodt fromits long-run
restrictions
on thecoefficients
to have macroeconomic
are: 0Ci> 0 and a2 > 0.
stability
on inflation
deviation
is less thanzero,thena risein inflation
Supposingthatthecoefficient
wouldlead to an interest
ratecut,whichwillinduceincreasedspending.
In turn,
thiswould
tendto increaseaggregatedemand,thereby
the
inflation
further
(an unstable
increasing
On
the
other
if
it
is
than
zero thenthisinstability
does notarise,
hand,
solution).
greater
becausethentheruleensuresthatinflation
is equaltoitstargeted
value71*[Taylor(1999a)].
to
TargetingRules: Some of thecentralbanksadoptedan elaborateframework
inflation
on
and
on
track
the
1990s.
To
start
this
with,
keep
target
output
during
framework
was not'tightly'supported
byacademicresearch.However,itrecoveredfrom
this deficiencywith the evolutionof literature
on 'inflationtargeting'or 'inflation
forecasttargeting'[Svensson(1997)]. The revisedframework
startswitha rule that
allowssomediscretion
to thecentralbankers.Hence it was also regardedas 'constrained
discretion'by Bernankeand Mishkin(1997) and targeting
ruleby Svensson(2002). It
proceedslikethis.The centralbankannouncesa numericalinflation
target(pointtarget
or targetrange)and monetary
policyhas a legislatedmandateforachievingthistarget
with clear instrumental
independence.There is a high degree of monetarypolicy
and accountability
of concernedauthorities.
The inflation
forecastis taken
transparency
as theintermediate
target.
^This indicates the robustnessof the rule.

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Malikand Ahmed

40

Withintargeting
distinction
is made between'generaltargeting
rules,a further
loss function,
rule'and 'specifictargeting
rule'.Whiletheformer
specifiesan operational
a condition
in
the
case
of
the
latter
whichthemonetary
is
committed
to
minimise,
policy
rate
of
and
is specified,e.g., marginal
transformation
for settingthe instrument
betweenthe targetvariablesis equalised. It gives an implicitreaction
substitution
thatneed not be announced.Accordingto this
functionof the monetaryauthority
centralbanks collect large amountof data and use a complex policy
framework,
formulation
to setthepathof instrument.4
The rulehas a goodtheoretical
base as thereis
no ad hoc representation
of reactionfunction.
Here theconditionforinstrument
pathis
describedby optimalfirstorderEulerconditionsand thecentralbankbehaviouris not
modeledin a mechanicalway.Thereis also a clearroleofjudgmentin theformulation
of monetary
andimplementation
policy[Svensson(2005)].
3. MODEL SPECIFICATION AND METHODOLOGY
Ever since the introduction
of the Taylorrule,threeissues thathave occupied
much space in researchare positiveanalysisof centralbanks' strategyto control
inflation,robustnessof rule to changes in transmissionmechanismand ex-post
macroeconomic
once theruleis adopted.As indicated,
theobjectiveof the
performance
thepolicyreactionfunction
of SBP, insteadourfocusis
presentstudyis notto identify
on drawinga comparisonof actualpolicywiththeone suggestedby theTaylorrule.We
in knowingwhether
are also interested
theeconomicperformance
wouldhave improved
hadtheTaylorrulebeenfollowed.
withthefirstobjective,theissuecan be addressedeitherby invokingthe
Starting
standardregressiontechniquesor througha simplecomparisonof the actual and the
simulateddatasimilarto one usedbyTaylor(1993). Regarding
thefirstoption,letus rerule
as:
the
specify Taylor
/,= r*+ 7I,+ CCiy,+O (71,-71*)

(2)

where
r* it 7t, yt -

realinterest
rate.
Long runequilibrium
Shortinterest
ratetakenas monetary
policyinstrument.
thecurrent
one.
inflation
over
four
Average
previous
quarters
including
deviationofactualoutputfromthe
Outputgapcalculatedas percentage
normallevel.
ti* - Longruninflation
targetofthecentralbank.
Thereare fourparameters,
*, *, <'and a^ in expression2. The valuesof these
adoptedby Taylor were: 2 percent,2 percent,0.5 and 0.5, respectively.
parameters
Following in Taylor's footsteps,we have also assumed thatthe centralbank has
information
on current
outputandinflation.
intoan estimableformas
The aboverule(expression
2) can easilybe converted
it =ao+a,;y,

+a27t,

(3)

aretheReserveBankofNewZealandandtheBankof England.
Examplesofsuchpolicyformulation

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Performance
TaylorRuleand Macroevonomic

41

wherea0 = r*+a2n* and oc2=(1 + Gt2


)
followsthe rule thenparametervalues
It is contendedthatif the SBP strictly
shouldbe Oo= 1, 0Ci= 0.5 and cc2= 1.5,and ifit is notthencti> 0 and a2 > 1 musthold,
otherwisethe systemwould be unstable.It is relevantto pointout thatthe second
conditionis referredto as Taylor Principle' in the literature[Taylor (1999) and
Woodford(2001)].
Expression3 can be estimatedby OLS if time-seriespropertiesare satisfied.
of the
Otherwisetheresultsare notconsistent
[Enders(2004)].5 For superconsistency
have
residuals
the
estimated
OLS estimateseven in thecase of non-stationary
variables,
in
the
themodelparameters
to be stationary.
To enforcetheseconstraints,
presentstudy
residuals
of unitrootin theestimated
aftertestingthepresenceor otherwise
areestimated
rateis simulatedwithactual
of theequation.In thesecondstep,theshortterminterest
The
data on outputand inflation
policystrategy.
assumingtheTaylorruleas monetary
both
actual
the
then
if
bank
has
been
following Taylorrule,
conjectureis that thecentral
and simulatedseriesshouldbe close to each othershowingsimilarbehaviourand the
samebasic statistics
likemean,range,standarddeviationetc. It may,however,be added
thateven thoughTaylor(1993) has used thisapproachto evaluatetheFed's policy,this
well in identifying
It can, nonetheless,
methodis somewhatless sophisticated.
perform
instrument.
thebehaviourof monetary
policy
To accomplishthe second objectiveof the study,the economyneeds to be
simulatedwithand withoutthe Taylorrule as monetary
policystrategyto assess the
on
the
basis
of
in
and outputand the
macroeconomic
variability inflation
performance
forhistorical
loss to society.This analysisis undertaken
as well as stochasticsimulation.
In thisregard,some issues need further
elaboration.The firstrelatesto macroeconomic
modelon thebasis of whichtheeconomyis to be simulated.The literature
highlights
threetypesof transmission
mechanismsemanatingfromthe Lucas-typeexpectationsaugmentedPhillipscurvemodel,Neo-Keynesianmodel,or theNew-Keynesianmodel
of thefirstand thethirdmodelnotonlyrequiresthe
[Cukierman
(2002)]. The estimation
of rationalexpectations,
one also needsto haveknowledgeof priorvaluesof
assumption
someof theparameters
formodelcalibration.
Since therationalexpectations
hypothesis
has notyetbeen testedin Pakistan,and also no earlierstudiesare availableto provide
the obvious choice for the presentstudyhas been
priorvalues of the parameters,
to theuse of theNeo-Keynesian
restricted
typemodelsuggestedbySvensson(1997) and
estimated
by Rudebuschand Svensson(1999). Accordingto Svensson(1997) themodel
and capturestheessential
althoughsimple,has reasonablysoundtheoretical
properties
featuresof more elaboratemodels whichsome of the centralbanks use for policy
in theeconomy.6It
analysis.The modelis backwardlookingand assumespricerigidity
be
described
the
two
with
the
central
bank's reaction
can
by
following equationsalong
function
as
given expression3,
/=i>;/-i+2(i/-i-^-i)

+ w/

(4)

5Other
techniqueslikeTwo StageLeastSquares(TSLS), GeneralisedMethodof Moments(GMM), and
VectorAutoregression
but it would be at thecost of loss of
(VAR) etc. mayimproveestimation
efficiency,
rule'stheory,
as therulespecifiesinterest
rateas a linearfunction
ofoutputgap andinflation.
In thecase of Pakistan,inertiain outputandinflation
is consistent
withVAR studybyMalik(2006).

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Malikand Ahmed

42

, =Yirc,_1+Y2)'/-i+e,

(5)

The parameter
are: 0 < i < 1, 2 < 0, 0 < yi > 1, and y2> 0. Since
restrictions
pricesare assumedto be rigid,thecentralbankcan affectaggregatedemandthrough
rate.Outputis affected
rate
changesin therealinterest
byone periodlaggedrealinterest
and itseffecton inflation
is indirect
and takeseffectafterone period.This modelcan be
estimated
are stationary
and thereis
by OLS as longas thevariablesunderconsideration
no crossand contemporaneous
correlation
betweentheresidualsof theequationsin the
model. If the variablesare non-stationary,
thenthisproperty
can be imposedin the
estimationand restricted
OLS can be used to estimatethe model [Rudebuschand
Svensson (1999)]. Furthermore,
if thereis contemporaneous
correlationacross the
then
the
needs
to
be
estimated
as
a
Unrelated
(SUR) model.
equations,
system
Seemingly
The finalobjectiveof thestudyconcernsfindingtheoptimalparameter
valuesof
therule forPakistan.This has been done by back-casting
theeconomywithdifferent
combinations
of theparameters
in theruleand thencomparingtheresults.The optimal
set of parameters
is the one thatdecreasesoutputand inflationvariability
and hence
minimisesthe loss to society.The expression6 in the followingdescribesthe loss
function
whichis definedoverthevariancesofoutputgap and inflation
respectively.
L = V[var(y,)+ a var(,)]

(6)

wherea is the relativeweightassigned by societyto inflation.Finally,stochastic


simulation
establishesthestatistical
ofthesetofparameters.
significance
4. ESTIMATION RESULTS AND DISCUSSION
RegressionApproach
To see whether
the SBP has beenfollowingtheTaylorrule,themodelhas been
fortheperiod1991-2006usingquarterly
dataon call moneyrate(shortinterest
estimated
ratetakenas monetary
consumer
policyinstrument),7
priceindex(CPI) as a measureof
and
real
The
results
indicate
thattheactualpolicyof the
inflation,
outputgap.
clearly
SBP does notcorrespond
to theTaylorrule.The coefficient
of outputgap has opposite
thanthe one prescribedby Taylor
sign while the magnitudeof inflationis different
as nullof the
(1993).8 Since theresidualseriesfromthisestimated
equationis stationary
unitrootin Augmented
DickeyFuller(ADF) test,it is easilyrejectedat theconventional
levelofsignificance;
we concludethattheresultsaresuperconsistent.
therefore,
,-,= 4.34 -0.38;y,+ 0.51 ,
(4.28) (-2.28) (4.17)

(7)

DW= 0.89
AdjustedR2= 0.22,
ADF-statsforresiduals= -4.11
There are several pointsrelatedto theseresultsthatneed further
discussion.
First,theoutcomethattheSBP has notbeen followingtheTaylorrule shouldnotbe
7Thisis the only interestratedata on whichare available forthe sample period.Call moneyrate
indicatesliquidity
conditions
in themoneymarket
andis notdirectly
an indicator
ofmonetary
policystance.
inparentheses.
"/-statistics

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TaylorRuleand MacweconomicPerformance

43

taken as a surprise it has never claimed to be following such a rule. Not only that the
policy was ineffective,it was not pursued independentlysince prior to the 1990s the
SBP was mainly directed by the government.The monetaryauthorityonly got quasiindependence as a consequence of financial sector reforms initiated during early
1990s. Since then the job is entrustedto the SBP, but it is being conducted in a fairly
discretionarymanner.
The second pointrelatesto the coefficientof outputgap. Accordingto the estimates,
the SBP, over the years,has eitherraised interestrate or contractedmoney wheneverthe
economy was in the recessionaryphase; and this policy was relaxed whenevertherewas
inflationary
pressureor the outputwas above trendor the potentiallevel. This outcome not
contradicts
tojustifyalso. One possible explanationcould be
only
Taylor(1993), it is difficult
the
central
a
bank
of
that,being
developingcountry,SBP mighthave resistedleaningagainst
the wind assumingthatthe economy is less elastic to domesticpolicy changes compared to
externalshocks. Therefore,wheneverthe economy startedto blossom due to exogenous
factors,the SBP allowed it to do so to keep the momentumgoing. While thisjustification
makes sense only when there is an up-swing,it is less convincingin the opposite case
scenario,especiallyraisinginterestrateduringa recession.But to be fairwiththe monetary
one cannotruleout thepossibilityof gettingsuch resultsin an economy wherethe
authority,
central bank's loss functioncontains monetarypolicy objectives other than output and
inflation,
implyingthatthereactionfunction(expression7) is mis-specified.
The thirdissue is concerned withthe coefficientof inflation.According to Taylor
Principle, the response of the central bank to inflationmust be at least one-for-one
otherwise the system would be divergent. This is so because the central bank's
persistence with easy money approach when inflationis above targetwould mean that
prices can potentiallymove withoutbounds. We have foundthe coefficientof inflationto
be substantiallyless thanone. This implies a pro-cyclicalresponse of monetarypolicy to
thebusiness cycle.9 Once again thismay have been due to the dominance of shocks to the
economy thatwere outside the purviewof the monetarysector.
Fourth,the R2 is only 0.22 indicatingthatonly about one-fifthof the variationin
shortinterestrate is explained by outputgap and inflation.If so, it is essential to identify
factors,otherthanoutputgap and inflation,which play importantrole in monetarypolicy.
It is well established that the monetaryauthorityin Pakistan, like in other developing
countries,is also worriedabout exchange rate stability,interestrate smoothing,financial
sector stabilityetc. [Malik (2007)]. Thus an extended specificationof the model remains
an alternativeoption to be considered.
Finally, the value of Durbin-Watson (DW) statisticsindicates a high degree of
autocorrelation in the residuals of the estimated reaction function. One possible
implicationof this outcome is thatthe SBP, instead of pursuinga policy consistentwith
the Taylor type rule thatmighthave increased the interestrate volatility,has preferredto
smoothinterestrate.10Alternatively,it mightalso be a reflectionof a mis-specifiedmodel
whereimportantvariables have been omitted.
does not always play a reactionary
9SBP, being centralbank of a developingcountry,
role. If the
theeconomy.
economyis in boomitmayletitgo. Whilein othertimesitis proactivein stimulating
^Vhile alternative
variantsof theTaylorruleare proposedin theliterature
to deal withinterest
rate
theweighton thisobjectiveis notyetagreedupon.
smoothing,

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Malikand Ahmed

44

SimulationApproach
ithas beenshownthattherule-induced
and the
Usingan alternative
methodology,
actualshort-run
interest
ratehave shownfairlydifferent
behaviour(Figure1 and Table
1). Withtheexceptionof 1997-99and2002-04,thelatterhas loweraverageleveland the
fluctuations
are also notas wildas has been thecase withtheformer.
It meansthatthe
rule would have favoureda more aggressiveresponseto outputand inflationary
fluctuations
thantheone adoptedby theSBP. This is whythelevel of variationin the
actualinterest
ratehas beenquitelow as comparedto therule-induced
interest
rate.
Table 1

Mean
Maximum
Minimum
Range
Variance
St. Deviation

Actualand TaylorRule-induced
Rate
ShortInterest
Actual
Rule-induced
8^24
O42
15.42
20.30
1.05
0.51
14.37
19.79
11.80
32.96
3.44
5.74

Fig. 1. Actualand theTaylorRule-inducedShortInterestRate

!
! 21

ii'2:^'

/ W

I :kvvu '}
i

OOOOOOOOO

p^

ccud

ruleinciicedI

JuddandRudebusch(1998), thetime-series
was dividedintothree
Next,following
consistent
with
the
era
of
three
former
heads
of
the
SBP
to see whether
or
sub-samples
not therewas an inclinationtowardsrule-basedpolicy(expressions8-10). It is quite
of SBP had an appetiteforrulerevealingto findthatnoneof thepastthreeGovernors
based policyduring1991-2006.Whiletherewas no consideration
foroutputor inflation
during1991-93,theemphasischangedtowardsgrowthduring2000-06,probablydue to
thefactthatinflation
was alreadytoo low. The periodin the middlehad no clear-cut
in
fact
it could be placed somewherein betweenthe two policy
policy objective
regimes.
/,= 17.04- 0.60 y,- 0.78 , (1991-93period)
(8)

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Performance
TaylorRuleand Macroeconomic

i> 8.68 -0.08?, -0.19 ,

45

(1993-99period)

(9)

/,=5.77- 0.18 y,- 0.14 71, (2000-06period)

(10)

MacroeconomicPerformancewithTaylorRule
in managingtheeconomyis thatthereshould
considerations
One of theimportant
be consistencyof policies irrespective
of the natureof the rule. As indicated,the
of the economyhas been measuredby estimatingthe
macroeconomicperformance
macroeconomic
is definedin terms
whereimproved
performance
society'sloss function11
of less inflationand less outputvariability.
It is arguedthatinflationvariabilityis
thatdistortsthe
negativelycorrelatedwith growthbecause it generatesuncertainty
and
economic
decisions
like
investment
[Fischer
(1993)].
agents'major
saving
Given thisperspectiveand to accomplishthesecondobjectiveof thepaper,the
economyhas been back-castedfora periodrangingbetween1992 and 2006 and the
resultsare comparedwiththeoriginalTaylorrule(usingtheoriginalparameter
values)
whilethe searchforthe optimalparametervalues in the rule is delayedtill the next
subsection.12
Counter-factual
simulations
of thetransmission
mechanism
requireestimation
of
the
on
the
basis
of
which
the
data
can be
(macroeconomic
model)
economy
previous
withalternative
Forthispurpose,
theNeo-Keynesian
regenerated
monetary
policysetting.
type
modelforPakistanhas been estimated
are reported
as
by OLS. The resultsof estimation
1
1
12
and
t-statistics
in
(with
expressions
parenthesis).13
y,=0.53yM-0.27(fM-7M)
(4.68) (-3.96)
S.E =1.60,
DW = 2.08

(11)

, =3.72 + 0.51+0.39
(3.89) (4.61) (1.88)
S.E = 3.42,
DW = 2.04

(12)

It is evidentthatthesignsof theestimated
are consistent
witheconomic
parameters
and
the
coefficient
are
also
in
values
the
is
affected
theory
acceptable
range.Output
byitsown
values
and
the
real
interest
rate
over
the
four
Inflation
toohas
lagged
average
previous quarters.
inertia
and
it
is
also
affected
Theseresults
one-period
bytheoutput
gapoftheprevious
quarter.
confirm
topopular
stanceheldbythecentral
ofinflation
that,
bank,onlyaboutonethird
contrary
inPakistan
is explained
factors.
theassumption
bymonetary
Usingtheseresultsand invoking
thattheTaylorrulehas been themonetary
theback-casting
exerciseof
policystrategy,
theeconomywas undertaken
in
each
the
estimated
shocks(to
by incorporating
period
and
from
1
1
and
12.
The
outcome
of
this
exercisehas
output inflation)
Equations
striking
11Itis assumedthatthe
andoutputstability.
societyputsequal weightto inflation
l2Theentireprocesshas followedthefollowingcourseof action.The three-equation
modelincludes
demandand supplyequationsand a moneyreactionfunction.
HeretheTaylorrulegeneratesthevalue of real
interest
allows us to determine
the value of outputy. When
rate,whichwhenused in thedemandfunction
substituted
in thesupplyfunction,
itgenerates
value of . The rulebased valuesof and n are thencompared
withactualvalues.An outcomeis preferred
wherevariations
in thesevariablesare low.
l3Resultsby SUR model and by FIML have been foundalmostthe same as thereis insignificant
correlation
betweentheresidualsofthetwoequationsin themodel.
contemporaneous

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46

Malikand Ahmed

beenthattheeconomywouldhaveperformed
betteriftheTaylorrulehad beenadopted
rather
thanstickingwiththediscretionary
policystance(Table 2). AdoptionoftheTaylor
rulewouldhavedecreasedthevariability
in outputgap andinflation.
To reconfirm
theseresultsfurther
andtoavoidover-reliance
on historical
simulation
stochastic
has also beencarriedout.Thishasbeendoneby
simulation
(one timeestimates),
thestandard
The averageresultsof 1000
deviationof outputand inflation.
bootstrapping
trialsalongwiththestandard
errors
ofestimates,
in
Table
theearlier
2, reconfirm
presented
in outputand inflation
results(reduction
that
continue
to
hold
true
even
when
variability)
the bootstrapped
measureof variationis used. Similarlythe probability
(p-value) of
standard
deviationof rulebasedoutputgap and inflation,
thantheone found
beinggreater
in theactualdata,is quitelow. We havefoundthatin only20 outof 1000simulations
the
standarddeviationof simulatedoutputgap has been greaterthanor equal to thatof the
actualdata.For inflation
Theseresultsagainprompt
series,itwas truefor100 simulations.
us toconcludethattheTaylorrulewouldhaveperformed
better
thantheactual
significantly
policythatwas pursuedbySBP during1991-2006.14
Table 2
withtheTaylorRuleand theEstimated
Simulation
Model
Rule Based
Actual
Historical Stochastic* p-value**
Interest
Rate
S'28
924
Average
St Deviation
3.53
3.18
-0.24
-0.83
OutputGap
Average
St Deviation
2.47
1.72
0.002
1.80(0.21)
(0.21)
Inflation
7.36
7.00
Average
St Deviation
4.31
3.50
0.10
4.04(0.47)
(0.47)

*
Averageof 1000 values of standarddeviationsin bootstrapsimulation.Standarderrorsin parenthesis.
**
Probabilityof standarddeviation of a variable with rule being greaterthanthatof actual data.

FindingtheOptimalParameterValues forPakistan
In an effort
tofindoptimal
values(inTaylorrule)forPakistan,
we startwith
parameter
theoptimalinflation
The
anecdotal
evidence
that
the
central
banks
thathave
target.
suggests
as monetary
announceabout2 percentinflation
adoptedinflation-targeting
policystrategy
Thisis in linewithTaylor(1993) whoadvocated
target,
thoughwithsometolerance
range.15
an inflation
thatwasconsistent
withthe2 percent
of2 percent
realeconomicgrowth
of
target
theUSA. Comparedto this,Pakistanbeinga developing
with
a
natural
country
requirement
forhigher
of2 percent.
But
rate,cannotoptfora lowrealgrowth
(andinflation)
growth
target
to avoid ad hocism,we have used sevendifferent
inflation
for
simulation
targetoptions
purpose.To startthisprocess,the2 percenttargetwas adoptedto simulatetheeconomy.
l4The comparison of actual and backcasted data on inflation,output-gapand interestrate using Taylor
rule is given in Appendix A, Figure 2.
None of thecentralbanks,withany monetarypolicy strategy,
as central banks are not
targetzero-inflation
inflationnuttersin King (1997a) terminology.

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Performance
TaylorRuleand Macroeconomic

47

an averagerateof about5 percentreal GDP growthoverthe


SincePakistanexperienced
theempirical
was
selectedas another
this
rate
1980-2006,
option.Similarly,
following
period
evidenceof Khanand Senhadji(2001) and Mubarik(2005) fivevaluesrangingbetween7
and 11 percent
havealso beenused.
percent
ratehas been calculatedforPakistanas the
The long-run
real interest
equilibrium
rateand inflation
overtheperiods,1973betweentheaveragenominalinterest
difference
in
and
1991-2006
as
shown
Table
3.16
Even
1981-2006
2006,
thoughtheresultsdo not
in
all
a
clear
nevertheless
the
three
the
rate
periods averagereal interest
portray
pattern,
was foundto be close to zero.As a result,theequilibrium
valueof zero real interest
rate
in thecounterfactual
hasbeenusedas benchmark
simulation.
in theTaylorruleforPakistan
Finally,theoptimalweightsforoutputand inflation
have been estimated.Even thoughTaylor(1993) used equal weightof 0.5 forboththe
we haveusedthisschemeas a starting
objectives,i.e., outputand inflation,
pointonly.In
two subsequentscenarios,eithertheentireweightwas assignedto outputstabilisation
withno regardforinflation
deviationor according moreimportance
to inflation
than
deviation.
While
the
former
alternative
could
be
more
attractive
for
the
output
developing
countries
and inflation
(at leastwithasymmetric
response)whereoutputwas theprimary
the secondaryissue, the latterpossibilityis obviously more attractivefor stable
economieswheremoreemphasisis on inflation
controlor pricestability.17
Table 3
Estimation
Real Interest
Rate
ofLong-run
1973-2006
1981-2006
Rate
8.34
8.01
AverageInterest
CPI
Inflation
9.16
7.52
Average
8.92
8.02
AverageGDPD Inflation
Real Interest
Rate*
-0.82
0.49
Equilibrium
Real Interest
Rate**
-0.58
O00
Equilibrium
* Wheninflation
is calculatedas percentage
in CPI.
growth
** Wheninflation
is calculatedas percentage
in GDP Deflator.
growth

1991-2006
8.24
7.89
8.92
0.35
-0.68

We havetakenthesethreesetsof weightsandsevendifferent
of inflation
(a
targets
totalof 21 cases) and back-castedthe outputgap, inflation,and interestrate using
estimated
and shocksin themacroeconomic
modelcomprising
parameters
equations11
and 12. Fromtheresultsof 21 cases, thebestset of parameter
values forPakistanwas
selectedon thebasis of minimisedvariability
in inflation
and outputand theminimum
valuesof theloss to society.We have foundthatvariability
in inflation
is a decreasing
function
of the level of inflation
but
the
of
started
target
variability output
increasing
abovea certainlevelof inflation
target.
The firstbestset of parameter
values withwhichtherulehas performed
well in
of inflation
and outputis thecase whenthecentralbankassigns
reducingthevariability
l6Judd
and Rudebusch(1998) usedthismethodology
fortheU.S. data.
17Itshould be noted howeverthatnone of the centralbanks,even the inflationtargetingones,
do this,as inflation
is flexiblein thesensethatcentralbanksputsome weighton output
practically
targeting
stabilisation
too,[Svensson(1997) and Ball (1999)].

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Malikand Ahmed

48

equal weights to output and inflationstabilisation in the reaction functionand targets


inflationat 8 percent with zero real interestrate.18The rule with this set of parameter
values is given in Equation 13. This roughlyindicates the optimal level of inflationfor
Pakistan and the resultsare consistentwithearlier findingsof Mubarik (2005) and Khan
and Senhadji (2001).
,=0 + 7C,+0.5^+0.5(71,

-8) or i, =-4 + 0.5^+1.571,

(13)

The resultsfor the measures of macroeconomicperformanceby the rule (both in


case of historicalas well as stochasticsimulation)withthe firstbest set of parametervalues
are given in Table 4. The procedureadopted here forcomparisonis the same as discussed
above forthe actual Taylor rule. It is clear thatthe variabilityin outputgap and inflation
decreases as we move fromdiscretionary
policy towardstheTaylor rule when the firstbest
set of parametervalues forPakistanare used. However the average values of the variables
are somewhat greater.To confirmthese results,and to find the probabilityof standard
deviationof outputand inflationin simulatedseries being greaterthan thatin the actual
series,we have used stochasticsimulationby re-samplingthe estimatedshocks. The results
indicate that the variabilityof both the variables has been lower, even in repeated
simulationand theprobabilityis also quite low.19
Table 4

withtheFirstBestSetofParameterValues
Simulation
FirstBestSet
Actual
Historical Stochastic* p-value**
Rate Average
8.08
Interest
8.28

OutputGap
Inflation

St Deviation

3.53

3.11

Average

-0.24

0.3

St Deviation

2.47

1.67

Average

7.36

7.88

St Deviation

4.31

3.49

1.72 (0.24)

0.05

3.91(0.47)

0.2

*
simulation.
deviationsin bootstrap
Averageof 1000 valuesofstandard
** Probability
thanthatofactualdata.
ofstandard
deviationofa variablewithrulebeinggreater

The second best set of parametervalues was foundwhen the centralbank assigned
one-hundredpercentweightto outputstabilisationwithno response to inflationdeviation
from the target. The implication is that it does not matterwhat level of inflationis
optimal to target. Regarding macroeconomic performance by the Taylor rule, the
parametervalues given below in Equation 14 were used.
it = 0 + 7t,+ yt+0(71, -*)

or it=7t, + yt

...

...

...

...

(14)

18Thecoefficient
valuesaresameas proposedbyTaylorbutinflation
targetis different.
rateusingthisproposed
outputgap and interest
Comparisonofactualand simulateddataon inflation,
ruleis givenin AppendixA, Figure3.

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Performance
TaylorRuleand Macroeconomic

49

in interest
It can be seenfromTable 5 thatvariability
rate,outputgap and inflation
decreasedas one movedawayfromdiscretionary
towards
theproposedTaylorrule
policy
forPakistan.20'21
The averagevaluesof all thethreevariablesare foundto be slightly
theseresultsfurther
andto findoutwhether
whentheruleis followed.To confirm
greater
in simulatedseries
or nottheprobability
of standarddeviationof outputand inflation
turnsout to be greaterthanthatin theactualseries,stochasticsimulationwas used to
remained
resamplethe estimatedshocks.The outcomeconfirmedthatthe variability
lowereven in therepeatedsimulations.
It was also foundthattheprobability
of standard
deviationof outputand inflation
beinggreaterin simulatedseriesthanthatin theactual
was quitelow.22
data,withtheruleas monetary
policystrategy
Table 5
withtheSecondBestSetofParameterValues
Simulation
SecondBestSet
Actual
Historical Stochastic* p-value**
Interest
Rate Average
8.28
8.17
St Deviation
3.53
2.58
-0.24
0.25
OutputGap
Average
St Deviation
2.47
1.55
0.03
1.70(0.20)
Inflation
7.36
7.84
Average
St Deviation
4.31
3.62
0.2
4.18(0.48)
*
deviationsinbootstrap
simulation.
Averageof 1000 valuesofstandard
**
ofstandard
deviationwithrulebeinggreater
thanthatofactualdata.
Probability

Loss Functionand ComparisonofParameterValues


Besides minimising
thevariability
in outputand inflation,
one can also calculate
and compareloss to societyassociatedwitheach setof parameter
valuesas an attractive
alternative.
The loss function
notonlyincludesboththeobjectives,it also takescare of
thetradeoffbetweenthem.In thisrespectitcan do a better
outtheoptimal
job offinding
values.
parameter
For estimating
theloss function,
to ensure
expression6 has beenused.In an effort
theassumptionthatsocietyassignsequal weightto inflation
and output
comparability,
has beenmaintained.
Usingexpressions11 and 12,theeconomyhas beenback-castedfor
21 setsof parameters
discussedabove,one at a timeand thebestset of parameters
was
chosenwhichminimised
theloss function.
The resultspresentedin Table 6 show thatthe loss is minimumwheninflation
of outputand inflation
in thereaction
targetis set at 8 percentand equal coefficients
function
areadopted.The secondbestsetofparameter
valueshas beenfoundexactlythe
sameas was proposedbyTaylor.The thirdbestoptionis foundwhentheentireweightis
in thereactionfunction.
The resultsof stochasticsimulation
givento real stabilisation
exercisegivenin Table 6 confirm
thesefindings.
It can be seen thattheperformance
of
valuesfoundoptimalforPakistan.
20BytheproposedTaylorrulewe meantherulewithparameter
2lDetailedcomparisonof actualand simulateddata on inflation,
ratewiththis
outputgap and interest
proposedruleis givenin AppendixA, Figure4.
"Howeverthisprobability
is higherincase ofinflation.

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Malikand Ahmed

50

therule(witheitherset of parameters)
is, on average,betterthanthatin case of actual
show
there
The
results
that
is
(0.02 in all cases) of loss,
policy.
verylow probability
associatedwiththerule,beinggreaterthanthatwithactualpolicysetting.Interestingly,
values give betterresultsthanthesecondbestpossibility
Taylor'sproposedparameter
whenhistorical
is undertaken
simulation
buttheoppositeis truein thecase of stochastic
simulation.
Table 6
Loss AssociatedwithDifferent
ParameterValuesfortheRule
Variance
Loss to Society
Inflation Historical Stochastic*
Output
p-value**
ActualData
60
18.54
12.32
FirstBest

2.80

12.15

7.48

SecondBest

2.40

13.11

7.76

TaylorRule

2.94

12.25

7.60

7.82
(1.92)
8.10
(1.78)
8.26
(1/72)

0.02
0.02
0.02

* Standarderrorin
parenthesis.
**
ofloss associatedwithrulebeinggreater
thanthatofactualdata.
Probability

5. SUMMARY AND CONCLUDING REMARKS


In thisstudytheTaylorruleforPakistanhas beenestimatedfortheperiod19912006 andforthesub-samples
Governors
ofSBP. One
coveringtheperiodofthreeformer
of the important
of
the
that
has
is
been
findings
study
monetarypolicy
generally
measuresratherthanadoptinga rule.This could have
conductedthrough
discretionary
and output
on policyobjectivesotherthaninflation
beendue to theSBP' s concentration
has
concluded
that
stabilisation.
historical
and
stochastic
the
simulation,
study
Through
commitmentto the Taylor-typerule would have significantlyimproved the
macroeconomicperformance,
especially in termsof less variabilityof outputand
inflation
valuesin therule,ithas beenfoundthattargeting
inflation.
Regardingparameter
at 8 percentand treatingoutputand inflationequally in the policyreactionfunction
wouldhaveyieldedan optimalscenariofortheSBP.23
The keymessagesthatemergesfromthestudyareas follows:
formoreelaboratepolicy
the factthatthe pre-requisites
First,notwithstanding
rulesare lackingand theinstitutional
capacityis also quiteweakin Pakistan,yetthereis
rules witha clear
to simpleinstrument
ample scope to reap benefitsby committing
thatadoptionof
It
is
the
issued
McCallum
of
(2000).
warning
by
proposed
understanding
and
other
a
for
Pakistan
be
as
first
instrument
rules
developing
may regarded
step
simple
countriesto move fromdiscretionary
policy to a more elaborateinflationtargeting
framework.
Second,althoughthereis a need forhavingan elaboraterangeof targetsin
thestudyis notputting
themonetary
(includingoutputand inflation),
policyframework
otherobjectivesin the simple
on thesepossibilities,
i.e., incorporating
any restrictions
rate.
23Theseresultsarebasedon theassumption
ofzerorealinterest

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Performance
TaylorRuleand Macroevonomic

51

rules. However, we recommenda humble beginningas it allows betterunderstandingof


groundrealities.Third, it is also advisable to adjust the parametersin the rule (especially
the inflationtarget)according to theeconomic conditionsprevalentin the economy.
thisis a passionatelypursuedarea of researchin
Finally,it may be added thatcurrently
macroeconomics. Thus, there is ample scope for furtherresearch. To start with, the
of variablesother
on theTaylorrule,especiallythe coefficients
inconclusivenessof literature
than outputand inflationin the policy reactionfunction,can provide furtherinsightsfor
developingcountries,includingPakistan.There is also a possibilityforexploringways and
In thisregardtheresearch
framework.
means foradoptinga moreelaborateinflationtargeting
can focus on the pre-requisitessuch as centralbank independence,and transparencyand
accountabilityof its actions.These threenotionsmightbe the outcome of elaboratepolicy
rulesand notjust thepre-requisites
forit. Research in thisarea would be quite beneficialfor
developing countries where institutionsare not yet strongand the focus on issues like
and accountability
is generallyquite weak.
monetarypolicytransparency

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Malikand Ahmed

52

APPENDIX - A
Fig. 2. Actualand TaylorRule-inducedShortInterestRate,
OutputGap and Inflation
Actual and Taylor Rule Induced Short InterestRate
18 -,

oooooooooooooo
cvjco^tincor^oooQT-csjco^tio
)
)
)
)
)
)

)
)

5
)

Oi
)

Q)
)

)
)

- - ^- actual eie^rule

inducedJ

Actual and Taylor Rule based Output Gap


12 -,
9 -

-6 J
OOOOOOOOOOOOOO

^^--^
OTOOOihCDOiOOQQOQO
050)0)0)0)0)0)0)000000
^-T--^-T-T-T-T-ojcgcgcvjcjcNj

^actual *^^^^rule

based !

Actual and Taylor Rule based Inflation


18 -,

-3 CT5
^J5
C7i
^D
^-^-T-T-r-^T-i-CvJCMCvJCgCvJCVj

^T

O^

actual ^^^^rule

c^"^

^^

"^

^^

^^

based

This content downloaded from 14.139.239.210 on Tue, 17 Nov 2015 17:43:20 UTC
All use subject to JSTOR Terms and Conditions

^)

TaylorRuleand MacroecommuePerformance

53

Fig. 3. Actualand FirstBest Rule-inducedShortInterestRate,


OutputGap and Inflation
Actual and Proposed Rule-Ibased Inflation
16

i-

i-

i-

i-

i-

i-

i-

i-

i-

i-

i-

i-

r-

i-

i-

i-

i-

i-

i-

i-

i-

i-

i-

i-

i-

i-

i-

i-

An- - i-

i-

i-

i-

i-

i-

i-

i-

i-

i-

i-

i-

i-

-2 -

actual ---rule

based |

Actual and Proposed Rule-Ibased OutputGap


9-,

-6 -

actual~~rule

based|

Actual and Best Rule-I based InterestRate

ol

oooooooooooooo
- ---actual

"---rule

based |

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All use subject to JSTOR Terms and Conditions

i-

i-

i-

i-

Malikand Ahmed

54

Fig. 4. Actualand Second Best Rule-inducedShortInterestRate,


OutputGap and Inflation
Actual and Proposed Rule-ll based Inflation
18 ^

-3 -

oooooo
O

O)

Oj

O)

kj

actual "- "-^rule based

^D

^3

^^

f"^

f"i

Actual and Proposed Rule-ll based Output Gap


9 -,

oooooooooooooo
I

-actual - -

rulebased

~|

Actual and Proposed Rule-ll based Interest Rate


18 -,
16 -

0 I

oooooooooooooo

,,,,,,,,,

r-r-,

actual """"rule
based

REFERENCES
Alesian,A. and L. Summers(1993) CentralBank Independenceand Macroeconomic
Performance.
JournalofMoney,Creditand Banking25 (May), 151-162.
Laurence
RulesforMonetary
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(1999) Efficient
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Barro,RobertJ.,and David B. Gordon(1983b) Rules,Discretionand Reputationin a
Model ofMonetary
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Policy.JournalofMonetary

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Barro,Robert,and David Gordon(1983a) A PositiveTheoryof MonetaryPolicy in a


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