Pro-Cyclicality of Pakistan’s Monetary Policy Under Global Financial Uncertainty

Résumé

The study investigates the impact of external factors on the macroeconomic indicators of Pakistan and checks the cyclicality of monetary policy (MP) under global financial uncertainty and its factors. This study employed monthly data from January 2005 to December 2024. First, the study estimates the reaction function to check the cyclical behavior of monetary policy, and whether Pakistan exhibits fear of free fall through VAR and then by impulse response function found the impact of external shocks on key macroeconomic variables. Finally, through variance decomposition, we assess, if is there any external dominance. The result of the study shows that Pakistan's monetary policy initial response is counter-cyclical in the face of global financial risk but also exhibits fear of free fall behavior because SBP increases the policy rate when the currency depreciates. The variance decomposition analysis shows that about 62 percent of variation is explained by inflation in interest rate and 28 percent of variation is explained by its own lagged value. SBP does not response to output gap despite its importance in Taylor rule. SBP should incorporate the output gap more explicitly in monetary policy formulation to ensure balanced economic stabilization.