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BANKING SYSTEM INNOVATIONS AND MONETARY POLICY: AN EMPIRICAL STUDY OF PAKISTAN 1. Lecturer, Department of Economics, University of Karachi email [email protected] 2. Research Student, Department of Economics, University of Karachi Rabia Shakir 1 Syed Muzammil Hussain 2 By

Banking System innovations and monetary policy

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BANKING SYSTEM INNOVATIONS AND MONETARY POLICY: AN EMPIRICAL STUDY OF PAKISTAN

BANKING SYSTEM INNOVATIONS AND MONETARY POLICY: AN EMPIRICAL STUDY OF PAKISTANLecturer, Department of Economics, University of Karachi email [email protected] Student, Department of Economics, University of KarachiRabia Shakir1Syed Muzammil Hussain2By1OUTLINEObjective of the StudyReview of LiteratureTheoretical AspectsChoice of VariablesMethodologyResultsConclusion

OBJECTIVES OF THE STUDYTo examine the role of monetary policy and transmission mechanism with respect to the recent Innovations in Banking System of Pakistan.

Increased consumer financing has led to demand pull inflation in recent years which is in contrast to the monetary policy objective of lowering inflation.

An attempt is made to provide an intuitive explanation of this contrast in monetary policy measure that encourages inflation, through an indirect transmission mechanism.

REVIEW OF LITERATUREAkhtar (1983) discussed financial advancements and their impacts on monetary policy in global scenario.

Lown (1987) contributed significantly to this issue and discussed monetary policy with respect to the financial innovations in a more rigorous manner.

Malik (2007) in his paper found that a simple Output-inflation Taylor rule is insufficient to attain the monetary policy objectives in the current scenario of Pakistan.THEORETICAL ASPECTSBanking Innovations in Pakistan.

Transmission Mechanism through Credit Channel of Monetary Policy

Consumer behavior and consumer financing

Banking Innovations in PakistanBeginning of Banking in PakistanNationalization of Banks Privatization of BanksTransformational reforms after PrivatizationThe post-reform era, 2006 presentLong journey to go

Transmission Mechanism Of Monetary PolicyCentral BankMonetary PolicyChannelsInterest RateCreditExchange Rate Asset PriceGrowth & Price StabilityOutputTransmission Mechanism

2413SOME QUICK FIGURES OF CONSUMER FINANCING IN PAKISTAN

Amount of Consumer Financing (SBP, 2006)

Consumer Financing Share by Sector(SBP, 2006)

ContCHOICE OF VARIABLESWe have taken four variables which are:Real Gross Domestic Product (Dependent Variable)Consumer Price Index to measure price levelsReal lending rate as proxy for interest rateBroad money as proxy for money supply(Independent Variables)Econometric FrameworkThe Empirical framework used in this paper is based on Keynesian IS-LM model and monetary theory.

The Functional Form of our model is as follows: RGDP = f (CPI, RLR, M2)Where, RGDP = Real gross domestic product (constant price, LCU)CPI = Consumer Price Index (2010=100)RLR = Real lending rate (percent per annum) M2 = Broad money (billions LCU)

The econometric model followed in this study can be written as:RGDP = 1 CPI - 2 RLR + 3 M2 + 0

Where 1, 2 & 3 are the coefficients of independent variables and 0 is the stochastic error term. The expected signs of 1 & 3 are positive, whereas the sign of 2 is expected to be negative as suggested by the theory (Hasanov & Omay, 2011).

MethodologyMethodology employed in this research consists of three stepsFirst, to check the stationarity of the dataSecond, Causality TestLast, testing Cointegration followed by vector error correction model (VECM)VariablesInterceptTrend and InterceptOrder of IntegrationRGDPLevel1.76941-0.71351I(1)1st Difference-5.52907*-5.50785M2Level4.95914.8931I(1)1st Difference-3.3185**-6.7578*RLRLevel-2.7487***-2.7538***I(1)1st Difference-4.4339*-4.3627*CPILevel1.63045-0.0773I(1)1st Difference-6.9209*-6.8766**& ** indicates rejection of null hypothesis at 1% & 5% respectively based on Mackinnon critical valuesSource: Authors Computation 2015AUGMENTED-DICKEY FULLER - UNIT ROOT TESTResultsGRANGER CAUSALITY TESTDependent variable: D(RGDP)ExcludedChi-sqdfProb.D(CPI)14.9426920.0006D(RLR)7.58207520.0226D(M2)9.45825020.0088All18.9207160.0043Source: Authors Computation 2015Johansen-Juselius Cointegration Test Results (Trace)HypothesizedNo. of CE(s)EigenvalueTrace Statistics0.05 Critical ValueProb. **None *0.78944288.3221747.856130.0000At most 1 *0.51882338.4663429.797070.0039At most 20.37522915.0576715.494710.0581At most 30.0001820.0058243.8414660.9384* denotes rejection of the hypothesis at the 5 %Source: Authors Computation 2015Normalized Cointegrating CoefficientsRGDPCPIRLRM21.000000-3.398197*793.0407*0.025390*(0.31670)(114.484)(0.00483)* and ** denotes rejection of the hypothesis at the 5 % and 10% respectivelySource: Authors Computation 2015Dependent Variable: RGDPMethod: Least Squares CoefficientStd. Errort-StatisticD(RGDP(-1)) 0.1657730.226510.73187D(RGDP(-2))-0.437011***0.24217-1.80456D(CPI(-1)) -0.1877560.15404-1.21889D(CPI(-2)) -0.511667**0.20333-2.51644D(RLR(-1)) 70.84949**26.4963 2.67394D(RLR(-2))31.0732423.0534 1.34788D(M2(-1))-0.000624***0.00223-1.79782D(M2(-2)) -0.0013670.00290-1.47225ECM t-1-0.073723***0.04104-1.79628ECM t-2-0.327835**0.121672.69437R-squared0.783890Adjusted R-squared0.675835Durbin-Watson stat2.360009* and **denotes rejection of the hypothesis at the 5 % and 10 % respectivelySource: Authors Computation 2015Error Correction EstimatesCONCLUSIONOur analysis illustrates that monetary policy has significant impact on output through interest rate channel.In our analysis, increase in money leads to decrease in output. (Mallet & Keen, 2012)However negative association of money is found with economic growth which is opposite to monetary theory.If we study the behavior of consumer in our economy, it makes sense, because economy of Pakistan is consumption oriented.

ContThe analysis of data shows that when supply of money increases in the economy, real lending rate decreases. (Mishkin, 2006) As a result, households consume more because credit is available at low cost. Therefore, they save less and spend more. Decrease in savings lead to a decrease in investment and eventually output gets affected.

Direction for further researchOther Channels of Transmission Mechanism can be studiedBy change in the length of data for instance taking monthly or quarterly data rather than the yearly dataThese estimations can be further strengthened with an in-depth study of consumer behavior theories