PIDE Working Papers 2007:34
A widely agreed proposition in modern economics is that policy rules have greater advantage over discretion in improving economic performance. Simple monetary policy instrument rules are feasible options for developing countries lacking the pre-requisites for more sophisticated targeting rules. Notwithstanding the focus of modern literature on the issue, the State Bank of Pakistan (SBP) has never declared itself to be following any type of rule. Surprisingly, this topic has remained out of research focus (among the academia and the practitioners) in Pakistan. This is the first attempt to deal with a rulebased monetary policy strategy in the case of the SBP. We have estimated the Taylor rule and simulated the economy using this rule as a monetary policy strategy. Our results indicate that the SBP has not been following the Taylor rule. In fact, the actual policy can be taken as an extreme deviation from it. On the other hand, counterfactual simulation confirms that macroeconomic performance can be improved, in terms of stability in inflation and output, when a simple Taylor rule is adopted. In this regard the parameter values (especially the inflation target) in the rule must be set according to the conditions of the economy under consideration rather than by relying on the ones suggested by the Taylor rule.