Monetary Transmission Mechanism in Pakistan: Credit Channel or Interest Rate Channel

Abstract

This study uses vector autoregressive approach to estimate the relative importance of credit and interest rate channels in the monetary transmission mechanism of Pakistan by covering the period from 1991-Q3 to 2012-Q2. The purpose of the study is to explore the role played by monetary policy shocksin economic fluctuations. The results based on variance decomposition analysis and impulse response function demonstrate that for the combine sample period covering from 1991-Q3 to 2012-Q2 both the credit and interest rate channels seem inef ective and it was dif icult to distinguish which channel is more important during this period in Pakistan's case. The sample period was then divided into two subsample periods and both the channels were observed in two subsample periods. However, credit channel was dominant in the first sample covering 1991-Q3 to 2000-Q4 and interest rate channel performs a much greater role in transmitting policy shocks in the second sample period of 2001-Q1 to 2012- Q2. Hence, it is concluded that the role of both transmission channels changed during the last two decades. The role of the credit channel in transmitting monetary shocks has considerably weakened since the early 2000s, whereas interest rate channel is more important during this period. These results have important implications for policy design, supporting a greater emphasis on financial prices than the quantity of credit in order to accomplish the targets of monetary policy in Pakistan.