Pakistan Institute of Development Economics



Endogeneity of Monetary Policy Reaction Fun~tion: An Experiencefrom Pakistan’s Economy

Monetary policy, in general, refers to those steps taken bythe Central Bank to achieve such broader objectives of the economy asgrowth, employment, external balance and price stability through changesin the money supply, interest rates and credit policies. The moneysupply thus created by the Central Bank should be in response to thechanges in key macroeconomic target variables such as GNP, balance ofpayments, inflation, internal debt and unemployment. Indeed, a properlyestimated monetary policy reaction function can provide usefulinformation regarding such matters as to whether the Central Bank, infact, has been systematically accommodating to the changes in the targetvariables. The reaction function can also provide insight into thequestion as to what should be the relevant indicators of the monetarypolicy. In addition, as argued by Havrilesky (1967), it may also play acrucial role in the formulation of long-term monetary policy strategy.The other important consideration in the development of a monetarypolicy reaction function pertains to the endogeneity of the monetarypolicy. As pointed out by Goldfeld and Blinder (1972), if a policyvariable responds to the lagged (or expected) target values, thenconsidering such a policy variable as exogenous would not only introducethe problem of misspecification but will also produce serious biases inthe parameters estimated from those models. In particular, if themonetary policy variable happens to be strongly influenced by targetvariables, then the standard result of the relative effectiveness of themonetary policy vis-a-vis fiscal policy can be questionable on thegrounds of reverse causation problem.

M. Aynul Hasan, Qazi Masood Ahmed

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