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International Journal of Applied Economic Studies Vol. 4, Issue 6, December 2016
Available online at http://sijournals.com/IJAE/
ISSN: 2345-5721

Impact of Monetary Policy on Economic Growth

Empirical Evidence of Pakistan

Dilshad Ahmad
Faculty Department of Management Sciences
COMSATS Institute of Information Technology, Vehari, Pakistan.
Corresponding Author: dilshad@ciitvehari.edu.pk

Mohammad Afzal
Faculty Department of Economics
Preston University, Islamabad, Pakistan.
profafzal@gmail.com

Usman Ghani
MS. Scholar Department of Management Sciences
COMSATS Institute of Information Technology, Vehari, Pakistan.
usmankhan7263@gmail.com

Abstract
The study focused to explore, importance of monetary measures in promoting economic growth of Pakistan. The study
obtained annual time-series data covering the range of 1973 to 2014, employing Augmented Dickey-Fuller (ADF) unit
root test to measure stationary of variables. Gross domestic product, Money supply, Inflation and Interest rate are
stationary at level while exchange rate measured stationary at first difference. Autoregressive Distribution Lag (ARDL)
Cointegration approach applied to distinguish the robust among the variables with specification of short-run and long-
run. Empirical findings mentioned long-run association occurs among variables, money supply and exchange rate,
which positively influence economic growth. Inflation positively while insignificance and interest rate negatively affect
economic growth. The study suggest a stable exchange rate policy be ensured to enhance, economic growth of the
country and should be used monetary policy to generate an agreeable venture atmosphere which attracts both internal
and external investors thereby to stimulate economic growth. Economic growth possible to attain through promoting
effective monetary policy measures necessary to control over the inflation and favorable interest rate.
Keywords: Monetary Policy, Economic Growth, ARDL, Error Correction Model, Pakistan.
JEL Classification: E01, E44, E52.

1. Introduction

Monetary policy measures play vital contribution in the economic growth of a country. Central authority through
managerial monetary extent of money supply, interest rate and various monetary measures of economic activities
controls monetary policy. Monetary policy is also considering a source of economic development to attaining full
employment and improving balance of payment (BOP). Stabilization of exchange rate, price level and interest rate are
prominent monetary policy functions performed to control money market through money measures. Formulation

1
Impact of Monetary Policy on Economic Growth Empirical Evidence of Pakistan
Dilshad Ahmad, Mohammad Afzal, Usman Ghani

process of monetary policy on Pakistan undergone economic changes inside country and across world developed
theoretical and empirical consciousness of monetary policy. Monetary policy affects macroeconomic goals like balance
of payments, price stability, economic growth and other objectives monetary management using monetary measures to
attain economic growth. Nokoro (2005) mentioned economic growth as prerequisite to reducing poverty and improving
standard of living and priority based to its effectiveness and increasing role of economic growth. In an economy
monetary policy as amalgam of measure constructs to readjust the value of money and supply of money, in accordance
with predicted economic activity stages referred by Folawewo and Osinubi, (2006).

State Bank of Pakistan was founded in 1948 major focus to stabilization of economic growth through monetary policy.
According to act of 1956, purpose of State Bank of Pakistan (SBP) to attain balanced growth and control over inflation.
Laidler, (1993) reported increasing interest rate minimizing the stock of money, causes reduction in Gross national
product (GNP) were results of the impact of Structural adjustment programme (SAP). Effective contractionary and
expansionary monetary measures play significant role in controlling inflation, interest rates and broaden the monetary
base (State Bank of Pakistan, 2004). According to Shamshad, (2006) currently from some year’s monetary policy
playing largely dual supportive objectives, considering significant role stability in price level and growth in Pakistan.

Significances of monetary measures are necessary to elaborate functions of monetary policy and multiplicatively affect
the economic growth. Economic growth also effected by influencing aggregate demand and aggregate supply through
monetary policy. Hyperinflation, capital flight, prompts speculation, undermine savings and dollarization, negatively
affecting the poor. Focus of study is to estimate how monetary policy influence economic growth as following
objectives.

i. Examine the contribution of monetary policy in economic growth of Pakistan.

ii. Analyze the short-run and long-run relationship among variables.

Structure of the study is organized firstly introduction while literature review analyzed in second section. Methodology
and data sources reported in third section and empirical analysis and findings of the study have elaborated in fourth
section. Conclusion and suggestions of the study as reported in last section.
Literature Review:
Economic growth stabilizes through important macroeconomic variables. Empirically it has been sustained from
previous studies monetary policy and economic growth strongly correlated. State bank of Pakistan (SBP), as central
authority of the country used monetary policy instruments to maintain stability in monetary measures attaining
economic growth level of country. Money supply, interest rate, inflation and cash reserve ratio are significant tools of
state bank through which it influences economic growth. Empirical findings of previous studies as mentioned below.
Rehman and Ahmed (2002) investigated substance to monetary measures for sustainable growth in the economy. The
study analyzed the impact through level of stock of money multiplier approach obtaining the annually time series data
covering from 1980-81 to 1999-2000. Findings of the study mentioned monetary base significant determinant of
monetary stocks (M2) an effective tool to influence and manage monetary assets in Pakistan.
Ferdiun (2005) analyzed how monetary policy cause economic instability in Turkey data used from 1983Q4- 2003Q4
employing Johansen Cointegration approach and GARCH test for the estimations. Results of the study revealing
monetary policy effectiveness in Turkish economy control over inflation exchange rate stability using sensible
prediction structure incorporate fiscal role of exchange rate.

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International Journal of Applied Economic Studies Vol. 4, Issue 6, December 2016

Berument and Dincer (2008) examined monetary policy importance for Turkish economy using time series monthly
data covering from 1986:05 to 2000:10 employing Vector Auto Regressive (VAR) model in the study. Findings of the
study reported monetary policy transient effect on output, causing decline output and temporary decrease in prices while
volatility business cycles hamper through monetary policy tool.
Hameed and Amen (2011) investigated monetary policy effect on GDP obtaining data from1980 to 2009. Focus of the
study was to improve economic growth and stability in the prices. Regression analysis and autocorrelation used in the
study to find out relationship. The study outcomes find out money supply, inflation and interest rate significantly
influences growth of GDP in Pakistan.
Waliullah and Rabbi (2011) evaluated the insight relation among price level, money supply and GDP significantly
important for the monetary policy formulation in Pakistan and other developing countries. Johansen Cointegration
approach and Vector Error Correction Model (VECM) applied in the study to obtaining time series quarterly data from
1972Q1 - 2005Q4. Findings of the study remarked significant role of monetary policy in economic activity of Pakistan.
Gul et al (2012) had examined the linkages between monetary policy and economic growth instruments. The study
obtained annual time series data from 1995 - 2010 and employing Unstructured OLS method to find linkages. Results
concluded tight monetary policy with stabled accommodation in independent variable mentioned significance
connection with dependent variable.
Onyeiwu (2012) analyzed the monetary policy implication on economic growth in Nigeria through exchange rates
stability, maintenance of domestic prices and sustainable growth in the economy. The study employed ordinary least
square Method (OLS) for empirical estimation obtaining data from 1981-2008. Findings of the study reported as
positive effect of monetary policy on balance of payment (BOP) and GDP growth while negative effect on Inflation
rate.
Garg and Gupta (2013) mentioned significance role of monetary policy for Indian economy. Focus of the study was to
changing the selected monetary instruments importance; effectiveness of monetary policy ensuring price stability,
stretch monetary policy promoted economic growth and its mainstream effect in the post-reform duration in India.
Significant monetary policy dominated in Indian economy through stabilizes and healthy growth. Okoro (2013)
investigated the importance of monetary on Nigerian economy for the period 1970 to 2010 employing the error
correction model (ECM) for empirical estimation. Empirical detections of the study mentioned that monetary policy had
significant effect on Nigerian economic growth.
Saifullah (2013) analyzed economic growth in Pakistan influencing through monetary policy. Annually time series data
obtained from 1991-2010 and error correction model (ECM) employed for empirical estimation of the study. Empirical
findings of the study-referenced exchange rate, external reserve, inflation rate have significant impact on monetary
policy instruments of economic growth in Pakistan. Shabbir (2013) examined the monetary policy effect on economic
growth and corporate sector in Pakistan obtaining the data from 2000 to 2010 of non-financial listed companies of
Pakistan. The focus of the study was to find out how monetary policy effects on economic growth through balance sheet
channel.
Precious and Palesa (2014) investigated effectiveness of monetary measures to elevate economic growth obtaining the
time series data 2000-2010 and employing Johansen co-integration test and error correction model (ECM) approaches
for empirical estimation of the study. Empirical finding mentioned monetary policy play significant role for the well-
being of masses and economic growth of an economy.

3
Impact of Monetary Policy on Economic Growth Empirical Evidence of Pakistan
Dilshad Ahmad, Mohammad Afzal, Usman Ghani

Agbonlahor (2014) evaluated economic growth in United Kingdom influencing through monetary policy obtaining data
1940-2012 and employed vector error correction model (VECM) for empirical estimation of the study. Findings
mentioned connection occurs between money supply and Inflationary rate, which consider prominent instrument to
economic growth in United Kingdome.
Baghebo and Stephen (2014) analyzed the monetary measures influencing growth-stabilizing circulation of money and
favorable environmental basis to investment for economic development. Employing regression analysis ordinary least
square (OLS) for data 1980-2011 the empirical estimation of the study. Findings of the study elaborated monetary
policy promote the investment for the development in the economic growth.
Sulaiman and Migiro (2014) evaluated the linkages between monetary policy and Nigerian economic growth. Empirical
findings mentioned monetary policy plays an important role for continuous growth process and leads to sustainable
economic development. Nibeza and Tumusherure (2015) examined the monetary policy effect on Rwanda economy
obtaining annually data 1980 to 2006 and employed OLS, VECM approaches for empirical estimation of the study.
Empirical findings mentioned Central Bank monetary measures significantly effective controlling inflation and
increasing investment.
Okafor et al (2015) investigated role of monetary policy innovations in output growth rate in Nigerian economy.
Annually time series data obtained from 1985 to 2012 and employing vector autoregressive estimation technique for
empirical estimation of the study. Empirical findings pointed out money supply significantly effect on Nigerian output
growth.
Data and Econometric Methodology:

Annually time series data of GDP, M2, EXR, inflation & interest rate obtained from 1973 to 2014. State Bank of
Pakistan various publications, handbook statistics 2010, economic survey of Pakistan statistical supplements and World
Bank data are main data sources of the study. Description of variables reported table 1.

Table 1: Description of variables

Variable Description
GDP Gross domestic product
M2 Money supply
EXR Official exchange rate
INF Consumer price index referred as inflation
IR Call money rate ( proxy of interest rate)

Econometric techniques employed for empirical estimation of the study. Johansen cointegration approach and
autoregressive distributed lag model are prominent techniques among several econometric techniques of estimation for
short-run and long run cointegration among variables. Cointegration approach employed in the study according to
prerequisite of nature of data stationary. Econometric technique of time series data requires various statistical steps
firstly the stationary of data checked through unit root test which prerequisite for the valid estimation of the data non-
stationary data involves the unit root. To estimate the stationary ADF test employed in the study. Equation as given
below for the estimation test base

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International Journal of Applied Economic Studies Vol. 4, Issue 6, December 2016

p
GDPt   o   1t   2 GDPt 1   i GDPt  i  u1 .........(1)
i 1
p
M 2t  o  1t  2 M 2t 1   i M 2t  u 2 ...............(2)
i 1
p
EXRt  o  1t   2 EXRt 1   i EXRt  i  u3 .......(3)
i 1
p
INF  o  1t   2 INFt 1   i INFt  i  u 4 ........( 4)
i 1
p
IR  o  1t   2 IRt 1   i IRt  i  u5 ...........(5)
i 1

Stationarity of variables prerequisite for Long run relationship exist among the variables. For long run & short run
relationship among the variables, Autoregressive distributed lag model approach employed in the study. Equation 6
points out the estimation of ARDL approach as following

n n n n
ln GDPt   0  1t  
i 1
i ln GDPt i  
i 0
i ln M 2t i   i
i 0
ln EXRt i    i
i 0
ln INFt i
n
  i ln IRt i 1 ln GDPt 1   2 ln M 2t 1  3 ln EXRt 1   4 ln INFt 1  5 ln IRt 1   t ............(6)
i 0

In equation 6 parameters 1 ,  2 , 3 ,  4 and 5 , represent the long run relationship while the i , i ,i , i ,  i signify

short run changing aspects of model. is first difference operator and  is serially uncorrelated disturbance zero mean,
constant variance.

The null hypothesis of model is;

H 0 : 1  2  3  4  5  0 (Exists no long run correlation)

H1 : 1  2  3  4  5  0 (Exists a long run correlation)

The autoregressive distributed lag model approach hypothesis testing procedure prerequisite as first step for the
estimation procedure of cointegration with bound testing. Acceptance or rejection of null hypothesis based on
calculated F-statistic value with tabulated value by Pesaran et al (2001). No long run cointegration of null hypothesis
among the variables accepted when test statistics value lies in lower bound than critical value while rejected null
hypothesis when test statistics value greater than critical value of upper bound. Inconclusive results consider when test
statistics value lies lower and upper bound.

Affirmation of long-run correlation among variables rough estimated ARDL model long run correlation of the variables
with error correction relationship. The ECM estimation finding points out if disturbance happened in the short-run in
how much time and speed it will be recover in long run. Standard error correction estimation equation as given below

n n n n
GDPt  1   1 ECTt 1  b
i 1
i GDPt i  
i 0
i M 2t i   i
i 1
EXRt i    i
i 1
INFt i
n
 i IRt i   t ......(7)
i 1

Error correction term shows conversion of equilibrium and it should be negative and less than one which is statistically
significance and full fill the cointegration relationship. Empirically examine the log-run relationship among variables,
5
Impact of Monetary Policy on Economic Growth Empirical Evidence of Pakistan
Dilshad Ahmad, Mohammad Afzal, Usman Ghani

model has been estimated by using bond-testing approach developed by Pesran et al. (2001). Many econometric
techniques have been suggested for estimating long-run relationship or cointegration among variables. The study
employed autoregressive distribution lag (ARDL) model approach a pioneer’s work of Pesaran & Shin (1998). ARDL
approach can handle various orders of integration variables estimation as its flexibility of data handling comparative to
other cointegration approaches.

4. Empirical Analysis
In this section, we analyzed estimation of different tests. Table 1 shows estimated descriptive statistics. Augmented
Dickey-Fuller (ADF) unit root test estimation elaborated in table 2. While estimation of ARDL Bound Testing F-
statistics mentioned in table 3. Table 4 points out the results of long-run cointegration and short-run cointegration
estimation evaluated in table 4 and 5.
Table 1 Descriptive Statistics
LGDP LM2 EXR LINF LIR
Mean 6.160 5.786384 39.07107 0.923390 0.921479
Median 6.162 5.881758 29.33689 0.931851 0.950849
Maximum 7.404 6.998546 101.6289 1.425910 1.120574
Minimum 4.829 4.432456 9.900000 0.464510 0.269513
Std. Dev. 0.738 0.773984 28.88788 0.227209 0.152956
Skewness -0.0121 -0.131600 0.699323 -0.004553 -2.064817
Kurtosis 1.891 1.802761 2.266372 2.840473 9.253229
Jarque-Bera 2.153 2.629645 4.365233 0.044681 98.27433
Probability 0.340 0.268522 0.112746 0.977907 0.000000
Sum 258.7 243.0281 1640.985 38.78240 38.70212
Sum Sq. Dev. 22.37 24.56108 34214.91 2.116577 0.959223
Observations 42 42 42 42 42

Table 1 interprets the average of LGDP, LM2, exchange rate, LINF and LIR as 6.160732, 5.786384,
39.07107,0.923390 and0.921479 while standard deviation as0.738756, 28.88788, 0.227209, 0.152956 and 0.152956.
Descriptive statistics shows that maximum value of LGDP, value of during sample period was 7.404868 in 2014 and
minimum value of LGDP was 4.829252 in 1973. Maximum value of LM2 during sample period was 6.998546 in 2014
and minimum value of LM2 was 4.432456 in 1973. Maximum value of exchange rate during sample period was
101.6289 in 2013 and minimum value of exchange rate was 9.9 in 1974. Maximum value of LINF during sample period
was 1.425910 in 1974 and minimum value of LINF was 0.464510 in 2003. Descriptive statistics points out maximum
value of LIR during sample period were 1.120574 in 2009 and minimum value of LIR was 0.269513 in 2004. Median
values of LGDP, LM2, exchange rate, LINF and LIR are respectively 6.162194, 5.881758, 29.33689, 0.931851 and
0.950849. Normality of the variables as mentioned in the values of Jarque-Bera.
Table 2 Results of Augmented Dickey Fuller Unit root test
Variables ADF Level ADF 1st Difference Conclusion
Intercept Trend & Intercept Intercept Trend & Intercept Order of integration
LGDP -1.338 -4.018** ---------- ------------ I(0)
LM2 -0.915 -5.84*** ----------- ----------- I(0)
EXR 1.680 -1.2705 -0.41518 -3.6724** I(1)
LINF -3.43** -------- ---------- ------------ I(0)
LIR -3.8*** --------- ---------- ------------ I(0)
***at 1 percent level of significance **at 5 percent level of significance *at 10 percent level of significance
Augmented Dickey Fuller (ADF) test and Phillip Perron (PP) unit root tests are applied to check the stationary of the
variables while this study applied ADF test consider preferable due to its characteristics in most studies rather than
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International Journal of Applied Economic Studies Vol. 4, Issue 6, December 2016

Phillip Perron test. ADF test values of variables mentioned above. GDP, M2, inflation and interest rate are stationary at
level while Exchange rate stationary at 1st difference. Findings of ADF which accounted above points out GDP, M2,
Consumer Price Index (referred as Inflation) and interest rate are integrated in order (0). Exchange rate integrated in
order (1).Parenthesis results are also mention in the table.
Table 3 Bound Test F-statistics value
ARDL Co-integration
Lag length F-statistics
ARDL(4,4,4,4,3) 4.409766**
Critical values *
Significance level Lower bounds I(0) Upper bounds I(1)
1 percent 3.74 5.06
5 percent 2.86 4.01
10 percent 2.45 3.52
***at 1percent level of significance **at 5percent level of significance *at 10percent level of significance
Null hypothesis of no long-run relationship among variables rejected because value of F-statistic 4.409766, which fall
outside the critical value, bounds at 5 percent significance level. Bound test findings verify long-run relationship exists
and for investigates the long run and short-run parameters ARDL method applied.

Table 4 ARDL Model Long-run Results

Long Run Coefficients
Variable Coefficient Std. Error t-Statistic Prob.
LM2 0.376 0.091997 4.096181 0.0011
EXR 0.011879 0.001579 7.525176 0.0000
LINF 0.138602 0.177742 0.779794 0.4485
LIR -0.342266 0.276347 -1.238535 0.2359
C 4.236265 0.669662 6.325974 0.0000

The long run results in table 4 shows money supply coefficient is positive and statistically significance, if there is one
percent increase in money supply it will 0.376835 percent increase in economic growth. Exchange rate coefficient is
also positive and statistically significance, if one percent increases in exchange rates it will bring 0.011879 percent
increase in economic growth. Inflation coefficient is also positive but statistically insignificance. While the interest rate
coefficient is negative and statistically insignificance if there is 1% increase interest rate it brings -0.342266% decrease
economic growth.
Main findings from long run mentioned money supply and exchange rate positively affects economic growth while
inflation positively effect on economic growth yet insignificance, interest rate ineffective and need to control over
interest rate to enhance economic growth.
Table 5 ARDL Model Short-run Error Correction Model (ECM-ARDL) Results
Cointegration Form
Variable Coefficient Std. Error t-Statistic Prob.
D(LGDP(-1)) -0.513125 0.217472 -2.359499 0.0334
D(LGDP(-2)) -0.717466 0.217156 -3.303923 0.0052
D(LGDP(-3)) -0.219093 0.195799 -1.118966 0.2820
D(LM2) 0.019255 0.016803 1.145927 0.2710
D(LM2(-1)) -0.018736 0.015919 -1.176978 0.2588
D(LM2(-2)) -0.034595 0.017282 -2.001773 0.0651
D(LM2(-3)) -0.019772 0.017443 -1.133532 0.2760
D(EXR) 0.004291 0.001728 2.483596 0.0263
D(EXR(-1)) 0.000491 0.002276 0.215611 0.8324
D(EXR(-2)) -0.003221 0.002396 -1.344211 0.2003
7
Impact of Monetary Policy on Economic Growth Empirical Evidence of Pakistan
Dilshad Ahmad, Mohammad Afzal, Usman Ghani

D(EXR(-3)) 0.005073 0.001859 2.729590 0.0163

D(LINF) 0.034733 0.018753 1.852104 0.0852
D(LINF(-1)) 0.002690 0.023302 0.115421 0.9098
D(LINF(-2)) -0.042151 0.025708 -1.639566 0.1234
D(LINF(-3)) 0.047279 0.025254 1.872132 0.0822
D(LIR) 0.089631 0.041021 2.184995 0.0464
D(LIR(-1)) 0.033752 0.040115 0.841371 0.4143
D(LIR(-2)) 0.058093 0.040878 1.421120 0.1772
Ecm (-1) -0.257110 0.093623 -2.746224 0.0158

Results of short-run dynamic reveals that value of ECM (-1) coefficient which is -0.257110 having negative sign and
statistically significant. It indicates due to shock if disequilibrium occurs in the economy it will be recover 25.7% in
next year. Findings of short run estimation elaborated positive and significant affect of money supply, exchange rate,
inflation and interest rate on economic growth in short run.
Conclusion and Suggestions
The study analyzed the relation between monetary policy and economic growth obtaining annually time series data
1973-2014. To identify short-run and long-run empirical estimation among economic variables GDP, M2, EXR, INF
and IR, Autoregressive Distributive Lag (ARDL) model employed in the study. Empirical findings stated as positive
impact of money supply and exchange rate on economic growth while Consumer price index referred as inflation
positively but insignificantly affect the economic growth and Call money rate referred as Interest rate negatively affects
the economic growth. Monetary policy contingent on monetary instruments money supply; exchange rate, interest rate
etc. used to predominance monetary policy to stabilizing and effectiveness of monetary policy for a healthy economic
growth.
The study shows the importance of monetary policy on economic growth. Monetary policy plays an active role in
stabilizing economy and increasing the economic growth of a country. A stable exchange rate policy has ensured to
enhance the growth of the country through adopting effective monetary policy measures to control over the inflation
and increase the economic growth. Inflation hardly effect the poor’s and there life so adopt the monetary policy
minimize the inflation and generate economic phenomenon. Interest rate also more prominent variable in the monetary
sector it is prerequisite to provide a favorable interest rate to attract foreign and domestic investor to invest in the
county, which will significantly increase economic growth in the country.

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