THE SPECIFICATIONS AND TESTING OF NON MODIFIED AND MODIFIED LINEAR TAYLOR RULES: A TIME SERIES ANALYSIS OF INFLATION TARGETING IN PAKISTAN

Abstract

Purpose: This study has tested the various specifications of linear Taylor rule of inflation targeting in Pakistan. Linear Taylor rules with and without modification have been examined.

Design/Methodology/Approach: Short term interest rates i.e., Treasury bill of maturity 3 months, 6months and 12 months for the period of 2005q1 to 2019q3 have been used. OLS and GMM methods are applied.

Findings: Findings exhibit that the State Bank of Pakistan is not following Taylor rule and the Taylor principle is not satisfying in Pakistan. Results show that SBP is not preferring exchange rate management over output gap and inflation stability. This result is robust in all specifications except for GMM estimation of a forward-looking version of the Taylor rule which shows a significant positive impact of differenced lagged Exchange Rate. Interest rate smoothing is an important determinant of short-term interest rates. Real GDP is found negative and significant when replacing with output gap in Taylor rule. This paper also evaluates the important influence of fiscal deficit in Taylor rule to determine short-term interest rates in Pakistan.

Implications/Originality/Value: The study suggests that flexible inflation targeting may be adopted to control inflation in Pakistan so that exchange rate management and interest rate smoothing may also be considered. SBP should be autonomous in its decision making. Moreover, fiscal deficit may be financed through taxes.