Pass-through of Change in Policy Interest Rate to Market Rates

M. Idrees Khawaja, Sajawal Khan

Abstract


Monetary policy has been aggressively used by the central Bank
of Pakistan, in this decade, first to bolster growth and then to contain
rampant inflation. Despite the sufficiently tight monetary policy that
has remained in vogue in recent times, the inflation is still around 20
percent. This has raised questions about the effectiveness of monetary
policy. One possible reason for the lesser effectiveness, if not
failure, of monetary policy in taming inflation could be that in recent
times, inflation was primarily supply driven and that the monetary
tightening was in part offset by fiscal expansion, on the back of heavy
bank borrowing by the government. However one cannot rule out the
possibility that market imperfections might have also impeded the
effectiveness of monetary policy in taming inflation to the desired
extent. Incomplete and slow pass through of changes in policy interest
rate to deposit rate and lending rate is a kind of imperfection that
constrains the effectiveness of monetary policy. This study examines the
pass through of policy interest rate to different market rates. Monetary
theory predicts that the change in policy interest rate influences the
cost capital which in turn influences consumption, savings, investments,
and hence output. However if the impact of the change in policy rate on
the cost of capital is less than one for one or if the change in policy
rate fails to influence the cost capital immediately then the impact on
output would become visible only with a certain lag and the impact would
be less than one for one. This implies that if for example only 70
percent of the change in policy rate is passed on to cost of capital,
then to manage an increase of 100 basis points in cost capital the
policy rate should be raised by 143 basis points. This example serves to
emphasise that for effective monetary management knowledge of the
magnitude of passthrough of policy rate and the lag structure with which
the policy rate influences cost of capital is important. Substantive
empirical evidence confirms that changes in policy interest rate are
transmitted to the output with a certain lag and that the pass-through
of changes in policy rate to output or to other elements of the
transmission channel may be less than one for one. Given the policy
implications of the information, on the magnitude of pass through and
the lag structure with which the policy rate influences different market
rates, this Paper seeks to measure the pass-through of the changes in
six month Treasury bill rate to six month KIBOR, six month weighted
average deposit rate and weighted average lending rate. The study is
focused on Pakistan.

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DOI: https://doi.org/10.30541/v47i4IIpp.661-674

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