Policy of Inflation Targeting in the Presence of Fiscal Deficit and External Debt: Opt or Not to Opt.

Muhammad Ali Kemal


The main task of the macroeconomic policy-makers is to control
unemployment and inflation at the minimum possible level. Different
policies have been tried to control inflation at its minimum possible
level and inflation targeting is the most popular among them. It is the
commitment to maintain inflation at the announced level and use interest
rate as an instrument to control it if it is expected to diverge from
the announced level. However in a higher \dollar denominated debt.
country Central Bank is reluctant to increase interest rate because it
pressurises the foreign exchange market, which leads to exchange rate
depreciation. If there is exchange rate pass through effect to prices,
depreciation leads to increase in prices. Thus increase in interest rate
does not decrease prices instead results in increase in prices. The two
important linkages were tested in this study are (i) increase in real
interest rate depreciates the currency, and (ii) depreciation in real
exchange rate leads to increase in prices. Using VAR model we concluded
that real exchange rate is not significantly associated to the real
interest rate in the short run and exchange rate pass through effect to
prices is not present in Pakistan.

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DOI: https://doi.org/10.30541/v50i4IIpp.841-852


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