NONLINEAR TAYLOR RULE AND INFLATION-TARGETING IN PAKISTAN: A TIME SERIES ANALYSIS

Abstract

The paper estimates the non-linear Taylor rule of inflation-targeting in Pakistan. Three types of short-term nominal interest rates are used as policy instruments represented by three, six, and twelve-months treasury bills. Using quarterly time series data for the period 2005 (1^st Quarter) to 2019 (3^rd Quarter), a threshold regression technique has been applied. The study aims to observe the nonlinear behavior of the monetary policy of the central bank. Threshold values are estimated at 2.5% for the output gap, 6.02% for inflation, 7.45% for interest rate, and 0.68 for the exchange rate. The study finds a weak response of output gap and inflation in the context of the backdrop of economic activity, while the interest rate is positive and significant toward the output gap. Results regarding the non-linear Taylor rule by inflation indicate that the exchange rate is negatively significant in high and low inflationary regimes. Results of the study further disclose that inflation and interest rate have negative and significant responses towards exchange rate. Above the threshold value of the exchange rate (0.68) inflation escalates and the interest rate falls with exchange rate depreciation. As a policy implication, it can be suggested that the SBP should control exchange rate depreciation to overcome inflation. SBP should consider the exchange rate stabilization together with the objective of price stability in an inflation-targeting framework.