Monetary policy and the role of Central Bank

The policy with which the Central Bank controls the money supply in the economy is called the monetary policy. As Central Bank reduce the money supply in the market the interest rate increases or the other way we can say that to increase the Market interest rate the Central Bank reduces the money supply. Now the question arises that how the Central Bank do so? The simplest answer to this question is open market operations by the Central bank. In open market operations the central bank purchases or sales the bonds, security and treasury bills‎ in open market to control the money supply and inflation rate. When it purchases the bonds, securities and TB from market the money supply in the market increases and increased money supply leads to lower market interest rates. These lower interest rates or low cost of borrowing encourages the borrowers. As a result the domestic consumption increases this leads to demand pull inflation in the economy. So with the help of tight monetary policy the Central Bank increases the policy rate to control the inflation.

New Monetory Policy by The State Bank of Pakistan

From the beginning of this fiscal year persistent inflation and fiscal problems are resisting the improvement in the Balance of Payment and recovery of the falling economy. Due to uncertainty and worsen economic conditions the gap between national savings and investment has squeezed mainly because of decline in investments. At the same time aggregate domestic demand is exceeding the aggregate supply. Aggregate supply is squeezed mainly due to increased cost of production which is led by energy crises and increase in value of primary inputs. And the external debts has increased to $55.266 billion in January 2010 from $43.141 billion in the corresponding period of 2008, showing a net increase 28 percent in the last two years of the present government. So all this led to worsen inflation in Pakistan and government is not taking appropriate fiscal measures to control this situation. As inflation rate of 11.7% in fiscal year 2010 was 2.7% higher than the announced target of 9.5%. Inflation is projected to remain from 11% to 12% in fiscal year 2011.

To sterilize risks to macroeconomic stability, monetary policy has to take lead for containing aggregate demand pressures emanating mainly from expansionary fiscal position. Therefore, SBP is increasing the policy rate by 50 basis point, i.e. from 12.5% to 13% with effect from 2nd August 2010.