SHAMSUL GHANI (shams_ghani@hotmail.com)
Feb 25 - Mar 02, 2008

The central bank erects a monetary base (currency and bank reserves) upon which the size of money supply (currency and bank deposits) depends. The monetary base is also referred to as "high powered money".

The primary tools used by the central bank to control and regulate the economy are:

1. Open market operations
2. Reserve requirement ratio
3. Interest rate


Through open market operations, the central bank (in our case the State Bank of Pakistan) sells and purchases government bonds, treasury bills and foreign currencies with the primary objective of controlling money supply. Through selling operation, the bank soaks the excess liquidity whereas through purchasing operation, it provides the market the much needed liquidity. The purchase transaction is financed either through newly printed money or through creation of liability on central bank's balance sheet. In either case, the high powered money is created and the monetary base (currency and reserves) is broadened. This additional high powered money creates more money through commercial banks" lending process allowing the money multiplier effect to take place.


All banks and financial institutions are required by statute to keep with the SBP a certain percentage of their deposits in the shape of non-interest-bearing reserves. These reserves, besides being a liquidity control instrument, also formed the basis of SBP lending to the commercial banks, in the capacity of lender of last resort. By altering this ratio, the SBP controls the money supply. Any increase in this ratio decreases commercial banks" capacity to lend and vise versa. Commercial banks take this ratio as an implicit tax affecting their profits. This ratio has recently been increased from 7 to 8 per cent.


The SBP interest rate is the rate used for its lending to banks under repurchase (Repo) transactions. The rate has an explicit cost expressed in numeric terms. It has also an implicit cost conveyed through an implied yet well pronounced massage. When interest rate is increased, the banks take it as a signal that the SBP intends to control credit and money supply besides increasing market interest rate. With every alteration in the rate, the inter bank borrowing rate KIBOR is also altered in direct proportion. The banks" lending interest rate which has been linked to KIBOR is also adjusted accordingly. The SBP interest, presently standing at 10.5 per cent, has been altered as many as 34 times since 1956. It was scaled up 20 times as against 14 times when it was scaled down. The lowest rate had been 3 per cent during the period from 01-01-56 to 14-05-59 while the highest rate had been 20 per cent during the period from 13-11-96 to 17-06-97. During the period from 17-06-97 to 05-01-2000, the rate got 8 consecutive cuts bringing it down from 20 to 11 per cent. During a short period of 16 months (from 19-07-01 to 18-11-02) the rate got another 6 consecutive cuts bringing it down from 14 to 7.5 per cent. During this period of falling interest rates, the money held in bank time deposits and government saving schemes were forcibly dragged to the speculative and consumer markets making heavy dent in the country's savings rate. Since 11-04-05, the rate has taken an upward journey punctuated by 4 consecutive raises.


The SBP can not simultaneously set both the interest rate and money supply levels because it has no control over demand-for-money function. It can not accurately forecast demand for money at a certain interest rate. The problem with the focusing on interest rate is that the growth rate of money and inflation often tend to increase. A moderate money growth is the only option to avoid inflation in the long run. State Bank's interest rate hike aimed at controlling credit and money supply has so far failed to produce desired results as the core inflation target of 6.5 per cent has been widely surpassed with no signs of a downturn. To be fair, State Bank policies can not be effective in isolation. Government support especially at administrative front is required.

Inflation and unemployment are the ultimate targets of central bank policy. Interest rate and the rate of growth of money and credit are the intermediate targets which central bank can hit. Inflation targeting is widely popular with the central banks to achieve long term objective of price stability. The disadvantage of this approach is however, quite considerable as it restrains central bank's ability to control fluctuating output and employment levels. In the event of an adverse supply shock which raises prices and reduces output, inflation targeting may force the central bank to check money supply at a time when the economy is in recession.

Under the existing policy scenario, the SBP's thinking is quite clear that even if the interest rate increase adversely affects growth in the short term, the primary concern remains the check on inflation. In India, the interest rate is 7.75 per cent highest during the last six years- with the reverse Repo rate standing at 6 per cent. Being on the same geo political plane, the wide interest rate difference between the two economies is hard to understand. India's rate of inflation is only 4 per cent and their economic managers are determined to keep it under control even at the cost of economic slowdown. India's finance minister is reported to have said, "I will not be politically in trouble if my growth rate slows down from 8.5 to 8 per cent. I will be in greater trouble if my inflation rate increases to 6 per cent this year. Therefore, one has to balance growth and inflation." We, in Pakistan, have not been able to do this. Our inflation is sky rocketing on one hand and economy slowdown specter raising its head slowly but surely on the other.