EVALUATING THE CHOICE OF OPTIMAL MONETARY POLICY RULES WITHIN THE DSGE FRAMEWORK: EMPIRICAL EVIDENCE FROM PAKISTAN

Abstract

This study examines the effectiveness of different monetary policy rules for developing economies, specifically focusing on Pakistan. It investigates whether monetary policy would have been more welfare-enhancing had the interest rate, rather than the money supply, been used as the primary policy instrument. A calibration analysis was conducted using quarterly data from 1992Q3 to 2017Q2 within the Pakistan Dynamic Stochastic General Equilibrium (DSGE) model, incorporating parameters from the Taylor and Money Supply rules. Counterfactual simulations revealed that employing the money supply rule as an optimal policy instrument increases output and inflation volatility, whereas the Taylor rule leads to greater macroeconomic stability by minimizing these fluctuations and converging to a steady state. The findings indicate that the price- based rule outperforms the money supply rule, aligning with the monetary policy framework currently followed by the State Bank of Pakistan. This rare outcome underscores the effectiveness of Pakistan’s existing monetary policy approach in stabilizing the economy.