The core objective of policy makers is to stabilize vital macroeconomic variables and promote economic growth. The business cycle fluctuations require optimal response of monetary authorities. Distortions in inflation and output negatively affect the economy. Our main objective of the study is to estimate the response of State Bank of Pakistan to big and small shocks of inflation and output. Higher levels of inflation could be responded offensively by general public whereas distortions in output may directly affect the employment level in the economy. Moreover we also estimated the optimal response of State Bank of Pakistan to inflationary and output shocks. We used Ordinary Least Square (OLS) technique to estimate the monetary policy response using quarterly data over the period 1990 Q1 to 2015 Q3. The results indicate that SBP responds more aggressively to small shocks of inflation because past studies indicate that SBP finds it more convenient to change policy instrument by small margin. The response coefficient of output gap confirms the significance of real stabilization motive of SBP. SBP also make gradual changes in interest rate to stabilize the financial markets. Estimation of optimal monetary policy indicates that SBP should put more weight on stabilizing the small shocks of inflation and output. Supervisor:- Dr. Wasim Shahid Malik