ABSTRACT

Stabilizing output and inflation in Pakistan’s economy is essential for sustainable economic growth, promoting macroeconomic stability, price stability and effective monetary policy. The study aims to estimate a macroeconomic model including the predetermined and the forwardlooking variables and to conduct policy projections with restricted and unrestricted nominal and real policy rate for the Taylor rule and the optimal policy rule by keeping in view the dual mandate of minimizing the gap between the actual and the targeted inflation and the deviation between the actual and potential output. The study adopted the Rudebusch-Svensson and Linde model to estimate the macroeconomic model and for simulations to compare the monetary policy rules, the study opts the historical and stochastic simulation by adding demand and supply shocks in an economy. The time span of the study is from 1993Q1 to 2022Q4. The major findings of the study are that the Taylor rule is efficient in the historical and stochastic simulation of the backward-looking model, whereas the optimal policy rule is efficient in the historical and stochastic simulation of the forward-looking model. In the case of policy projection, the Taylor rule is efficient in minimizing the gap between the actual and the threshold level of inflation and the deviation between the actual and potential output in both the backward and forward-looking models. Based on the findings of this study, SBP should use rule-based policies rather than discretionary policies. This rule-based approach provides a systematic framework that helps central banks to make informed and data-driven decisions. Policymakers should consider adopting the Taylor rule as a guideline for formulating and implementing monetary policy and emphasizing forward-looking elements in decision-making to minimize the loss generated from the quadratic loss function.