ABSTRACT

The research examines whether the effects of monetary policy (MP) shocks are asymmetric on inflation and output. It uses quarterly data from Pakistan covering the period from 1980Q4 to 2024Q4. The  local  projection  method  (LPM)  (Jordà,  2005)  produces  the  impulse  response functions. This study enhances understanding of state-dependent policy effects by using the local projection method to assess the nonlinear responses of output and inflation to MP shocks. It also offers a theoretical contribution by utilizing interest rates to evaluate MP shocks. The linear results show that monetary policy initially has an insignificant effect on output but becomes significant later. State-dependent analysis indicates that during economic expansions, shocks have minimal impact on output but become significant at later horizons. In these periods, shocks have minimal effects on inflation; however, during economic downturns, they significantly influence output and generate notable short-term inflationary pressures. The study also explores long-term effects using GDP growth as a state variable. The long-run linear model finds that the response of GDP growth to MP is statistically significant and negative, while the response of inflation is significant and positive. The state-dependent long-run model reveals that shocks substantially affect GDP growth during periods of economic expansion, with their effects on inflation also being significant. During recessions, shocks have little impact on GDP growth, but inflation responses are initially significant and positive, with the late effects being insignificant. The findings suggest a price puzzle and supply-side factors affecting inflation in Pakistan, including lagged monetary policy transmission, credit constraints, fiscal influences, low central bank credibility, sticky prices, and a financial accelerator impacting output. The results highlight the nonlinearity of monetary policy effectiveness, supporting the existence of asymmetric effects on output and inflation. This research advises monetary authorities to consider these factors when designing policies, especially during periods of high or low economic growth.

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