ABSTRACT

This study contributes to the debate on the interaction of monetary policy, macroprudential policy, macroeconomy and financial stability in the case of Pakistan. Ensuring financial stability is paramount in sustaining a robust and resilient economy, and the synergistic implementation of monetary policy and macroprudential policy plays a pivotal role in fortifying the foundations of the financial system. The study uses the Markov Switching Causality-Vector Error Correction (MSC-VEC) model to investigate the causal relationship because it captures the dynamic nature of causation between policies and the macroeconomy and financial stability and identifies the specific timing of shifts in causality alongside real macroeconomic and monetary events. The timeline of the study is from 2004Q1 to 2021Q4.

First, we check the causal relationship between monetary policy, macroeconomy and financial stability. The study reveals that by implementing an increase in money supply stimulates output growth, while a decrease in money supply promotes price stability. Further, employing either a decrease in interest rate or an increase in interest rate are not effective for financial stability. In situations of economic stagnation or deflation, the central bank adopts an increase or decrease in money supply, while during periods of financial turbulence, it opts for a decrease in money supply or a restrictive price-based monetary policy.

Second, we check the causal relationship between macroprudential policies and financial stability. While credit-based Capital Adequacy Ratio (CAR) macroprudential tool liquidity-based Loan to Deposit Ratio (LTD) tool both promote the financial stability in Pakistan. Capital Adequacy Ratio (CAR) ratio is more effective than Loan to Deposit Ratio (LTD) in promoting the financial stability. Macroprudential policies play an important role to safeguard financial stability alongside monetary policy.