This study estimate the output gap by using financial variables and monetary policy reaction function using financial output gap for the case of Pakistan by using the quarterly data of 1991 to 2015. Our methodology based on Borio (2013), which incorporate the role of financial cycle proxies like Domestic Credit, housing prices, equity prices and real exchange rate in the output gap estimation and we salso check the long run and short run relationship of these financial variables with the conventional output gap (estimated from HP filter) by using ARDL approach. Our results shows that financial output gap behaves differently than the traditionally estimated output gap during financial crises of 2000s. And monetary policy reaction function better explained the variation of interest rate in response to financial output gap and inflation gap instead of using conventional output gap which does not have any effect of financial variables. Supervisor:- Dr. Ahsan ul Haq Satti