ABSTRACT

The study explores the challenges Pakistan’s substantial informal economy poses on the effectiveness of monetary policy transmission. It investigates the potential of Central Bank Digital Currencies (CBDCs) to address these challenges by enhancing transparency, reducing reliance on informal financial systems, and improving the central bank’s control over money flow. The research aims to determine how CBDCs can influence the structure of the money supply and the transmission mechanism of monetary policy in Pakistan. This study employs a quantitative research approach using the Structural Vector Autoregression (SVAR) model to evaluate the effectiveness of Pakistan’s monetary policy transmission mechanism. It assesses the current currency system and a hypothetical scenario where 5000-rupee notes are replaced with Central Bank Digital Currency (CBDC). The analysis examines the impact of this transition through the interest rate and credit channels, using SVAR and VAR models to simulate the potential effects on monetary policy and the broader economy. The analysis reveals that traditional currency leads to significant volatility in economic indicators like Real GDP and CPI following policy rate shocks, reflecting delays in monetary policy transmission. In contrast, CBDCs, especially in Scenario A2, result in a more direct and stable response, with smoother economic adjustments. This suggests that CBDCs could enhance the efficiency and effectiveness of monetary policy, reducing economic instability and improving control over inflation and growth. In conclusion, CBDCs present a promising opportunity to transform financial systems by enhancing the effectiveness of monetary policy and promoting economic stability. Although conventional monetary tools remain important, CBDCs could address modern financial challenges and contribute to a more resilient and equitable financial ecosystem. The policy implications highlight that implementing a CBDC in Pakistan could integrate informal economic transactions into the formal system, improving control over key economic indicators and fostering greater financial inclusion. Successful implementation will require a carefully designed framework and continuous adaptation to ensure the CBDC effectively supports the country’s monetary policy objectives