ABSTRACT

The study investigates the impact of external shocks on the macroeconomic variables of Pakistan and to check whether the monetary policy is pro-cyclical in the face of global financial risk and what are the drivers behind it. This study utilized monthly data spanning from January 2005 to December 2024. First, we estimate the reaction function to check the cyclical behavior of monetary policy, and whether Pakistan exhibits fear of free fall through VAR and then by impulse response function found the impact of external shocks on key macroeconomic variables. Finally, through variance decomposition, we assess, if is there any external dominance. The result of the study shows that Pakistan’s monetary policy initial response is counter-cyclical in the face of global financial risk but also exhibits fear of free fall behavior because SBP increases the policy rate when the currency depreciates. The variance decomposition analysis shows that about 62 percent of variation is explained by inflation in interest rate and 28 percent of variation is explained by its own lagged value. SBP does not response to output gap despite its importance in Taylor rule. SBP should incorporate the output gap more explicitly in monetary policy formulation to ensure balanced economic stabilization.