The primary objective of every public policy is to maximize the welfare of the society. There are economic policies which control the real and nominal variables of the economy and enhance the social welfare. Monetary policy is one of such policies: its role is to stabilize output and along with keeping low and stable inflation. Monetary policy can more effectively manage short run real stabilization. So main objective of every central bank is to maintain output at its natural level and keep inflation stable. Whenever output deviates from its potential level then it will affect inflation in either direction. If actual output is less than potential output it leads to high prices and vice versa, so central bank should minimize output gap. There are two types of monetary policies, expansionary monetary policy (loose monetary policy) and contractionary monetary policy (tight monetary policy). When inflation is very high in an economy central bank adopts tight monetary policy to contr ol inflation by controlling monetary policy tools (money supply or interest rate) but when central bank increases interest rate, there is corresponding decrease in business activity which leads to decrease in output. So there is short run tradeoff between output and inflation (Philips 1956). Supervisor:-Dr. Wasim Shahid Malik