Impact of Policy rate on macroeconomics performance: Case of Pakistan

In traditional monetary policy, interest rate was exogenously determined, in which money
supply was used as policy tool and interest rate was determined by market. But from 1990s
interest rate became endogenous variable that many central banks (European central bank,
Canadian central bank etc.) adopted inflation targeting framework, where inflation is the primary
target and interest rate is main policy tool controlled by central bank. Nowadays inflation
targeting policy tools are using across the globe including Pakistan. So it is need of time to check
the impact of policy rate on different macroeconomics variables. Therefore, this study is going to
see the impact of policy rate on domestic public debt, budget deficit and inflation in case of
Pakistan.

Interest Rate

It is defined as the proportion of an amount loaned which a lender charges as interest to

the borrower. Interest rate targets are a vital tool of monetary policy and are taken into account
when dealing with variables like investment, inflation, and unemployment. The central banks of
countries generally tend to reduce interest rates when they wish to increase investment and
consumption in the country's economy. However, a low interest rate as a macro-economic policy
can be risky and may lead to the creation of an economic bubble, in which large amounts of
investments are poured into the real-estate market and stock market. In developed economies,
interest-rate adjustments are thus made to keep inflation within a target range for the health of
economic activities or cap the interest rate concurrently with economic growth to safeguard
economic momentum. This study uses the following proxies for policy rate determination.

The name of interest rate changes with its context. For example

1. Reverse repo rate

2. Repo rate
3. Policy rate
4. Discount rate
5. Deposit rate
6. Borrowing rate
7. Treasury bill rate

Reverse repo rate

 It is also called ceiling rate or treasury bill rate. Reverse repo rate is the rate at which the
central bank of a country (State bank of Pakistan in case of Pakistan) borrows money from
commercial banks within the country. It is a monetary policy instrument which can be used to
control the money supply in the country.

Repo rate

It is also called Floor rate or discount rate. Repo rate is the rate at which the central bank
of a country (State bank of Pakistan in case of Pakistan) lends money to commercial banks in the
event of any shortfall of funds. Repo rate is used by monetary authorities to control inflation.

Policy rate

Ceiling rate and Floor rate are combinely called policy rate. The policy interest rate is an
interest rate that the monetary authority (the central bank. E.g. SBP in case of Pakistan) sets in
order to influence the evolution of the main monetary variables in the economy (e.g. consumer
prices, exchange rate or credit expansion, among others).

Deposit rate

It is also called saving rate. Deposit rate is the rate at which customers lend money to
financial institutions (like commercial banks and other financial sectors).

Borrowing Rate

Borrowing rate is the rate at which customers borrow money from financial institution
(like commercial banks and other financial sectors).