New Keynesian monetary model: Evidence from Pakistan

In this study, we specified and estimated a New Keynesian model (NKM) with the aim to support inflation targeting for the Pakistan economy describing the relationships among the main variables relevant to the transmission mechanism of monetary policy. The model encompasses three structural equations – inflation, the output gap, and the exchange rate – and an interest rate rule. The theory underlying the model is broadly in line with the current monetary theory prevailing in academics and central banks. We take three types of interest rate rule: standard, backward looking and forward looking rule that describes how the interest rate should be adjusted. We use FMOLS and ECM approach to monthly data ranging from January 2001 to December 2010. The results indicate that NKM performed quite well in Pakistan and paved a way to adopt inflation targeting because output and inflation have desired sign in Taylor type interest rate rule although the real exchange rate and depreciation in exchange rate are also statistically significant to effect inflation and output in Pakistan.