Instrument of managing exchange market pressure: Money supply or interest rate

Abstract

The magnitude of exchange market pressure has ramifications for the overall economy. Countries use instruments ranging from quantitative controls on movement of foreign currency to variation in the level of money supply or interest rate to keep the exchange market pressure within a certain desired band. Each instrument has different implications for the economy. Using the sum of exchange rate depreciation and foreign reserves outflow as a measure of exchange market pressure, the study seeks to investigate whether the authorities in Pakistan use interest rate or domestic credit for managing the level of exchange market pressure. Evidence from the Granger causality test suggests that during active life of foreign currency deposits (FCDs), interest rate has been used to manage exchange market pressure. However, the instrument changed to domestic credit with the freeze on FCDs in May 1998. Use of domestic credit to manage the exchange market pressure continued in the post 9/11 period. By and large, evidence shows that money supply is mainly used manage exchange market pressure. © The Pakistan Development Review.