Capital flows and money supply: The degree of sterilisation in Pakistan

Abstract

An attempt has been made in this paper to formulate and test the domestic credit policy reaction function in order to determine the degree of sterilisation by the State Bank of Pakistan. The model is formulated by taking the guide from the monetary approach to the balance of payments. For empirical purposes, quarterly data ranging from 1982:Q3 to 2001:Q2 has been utilised, and Johansen (1988) multivariate cointegration technique has been used. The Johansen cointegration tests indicate that there exists a significant long-run relationship between the variables involved in the money demand and the money supply functions. When the domestic credit reaction function is normalised on domestic credit, we obtain a positive and significant coefficient of international reserves, which is equal to 0. 28. This result also suggests that the SBP sterilises around 72 percent international reserve inflows via changes in domestic credit to maintain the exchange rate in the long run. Furthermore, an error-correction model is formulated and estimated also. The results of the error-correction model indicate that at least 11 percent adjustment towards the long-run equilibrium takes place in each quarter. The result also suggests that the SBP sterilises 88 percent of capital inflows in the short run. In addition, CUSUM of squares of recursive residual test also indicate the structural stability of the estimated error-correction model.