Interest Rate Pass-through in Pakistan: Evidence from Transfer Function Approach

The transmission of monetary policy through the interest rate mechanism has been thoroughly discussed in economic literature for quite some time. The traditional view is that, the change in real interest rate influences the cost of capital. The change in cost of capital affects the magnitude of investment and consumption and therefore the level of, real income and prices [Mishkin (1995)].1 Operationally the State bank of Pakistan, influences the yield on treasury bills (T-bills). This is done on the assumption that the yield on treasury bills influences other interest rates like the Money Market rate (Call money rate), banks’ deposit and banks’ Lending rates. The change in these rates influences the cost of capital and thus level of investment and consumption in the economy. Given this, the central bank can influence the yield on T-bills to influence the level of real income and the level of prices. The foregoing explanation of the monetary transmission mechanism makes it clear that if the changes in yield on the T-Bill rate are not passed on to the Call money rate and the bank deposit and the Lending rate then it becomes difficult for the central bank to use the channels that involve interest rate, for influencing the level of output and prices. Hence it is important to test whether the changes in the treasury bill rate are passed on to money market rate, bank deposit rate and the bank lending rate and if yes at what speed and to what extent. Therefore this study examines the pass-through of the changes in Treasury bill rate to Call Money rate, Banks’ deposit rate and Banks’ Lending rate.