Interest rate pass-through and cost channel of monetary policy: Evidence from minimum distance estimation of DSGE model for Pakistan

Abstract

Understanding the monetary policy transmission mechanism is pivotal for the design of an effective monetary policy. In this regard, the coexistence of interest rate and cost channel of monetary policy has raised important implications for the conduct of monetary policy. This article estimates a New Keynesian model to quantify the strength of interest rate and cost channel by estimating retail rate stickiness and share of firms considering interest rate in their marginal cost function. It examines the extent of interest rate pass-through and cost channel for exogenous monetary policy shock and endogenous movement in official rate arising due to other financial, nominal, and real shocks in the economy. The trade-off between the degree of pass-through and cost channel of monetary policy has also been examined. The minimum distance estimation of the Dynamic Stochastic General Equilibrium (DSGE) model has confirmed that the degree and nature of interest rate pass-through depend on the nature of shock hitting the economy and the cost channel exists only for monetary and financial shocks. A weak trade-off also exists between the degree of pass-through and cost channel of monetary policy. The study recommends that coordination between central banks and financial and non-financial firms is essential for effective stabilization through monetary policy.

Keywords:

• Monetary transmission mechanism
• retail rate stickiness
• price puzzle
• DSGE
• minimum distance estimation

JEL Classification:

• E44
• E47
• E58

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1. In log-linearized form of model, these variables will appear in small letters.

2. Habit persistence determines the degree of consumption persistence and preference shock is a shock to discount factor that effects intertemporal substitution decisions.

3. The parameter determines the degree of wage rigidity in labor market. Higher the value of parameter lower is the difference.

4. As weighting matrix is the requirement of estimator. However, According to Giannoni and Woodford (2002a), the convergence of optimization can be hindered by the weighting matrix.

5. For above formula, Dynare code and script min_impunk.m and fun_impunk.m have been used, which can be downloaded from the Fabio Canova website.

Additional information

Funding

The author(s) reported there is no funding associated with the work featured in this article.