• Monetary Policy is concerned with the regulation of money and credit to achieve higher economic growth and price stability in the economy. In Pakistan, M2 which comprises currency deposits of banks, is the broad monetary aggregate used to measure the quantum of money in the system. Growth of M2 is targeted on the basis of an estimated money demand function that incorporates annual economic growth and inflation projections.
• State Bank of Pakistan (SBP) prepares an Annual Credit Plan. This plan makes fund allocations for various sectors of the economy and determines safe limits of monetary and credit expansion during the year. Credit requirements of the private sector are accorded prior claim on domestic credit expansion over the government sector credit requirements. The credit plan makes sure that funds are properly allocated to meet genuine credit requirements of all the priority segments of the private sector.

Instruments of Monetary Policy

• Before the financial sector reforms, monetary policy was conducted through administrative controls and quantitative restrictions on money and credit aggregates. After the introduction of financial sector reforms in the beginning of 1990s, a number of fundamental changes were made in the conduct of monetary and credit management, which essentially marked a departure from administrative controls and quantitative credit restrictions to market-based monetary and credit management. The system of bank-specific credit ceilings as an instrument of money and credit control was gradually abolished in September, 1995.
• Building on the introduction of an auction system for government securities, SBP now manages domestic liquidity, to a large extent, by intervening in the secondary market through Open Market Operations (OMOs). OMOs involve purchase or sale of government securities by the SBP in order to supply or absorb bank reserves. State Bank conducts OMO in the intervening period between public debt auctions. It buys and sells Government securities both outright and under repurchase agreements.

• The intermediate target of M2 is achieved by observing the targeted path of reserve money, which is used as an operating target of monetary policy. A reserve money management programme has been developed which determines the quantum of OMOs to be conducted to support the operating target of reserve money. Occasionally, monetary aggregates are also controlled through changes in the discount rate, Statutory Cash Reserves Requirement and Statutory Liquidity Requirement.
• Under legal reserve requirements, banks are required to maintain a certain percentage of their demand and time liabilities as reserves. Currently banks are required to maintain 5 per cent under Cash Reserve Requirements and 15 per cent in approved securities under Statutory liquidity Requirements. In order to smooth the functions of cash reserve requirements, SBP adopted weekly averaging procedure for meeting cash reserve requirements, giving banks more flexibility in their reserve management and to avoid unintended short term swings in money, market interest rates. Banks are now required to maintain average cash reserves of 5 percent on weekly basis with a minimum balance of 4 per cent on daily basis.
• In order to meet the short-term liquidity requirements of money market, SBP provides lender of the last resort facility to eligible financial institutions. SBP provides this facility on the basis of 3-day Repo and charges the discount rate, which is 11 per cent presently. SBP determines this rate depending on the liquidity condition in the market. Discount rate serves as a signal for short term interest rate.

• Before the financial sector reforms, Pakistan had followed a system of administrative controls on the level and structure of interest rates. Guidelines were issued by the SBP to determine deposit rates and maximum and minimum lending rates were prescribed. There were subsidised lending rates for priority sectors and rate of return paid by the Government on debt through banking system was much below the market rate.
• Under the financial sector reforms, restrictions on banks’ maximum lending rates except for concessionary finance schemes were removed in 1995 and minimum lending rate was abolished on July 26, 1997. On June 16, 1998 SBP allowed banks and other financial institutions to determine their own deposit rates subject to principles of Sharia.
• After the introduction of auction system, government is paying market based interest rates on debt raised through the banking system. The gap between non-subsidised lending rates and subsidised lending rates for priority sectors has been gradually reduced.

• Fiscal policy aims to level out business cycles achieve full employment, price stability and sustained economic growth. Fiscal policy is implemented through changes in the government expenditure and taxation system. A cut in tax rates or a rise in government expenditure both tend to stimulate the domestic economy. Budget is the principal instrument for the implementation of economic and social policies of the government. It is more than a balance sheet of accounts. It is not only indicative of the resource mobilisation effort of the government but also of the priorities, aims and objectives of the state. Budgetary operations do have profound impact on price level, balance of payments, rate of national savings, domestic and external public debt and on the size and pattern of investment.

In Pakistan, fiscal policy is being used for attaining objectives such as self reliance, expansion of exports, containment of import of luxury and non-essential goods, promotion of investment and reduction in income disparity. The government intends to expand tax base, bring new areas and sectors under the tax net, reduce dependence on custom duties and shift it on taxes on income and consumption. Specific measures have been taken for making assessment and collection of tax simple and transparent in order to eliminate corruption from the tax collection system besides reducing administrative expenditure of the government for containing the fiscal deficit.

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