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After more than four decades of research in monetary economics, it was argued that an overall consensus had been achieved on how monetary policy should be conducted. The global financial crisis of 2008 has, not only shaken the so-called consensus on monetary policy but also made economists and policy makers realize that instability in financial markets has the potential to endanger the entire economic system. The concern towards financial stability raised the question, whether the monetary authorities should explicitly consider financial market dynamics in devising a monetary policy stance. This dissertation aims at investigating the impact of monetary policy stance on macroeconomic stability and financial market stability in Pakistan, during the years 1991 to 2010. The impact of monetary policy stance on macroeconomic stability has been investigated by estimating a monetary policy reaction function and then simulating a New Keynesian macro- economic model. In addition, to investigate that how monetary policy stance impacts financial markets stability, structural VAR model in levels has been estimated. This study concludes that in Pre 1999 era, monetary policy stance was more counter-inflationary whereas in post 1999 era, the monetary policy stance was relatively accommodative. The simulation results suggest that accommodative monetary policy lead to higher and more unpredictable inflation. The conclusion is drawn that the latter policy regime caused inflationary expectations to build up starting from the year 2005, and the inflation eventually spiraled sharply out of control to almost 20% in year 2008, before being brought down by aggressive monetary tightening by State Bank of Pakistan. In addition, this study concludes that the monetary policy significantly influenced financial market stability in Pakistan. However, the structural VAR analysis suggests that the monetary authorities in Pakistan do not consider the financial (market) stability while setting the interest rates.
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