Industrial Production and Monetary Shocks: Empirical Evidence from Pakistan

This study focuses on long run relationship between industrial production and financial markets through a restricted structural model. Conditional upon arbitrage between short and long term money market rates, we find an evidence of cointegration between output and the stock market. Statistical results indicate that positive long-run relation between the stock market and real output allows the identification of a demand shock as permanently affecting stock market. Similarly money supply and short-term interest rate shock permanently affect stock market while inflation affects negatively in long run. The results also indicate that the monetary reaction function is less responsive to inflation and the policy maker put more weight to output. Our results imply that due to cost-push nature of inflation, policy makers have some flexibility to target other sectors of the economy, such as investments in asset markets. A prudent central bank can use interest rate smoothing approach using arbitrage conditions.