Answer to Question #186415 in Macroeconomics for Abdul Rahim

Question

As per the SBP Monetary Policy Statement issued on March 19, 2021, State Bank of Pakistan maintained the policy rate @7pc. During the last two years of COVID-19 situations, the policy rate was slashed from 12.5pc to current 7pc to revitalize the economic activities in Pakistan. How this cut will impact the Pakistan’s economy? Do you think the interest rate should be reduced further to single digit to keep running the businesses and to overcome inflation and unemployment problems in Pakistan?

Answer 1

A reduction in the interest rate is always supposed to revive the economy, in theory. Therefore, the government is right to do what reduces the interest rate. But this is the short-term effect of the positive impact of the rate cut.

With the further reduction of the key rate, money becomes cheaper, and interest rates on loans and deposits are reduced. People and companies take out more loans, spend and invest more, and save less. This leads to higher demand, higher prices, and higher inflation, followed by bankruptcy of companies and unemployment. Therefore, the rate reduction should be considered and balanced.