The impact of monetary policy on consumer price index (CPI): 1985-2010

CHAPTER 3: RESEARCH METHODOLOGY

3.1 Introduction

This chapter explains in few words how the research has been conducted. It gives the plan and strategy research design that is required for the study. The plan includes what is done from writing the hypotheses and their operational implications to the final analysis of data. The strategy includes the methods to be used to gather and analyze the data and implies how the research objectives was reached and how the problems encountered will be tacked (Kerlinger, 1973: 300)

The study covers the period of 1985-2010. It includes explanatory variables that explain the monetary policy. The CPI has been used as the dependent variable in the estimation. In this chapter the theory building is done for making the economic model and also the econometric technique is discussed for estimation of the model. The study setting and variable selection is also discussed and the data are taken from NBR Library and on the website of World Bank.

3.2 Model Specification

To investigate the impact of monetary policy on Consumer price index (CPI), this study builds on the literature review and theoretical framework in the previous chapters. By taking into consideration the above theories of economic growth, the model can be built as the follows:

Where

CPI: Consumer Price Index

M2: Money Supply

NIR: Nominal interest rate

EXCH: Exchange rate

Ut: Error term

In the model represented by equation above, are the parameters to be estimated and is the error term that captures other variables not explicitly included in the model. In addition, it is expected that < 0, , â3<0.

Modifying the classical quantity theory of money the Keynesian believe that money supply through its transmission mechanism affects the CPI indirectly. Monetarists while agreeing to Keynes that in the short run economy does not operate at full employment therefore expansionary monetary policy may work positively in the long-run they support classists that rising money supply will increase inflation only. Therefore they suggest that the policy must accommodate increase in CPI without changing price level (Lan lord, 2008).

Most of the modern economists are of the view that long run growth depends upon enhancement of productivity. If an appropriate monetary policy is supplemented by the external environment of suitable liquidity, interest rate, robust demand, soft assistance from the world bank of the financial institutions and debt rescheduling would lead to sustainable economic growth in the long run. (Laurence H. Meyer, 2001) (Russell, 2010) (Economy watch, 2010).

Price stability is a situation where inflation is low enough that it no longer has a material effect on people's economic decisions. A credible commitment by the monetary authorities to keeping inflation low and stable provides a climate conducive to sound economic decisions. It also leads to lower interest rates, supporting productive investments that allow the economy to grow at a sustainable, non-inflationary pace over time and to generate higher incomes and new jobs.

In that sense we see price stability as a measure of economical stability. In an economy where prices are considered stable, factors such as inflation and deflation have a minimal effect, and prices on goods and services change little from year to year. Generally, price stability is considered to be a good, though not necessarily totally achievable goal for an economy ( http://en.wikipedia.org/wiki/Inflation_targeting).