Virtual University Journals
Search
Search
Monetary Policy, Inflation Expectations, and Geopolitical Risk: A Structural VAR Analysis of Pakistan (2020–2026)
Ms. Yashfa Javed
Abstract:
An important task for any central bank is keeping inflation expectations stable. For small open economies exposed to external shocks, this task is becoming harder. This study analyzes how external shocks — principally global oil-price shocks and geopolitical risk associated with Middle East tensions, including recent Iran–U.S. tensions — affect the State Bank of Pakistan’s (SBP) ability to keep domestic inflation expectations stable. A Structural Vector Autoregression (SVAR) model is applied to monthly data from January 2020 to March 2026, using sign restrictions to trace how external shocks transmit through the exchange rate and monetary policy to public inflation expectations. Preliminary Forecast Error Variance Decomposition (FEVD) results indicate that external variables (oil prices, geopolitical risk and the exchange rate) account for roughly 96% of the variance in inflation expectations at a one-month horizon (oil price and GPR alone) and remain the dominant — though reduced — source of variation at a ten-month horizon, where oil prices, GPR and the exchange rate together account for approximately 54%. The analysis is consistent with an “Uncertainty Channel,” whereby geopolitical tension is associated with rapid currency depreciation and upward pressure on adaptive inflation expectations. Because the model does not yet include an output or GDP variable, claims about a “Sacrifice Ratio” are presented as a theoretical implication rather than an estimated result pending future extension of the model. Subject to completion of the structural estimation described in Section 3, the findings suggest that conventional interest-rate tightening has limited power against externally driven, supply-side inflation pressure, and that policymakers may benefit from strengthening communication strategy and diversifying energy sources to reduce exposure to external volatility.
Keywords:
Monetary Policy; Inflation Expectations; Geopolitical Risk; SVAR; Oil Prices; Pakistan
Full Text:
PDF