International Journal of Business and Social Science Vol. 2 No. 1; January 2011 190 Effectiveness of Monetary Policy in Pakistan: Empirical Evidences based on Bound Test Approach Waliullah Graduate School of Economics and Management Tohoku University, Japan. E-mail: wali76 @yahoo.com Dr. Fazli Rabbi Assistant professor, Department of Economics University of Swat, Pakistan, E.mail: rabbi.fazli@gmail.com Abstract The insights on the long run relationship amongst money, price level and the GDP are of significant importance for monetary policy formulation in a developing country like Pakistan. Taking into account the vital importance of these three variables, we empirically analyzed the long-run relationship amongst money, price level and GDP in the context of Pakistani economy. Time-series econometric techniques such as unit roots, ARDL and ECM are employed to quarterly data for the year 1972:1 to 2005: IV. ARDL has numerous advantages over the traditional approaches of causality and cointegration. Our results clearly suggest that there is a stable long run relationship amongst money supply (M1), GDP and the CPI in Pakistan. Radical changes in monetary policy in the past have significantly affected the movement of the macro economy in the country. JEL Classification: C22, E51, E52. Keywords: Monetary Policy; Price Level; Autoregressive Distributive Lag Model (ARDL). 1. Introduction Monetary policy plays an important role in the economic growth of a country. The relationship among money supply, income and prices has long been a subject of controversy between the Keynesian and monetarist schools of thought. According to Keynesian, in the Hicks-Hansen, IS-LM model, money affects income through changes in the rate of interest. This is a short-run model in which the price level is assumed to be constant. As long as the investment demand curve is elastic and the demand for money is not infinitely elastic, changes in money have a positive effect on income. Changes in money stock are induced by changes in income and not vice versa. Monetarists, on the other hand, relied on the equation of exchange as a theoretical framework for explaining the relationship between money and income. In their framework, given that the income velocity of money is stable, money has a direct and proportional effect on income. In the long-run money has a neutral effect on income, since prices change proportionally to change in money leaving the real value of income unchanged. Friedman and Schwartz (1963), and subsequent works by Friedman (1968), attempts to provide theoretical as well as empirical support for the close relationship between money and income. Therefore money plays an active role in income generation, and changes in income are induced largely by changes in money stock. The question whether money causes the income is important for monetary economist and has been subjected to a variety of modern econometrics techniques, producing conflicting results. One of the frequently applied method to investigate the empirical relationship between money and income in Granger Causality Analysis (Granger 1969) and Johansen Maximum Likelihood Cointegration Test (1988) for determining the long run relationship. The method used by Johansen imposes a strict restriction that the variables in system will be of equal order of integration. Furthermore it does not include the information on structural break in the time series data and also suffer from low power. In Pakistan previous studies have focused only on the Granger Causality Analysis. Recently researchers have attempted to distinguish between the short run and the long-run relationships between money and income. Tanner (1993), Davis and Tanner (1997) have shown a temporary breakdown of money- income relationship in the United States during the 1980s. However, over the period of 1874-1993, money remained the most important variable accounting for fluctuations in income.