have a dampening effect on economic activity. in most instances, the adjustments that the private sector has to make are more pronounced compared to those made by the public sector. similarly, deterioration in the external accounts, either because of a large gap between payments and receipts or lack of funds to finance it, cannot continue without an adjustment in the exchange rate. attempts to maintain stability in the exchange rate by supplying the required foreign currency cannot be achieved on a sustained basis without interest rate increases. the reason is because injection of foreign currency by a central bank, when the outflow of foreign currency in the country is greater than the inflow, requires purchase of domestic currency in exchange. this reduces availability of liquidity of domestic currency, which pushes up market interest rates. to ease the liquidity pressures, the central bank can inject the domestic currency through its normal open market operations. however, this strategy becomes difficult to maintain if the foreign currency outflows continue to remain higher than inflows and if the domestic inflation starts to increase because of ample availability of domestic currency. the same principle applies to fiscal matters. the governments cannot for long periods continue to spend more than the revenues it mobilizes. the amount of borrowings required to close the gap comes with a cost – interest payments in the future. failure to increase revenues in proportion to increases in expenditures compounds the problem as the interest expense continue to rise, leading to more borrowings and rising debt levels. measures to raise revenues such as increases in taxes or cuts in expenditures such as reduction in subsidies tend to increase the cost of production and possibly inflation. the point i am essentially trying to make is that for a policy decision to be effective adjustment in some area of the economy is required. if the required adjustment is not taking place or if there are other policies that are diluting or neutralizing it, then the credibility of decision makers suffers, leading to uncertainty. what is required is that policy makers articulate an agenda of priorities for the future of the economy, communicate it to the general public, develop political consensus, take timely and coordinated decisions, and implement the agenda over a number of years. delays or uncertainty in any aspect of this strategy results in less than desirable outcomes making the trade - offs among key priorities tougher. against this conceptual backdrop, let ’ s talk about the specifics of the current high inflation phenomenon in pakistan and the role of monetary policy in dealing with the issue. in cumulative terms, pakistan ’ s economy has experienced an inflation

unfortunately, it did not happen. in cumulative terms, the fiscal deficit grew by 146 percent in nominal terms during june 2007 and june 2010 compared to 113 percent during june 2003 and june 2007. if we take out the interest payments, which have been mentioned as a factor adding to the fiscal problems, and look at the primary deficit, the fiscal driven aggregate demand pressures look more pronounced. the primary deficit grew by 3182 percent in the last three years compared to an improvement of 140 percent in the three years before that. the same is the case with revenue deficit – the difference between current expenditures and total revenues. this deficit increased by 298 percent compared to only 27 percent respectively. thus, there is an unquestionable increase in aggregate demand pressure because of the public sector. what is more worrying is the trend in the financing pressures of this substantial fiscal expansion on the resources of the banking system. during june 2007 and november 2010, the cumulative borrowings from the banking system increased by 187 percent compared to 58 percent during june 2003 and june 2007. we all know that, within the banking system, the government has substantially increased its reliance on borrowing from the sbp. the stock of outstanding borrowings of the government from the sbp is in excess of rs1500 billion today compared to only rs53 billion at end - june 2003. imagine the effect on market interest rate if the government had borrowed this amount from the scheduled banks. undoubtedly, interest rates would have been much higher. moreover, since the interest rate by definition is the price one has to pay to bring future resources into the present, the borrowings and the increase in debt of this scale is not possible without a corresponding increase in interest rates. the continuation of these trends is fueling expectations of inflation and, resultantly, in interest rates remaining high. thus, if anything, the criticism on sbp ’ s current monetary policy stance could be that it has not been tight enough. the reason for the sbp pursuing a relatively “ loose ” monetary policy is our concern that it would further crowd out the private sector and negatively impact the growth rate. faced with this trade - off, sbp has been trying to strike a very difficult balance between such considerations. there is no denying that private sector has borne the brunt of required adjustment in the economy and government has considerably crowded out the private sector both through reduced availability and price of credit. between june 2003 and june 2007 private sector credit cumulatively grew by 162 percent, while it increased by only