This study estimates the demand for bank lending by the private business sector in Pakistan. For the purpose of analysis a three-step methodology is applied, that is, univariate analysis, multivariate cointegration analysis, and error correction mechanism. It is found that the individual series are difference stationary, and there is a long-run stable relationship between the variables. The preferred model, obtained by the application of the general-to-specific methodology is also found to be stable throughout the study period. The study shows that the output of business sector is an important determinant of the demand for bank credit in Pakistan, implying that to achieve the objective of monetary policy the behaviour of the output of business sector must not be ignored. Furthermore, the study shows that the rate of interest on bank advances is an important determinant of the demand of credit by the business sector. It implies that monetary authorities can move the flow of bank credit to the private sector while changing the interest rate charged on bank lending. The analysis has important implications: a tight monetary policy implies a high rate of real interest; a high rate of interest on bank lending negatively affects the demand for bank credit by the business sector (and the investment), which in turn leads to low aggregate demand and lower output. That is what has happened in Pakistan in the last decade.
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