TRANSMISSION OF OIL PRICE SHOCKS TO PAKISTAN'S MONEY MARKET: AN INTERTEMPORAL ANALYSIS USING ERROR-CORRECTION MODEL AND IMPULSE RESPONSE FUNCTIONS

Abstract

The Iran-US war and the subsequent blocking of the Strait of Hormuz have triggered a severe energy crisis, driving global oil prices above $100 per barrel. For Pakistan, this is not merely a price shock but a structural policy bind. This study employs an error-correction model to quantify the money market’s adjustment following the February-March 2026 disruption. Impulse response functions show that a unitary inflation shock reduces real demand for both M1 and M2, with the effect peaking after three months and dissipating after one year for M1 and after 1.5 years for M2. The oil shock arrives just as the SBP was poised to ease policy, forcing a conventional monetary dilemma. The key takeaway is that the money market requires a prolonged adjustment process. In the short term, the SBP should preposition liquidity facilities to manage the three-month peak inflation window while maintaining a tight liquidity stance through OMOs for the next 6-9 months to counter rupee depreciation and rising import costs. Over the medium term, formalizing a Hormuz contingency corridor for the policy rate would anchor expectations by signaling that rates will stay elevated until the speed of adjustment for M2 shows structural improvement. In the long term, using FX swaps instead of outright spot purchases can help build reserves without accelerating the contraction of M1, allowing for a smoother adjustment path