An Empirical Investigation of Domestic and External Determinants of Inflation in Pakistan

• Author: NABILA ASGHAR, ATIF ALI JAFFRI and ROOMA ASJED

Abstract. In this study ARDL approach is applied for estimating the long-run and short-run relationship among the variables using annual data for the period 1972-2010. The results show that in the long-run money supply growth, lagged inflation, foreign inflation and dummy variable for global financial crises 2008 have positive and significant impact on inflation in Pakistan. Further, except money supply all the variables affect inflation in the short-run. The significant and negative coefficient of lagged error correction term is an indication of the convergence towards long-run equilibrium. The study recommends that in rapidly globalizing world, serious considerations need to be given by policy makers to external shocks like foreign inflation and global crises for formulating policies which help in controlling inflation in Pakistan.

Keywords: Inflation, Nominal effective exchange rate, Financial crisis

JEL classification: E31, F49, G01

I. INTRODUCTION

Low rate of inflation along with high and sustainable economic growth is considered to be one of the major goals of macroeconomic policy formulation in developing economies.

Inflation has important implications for the economic management and life style in an economy. It adversely affects the overall growth, the financial sector development and the vulnerable poor segment of the population (Qayyum, 2006). Moderate level of inflation is considered to be good for growing economies, whereas high rate of inflation adversely affects economic performance and living standard in the economy. Pakistan economy is facing on average double digit CPI inflation in last seven years since FY2005 whereas average real GDP growth rate of more than 7 percent during FY2004-07 has declined to less than 3 percent on average during FY2008-11 (see Figure 1).

FIGURE 1

Real GDP Growth and CPI Inflation in Pakistan Since FY2002 (in %)

The recent increase in the rate of inflation in Pakistan has once again originated a debate on the determinants of Inflation. Major determinants of inflation in Pakistan along with output gap include external factors and policy coordination problems as frequently highlighted by State Bank of Pakistan in its monetary policy statements (MPS).

Pass-through of external shocks to macroeconomic goal variables like inflation in small open economies like Pakistan is major area of concern for both academia and policy makers. Recent literature related to Pakistan has focused on the impact of exchange rate, foreign inflation, foreign direct investment, workers’ remittances, foreign debt and other macroeconomic variables on inflation (Choudhri and Hakura, 2001; Bhundia, 2002). The pass-through of external shock on inflation in Pakistan has critical implications for effectiveness of monetary policy to control inflation in Pakistan. According to Edwards (2006), ”if the inflationary effects of exchange rate change are large, the authorities will have to implement monetary and fiscal policies that offset the inflationary consequences of exchange rate changes.“ In rapidly globalizing world, effectiveness of demand management policies in controlling inflation depends on limiting pass-through of external shocks into local inflation.

Recent literature suggests that evidence of low pass-through supports the adoption of an inflation targeting regime in Pakistan (Jaffri, 2010).

The current study investigates the impact of external shocks along with domestic determinants of inflation in Pakistan by using annual data from 1972 to 2010. The study incorporates nominal effective exchange rate, foreign inflation and DUM2008 (proxy for global financial crisis) as explanatory variables along with output gap and money supply to check the effect of external shocks on domestic inflation in Pakistan.

II. LITERATURE REVIEW

The role of external shocks in determining inflation and other macroeconomic variables in small open economies like Pakistan is very frequently addressed question in recent empirical research. As Krznar and Kunovac (2010) reported that changes in external factors like change in world prices produced significant spillover effects on producer and consumer price indices in domestic economy of Croatia. The study employed the seasonally adjusted quarterly data from 2000Q2 to 2010Q1. The variance decomposition analysis by applying Vector Autoregressive (VAR) model revealed that external shocks must be taken into account in theoretical modeling of domestic prices and economic activity.

Gerlach-Kristen (2006) distinguished some key domestic and external factors that are mainly responsible for swings in output in economy of Hong Kong. The paper estimated a structural model by utilizing data for the period 1990 to 2002. Using general to specific approach the results of VAR model are compatible with the New Keynesian Phillips Curve. Furthermore, the import prices in domestic currency showed rising trend in the long-run in domestic economy if the foreign prices rise. It was mainly concluded that CPI inflation showed strong reaction against the internal and external shocks in the time period under analysis.

The cost caused by the financial crisis 2008 is also a major factor in shaping the pattern of inflation in emerging economies. An exploratory study by te Velde (2008) identified some worrying signs triggered by the financial crisis to world economies. The substantial slow down in developed economies can turn the course of economic activity in developing world. The combination of higher food and oil prices lead to the double-digit inflation in several economies. Such serious implications alert the policy makers in developing countries to reduce the magnitude of this shock through the appropriate policy response.

Kemal (2006) investigates whether in the long-run an increase in money supply results high rate of inflation. Study applies cointegration technique on quarterly data from 1975:1 to 2003-4. Results provide support for the quantity theory of money and also suggest that the money supply works in the short run period in less than a year. Similarly, Qayyum (2006) also found a strong correlation between money growth and inflation. Excess money supply growth has been the central contributor to the rise in inflation in Pakistan in the corresponding period.

Akbari and Rankaduwa (2006) have investigated the important determinants of the general price level in case of Pakistan by using...