Monetary Policy and Its Inflationary Pressure in Pakistan

• Author: IMRAN SHARIF CHAUDHRY, RUQUIA ISMAIL, FATIMA FAROOQ and GHULAM MURTAZA

Abstract

Inflation has always been a central issue of socio-economic policy framework. The mechanism, through which it comes out, is of vital importance to explore for prudent policy formulation. The present study aims at investigating the impact of money supply growth on the rate of inflation in Pakistan. Annually time series data ranges form 1973-2013 is employed for the analysis. The model of the study works out the short-run and the long-run impact of money growth on the rate of inflation in Pakistan. ARDL technique is used, depending upon the time series properties of data that confer mixed order of integration. Diagnostic and stability tests confirm that models are econometrically sound and stable. The results go over the main points; interest rate and money supply are important policy variables for controlling inflation in the long-run while it is the national output level which put downward pressure on inflation rate in the short-run.

Keywords: Monetary policy, Price level, ARDL, Cointegration, Pakistan

1. INTRODUCTION

   Money supply and inflation, and their mutual relationships are the most prominent indicators of strength, potential and the prosperity of a country.

   The nature of monetary policy as well as the determination and maintenance of the price level always remain in the primary focus of social and economic planners. Moreover, it is most often observed and argued by the monetarists that money supply and rate of inflation are intricately related to each other. However, it is also observed that substantial increase in the quantity of money supply may either positively or adversely affect the overall economic progress. That is why, the two aspects, i.e. money supply and their interdependence, are always the subject matter of hot debates prevailing on the macroeconomic scene at various grades of the economic circle.

   Contrary to traditional view of the economists that inflation can be eliminated completely, it is an ever existing and continuous phenomenon, i.e. inflation is always present in an economy. It is the rate of inflation which undergoes fluctuation from time to time and with respect to the prevailing circumstances. That is why the primary concern of the macro-economic policy makers is to control the rate of inflation and maintain it as certain optimum level which is largely dependent on the nature of monetary and fiscal policies, and the availability of natural economic potential.

   Above discussion gives the impression of great importance to analyze the impact of monetary policy on inflation rate in different time horizons for Pakistan. After the introduction in the first section, Section II provides a profile about the money supply and inflation trends in Pakistan. Section III consists of a brief review of the existing literature. Methodological issues and sources of data are elaborated in Section IV. The empirical estimation of different models of money supply and inflation are brought into the analysis in Section V. Finally, conclusion of study along with possible policy recommendations are set forth in Section VI.

2. MONETARY AGGREGATES AND PRICE LEVEL

   Monetary aggregates have become most important sector over the last few years, specially, in order to control inflation rate and to enhance growth. The annual changes in different definitions of money supply (M1, M2, and M3) are shown in the following Table 1. It presents yearly change in the amount of monetary aggregates (M1, M2, and M3) as well as in percentage change.

   Figure 1 presents that money supply (M1) consists of the outstanding stock of currency in circulation, the demand deposit of scheduled bank and the other deposits with the State Bank of Pakistan. Increase in the share of M1 indicates that it has positive contribution to inflationary pressure on the economy of Pakistan. Figure 1 shows an upward trend in money supply (M2). Money supply (M2), during 2006-07, expanded by Rs. 47.8 billion or 14 percent higher than the corresponding period the previous year.

   TABLE 1 Money Supply in Pakistan (Rupees in millions)

   Narrow Monetary Broad

   End year Percentage Percentage Percentage

   Money Assets Money

   stock change Change Change

   M1 M2 M3

   2001-02 876.84 15.1 1,761.37 15.4 2,640.94 14.1

   2002-03 1,106.25 26.2 2,078.71 18.0 3,102.00 17.5

   2003-04 1,371.64 24.0 2,486.56 19.6 3,517.60 13.4

   2004-05 1,624.12 18.4 2,966.39 19.3 3,975.50 13.0

   2005-06 2,564.60 19.7 3,406.50 15.2 4,623.40 12.3

   2006-07 3,256.72 76.9 4,065.16 11.0 4,837.50 9.4

   2007-08 3,639.50 18.8 4,689.14 12.0 4,942.40 11.4

   2008-09 4,262.22 19.3 5,137.21 15.0 5,099.50 15.2

   2009-10 4,372.50 20.4 5,777.23 19.0 5,345.60 16.3

   2010-11 4,599.50 23.2 6,695.20 22.0 5,560.90 18.2

   2011-12 4,619.10 24.1 7,641.79 23.0 5,710.40 19.1

   The main reason of this high monetary growth, during this period, was sharp rise in the net foreign assets (NFA) of the banking system and the growth in the net domestic assets (NDA) of the banking system accelerated at a lesser pace.

   The overall money supply (M2) increased by 14 percent as against 12.1 percent in the same period last year. The monetary expansion was kept marginally below the projected nominal GDP growth over 14 percent in view of monetary overhang that had built up from excessive yearly monetary expansion since 2002-03.

   Figure 2 presents the upward increasing trend in money supply (M3) during 1990 to 2011. During the 1990s, money supply increased at large level not only in public sector but also in private sector.

   In Pakistan, inflation rate was recorded as 3.3 percent during 1960s on an average and it geared up to 11.9 percent in the 1970s. The inflation rate fell again to an average of only 7.5 percent in 1980s. Since the early 1990s, inflation rate has been creating a serious matter for economists. A number of reasons for this double-digit inflation rate are observed in 1990s which include supply shocks, monetary policy, tax policy, external shocks, pricing policy (i.e. procurement prices for agriculture products). While, expectations of people are the main factors that explain the inflationary pressures. The inflationary trends are explained with the help of Figure 3.

   Analyzing the trends of inflation rate in Pakistan, there can easily be observed a fluctuating trend over the last 18 years. The pressure on prices increased due to inflation which...