Openness, Inflation and Growth Relationships in Pakistan An Application of Ardl Bounds Testing Approach

• Author: MUHAMMAD AFZAL, MUHAMMAD EHSAN MALIK A. RAUF BUTT and KALSOOM FATIMA

Abstract. Employing ARDL approach to cointegration, the present study validates the Romer (1993) hypothesis, i.e. the existence of the inverse connection between inflation and openness in Pakistan for the period of 1970-71 to 2008-09. A more robust inverse linkage between inflation and openness is noted in the short-run as compared to the long-run. Bi- directional causality running between inflation and openness is also found. The positive linkage between real GDP and inflation is observed that seems to be in line with the truth of Phillips curve and Okun’s law. The study recommends that the economic managers of Pakistan’s economy should adopt such policies that promote openness so that inflation can be controlled and economic growth can be accelerated.

Keywords: Inflation, Openness, Economic growth, ARDL, Causality

JEL classification: O11, F41

I. INTRODUCTION

The world has now become a global village. Knowledge, information and products are being exchanged very quickly and rapidly among nations.

The word `globalization’ is not new, yet both the scope and the rate of change of the globalization process seem to have changed in the positive direction over time (Taylor, 2006). Both the foreign direct investment (FDI) and global trade flows have witnessed significant increase since early 1980s (IMF,2006) and almost all the open economies are affected by the current globalization process. However, the impact of globalization seems to be varying from economy to economy, depending upon the nature, structure and degree of openness of the economy. Starting right from laymen, politicians, sociologists, economists, and international relation experts to academia all are widely and rigorously discussing and debating the impact of globalization and liberalization on human well being in the 21st Century.

Economic globalization is a process of increasing the connectivity and interdependence of markets and business by removing restrictions and barriers on exchange of knowledge, products and commodities across the borders and regions. Economic globalization promotes cultural, financial and trade reliance among nations. Globalization is generally expected to reduce poverty and enhance economic development through faster growth in most integrated economies. Burger and Krueger (2003) has shown that trade openness causes an increase in aggregate incomes and thereby economic growth (EG). According to IMF (2006), economic globalization depends on over time human innovation and technological progress. It is concerned with increasing integration of economies around the world, particularly through trade and finance flows. It is also concerned with the movement of labour and technology across international borders. In addition, globalization has broader cultural, political and environmental dimensions.

Economic globalization and trade openness have become the major cause of the flows of the international capital and more productive utilization of the under employed resources. The link between trade openness and the inflation (Inf) is still an empirical question or even a puzzle in the economic literature. For a better macroeconomic management, Inf must remain in control. Inf affects (is affected by) EG and trade openness. Therefore macroeconomic managers must take into account the interrelationship among trade openness, EG and Inf Understanding the relationship among trade openness, EG and Inf is being studied in economic literature for development of the economy of a nation. Theoretical literature illustrates that openness helps in the efficient allocation and utilization of resources through comparative advantage that, in turn, leads to increased EG (IMF, 2006).

Trade openness is a tool of anti-monopoly as well as a medium for the long-windedness of the new technology, ideas and managerial skills among nations. It also harmonizes or even unifies the monetary and fiscal policies.

GATT was introduced and signed by twenty-three countries in 1947. The motive behind the GATT was to promote free trade among nations. Countries were agreed on lowering the trade barriers. They gained from trade and world output enhanced due to free trade and reduction in trade barriers. The South Asian Association for Regional Cooperation (SAARC), an economic and political organization, was founded by governments of Pakistan, Bangladesh, India, Bhutan, Sri Lanka, Maldives, and Nepal on December 8, 1985. Its motive was to speed up social development and EG in the member states. The North American Free Trade Agreement (NAFTA) was signed in 1994 by the governments of the United States, Canada, and Mexico to create a trilateral trade in North America. The agreement diminished the trade obstruction and import-export duties between United States, Canada and Mexico. It significantly eliminated the Mexican tariff by 65 percent on roughly half of all US industrial manufactured products.

NAFTA has two components, the North American Agreement on Environmental Cooperation (NAAEC) and the North American Agreement on Labor Cooperation (NAALC). The Agreement on South Asian Free Trade Area (SAFTA) was signed at Islamabad (Pakistan) during the 12th SAARC Summit on 6th January 2004. SAFTA was established on 1st January 2006. The objective of this agreement was to encourage and promote economic cooperation and mutual trade among contracting nations by removing barriers to trade, facilitating movement of goods across borders and promoting fair competition in the free trade area. To liberalize international trade and stimulate EG, the World Trade Organization (WTO) was established in 1995 under the Marrakech Agreement, replacing GATT. The WTO deals with regulation of trade and provides a framework for economic negotiating and designing trade agreements. Pakistan has been a WTO member since 1st January 1995. One hundred and thirty-nine countries are now members of WTO.

The WTO commitment to harmonization the tariff structure across countries lowers the import cost of a significant portion of traded commodities. This motivated the researchers to check the impact of trade openness on inflation and other macro economic variables in countries like Pakistan.

Economies specialize in the products on the basis of comparative advantage and factor prices equalize among trading nations because of identical technology and production throughout the world. Trade is adversely affected by many factors such as demand and supply shocks, Inf, over population, and technological shocks etc. But among all these factors, high Inf affects the economy as well as the society significantly and adversely. Improper price regulation and imperfect information about aggregate price level causes inflationary situation in the economy. A high rate of inflation causes many economic problems like poverty, unequal distribution of wealth, market imperfections, deficit in balance of payments and unemployment as well as non-economic problems like social evils such as smuggling and hoarding etc. Inflation also disturbs the very important role of smoothness of price mechanism. Moreover, high inflation rate has more volatility over time.

The volatility of inflation rate is a hindrance for future economic planning and project evaluation and productive use of resources. High and unpredictable inflation slows down the process of EG and hurts the economy. Friedman (1977) found inverse effect of a highly volatile Inf rate on economic efficiency because of two reasons. Firstly, increased volatility in Inf causes long-term contracts more expensive on account of that the future value of dollar payments is more uncertain. Secondly, increased volatility in Inf lowers the ability of markets to pass on the information to market participants about relative price movements. Greater Inf reduces economic efficiency which increases the rate of unemployment in the short term and reduces EG. Samimi and Shahryar (2009) also supported these results. It is believed that reasonable and stable Inf rate boosts up the EG and hence development process of a country.

Moderate Inf increases returns to savers, enhances investment, and therefore, speeds up the EG of the country. Maintaining non-inflationary stable EG is inevitable not only to uphold macroeconomic stability but also to save the poor from unfavorable effects of inflation (Ashra, 2002).

Openness to trade (OT) or trade integration affects Inf through ”direct import price effects“ and ”indirect competition enhancement effects“. The flow of low cost imports diminishes the Inf in the high cost economies. The higher the share of imports, the more the domestic prices will be driven down. An increase in cheaper imports promotes price competition in importing countries that in turn narrowing markups and raising productivity and hence dampens the inflation. An increase in the productivity for manufacturers through exposure to global competition in their export markets is another example of the ”indirect competition enhancement effect“. The overall price level may turn down because of direct and indirect price effects of cheaper imports of finished goods and intermediate inputs. There are some direct and indirect, quantitative and qualitative methods of controlling inflation. Opening the economy is one of them. Increasing openness is likely to have negative effect on Inf and output (Jin, 2006).

Increased openness can also lead to lower Inf indirectly. As the competition increases there will be faster domestic productivity growth and firms can pay high wages without shifting their cost in the form of high prices. Grossman and Helpman (1991) identified four channels such as transfer of technical knowledge, competition among firms to innovate, greater reward for successful innovation and specialization in dynamic sectors, through which increased openness leads to faster productivity growth. There are also many other ways such as central bank’s Inf objectives, imperfect competition and...