Pass-through of World Oil Prices to Inflation: A Time Series Analysis of Pakistan

Author:NABILA ASGHAR and TANVEER AHMED NAVEED
 
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Abstract

Inflation plays vibrant role in economic stability and is considered to be an integral component of sound macroeconomic policies. Consumer prices are very much linked with the oil prices. A change in oil prices is assumed to be passing through to other goods prices directly or indirectly. The main objective of this study is to investigate long-run pass- through of world oil prices to domestic inflation in Pakistan using monthly data from January 2000 to December 2014. The standard Augmented Dickey-Fuller (ADF) unit root test is applied to test the order of integration of selected variables. The Autoregressive Distributed Lag (ARDL) bounds testing approach is applied to investigate long-run pass- through of world oil prices to domestic inflation in Pakistan in the presence of control variable, i.e. exchange rate.

The results of the study clearly explain that in the long-run international oil prices and exchange rate significantly affect the inflation rate in Pakistan. Furthermore, oil price (LOILP) has positive relationship with inflation and Nominal Exchange Rate (LER) has negative relationship with inflation rate in Pakistan. The findings of the Granger causality test reveal that there is unidirectional causality that runs from world oil prices to inflation rate, from inflation to exchange rate, and from world oil prices to exchange rate in Pakistan.

Keywords: Pass-through, Oil price, Inflation, Exchange rate

  1. INTRODUCTION

    Inflation plays an important role in economic stability of an economy and is considered to be integral component of sound macroeconomic policies. Low inflation could impact growth negatively while high inflation can affect poor more severely than rich. After 1973, when Pakistan experienced highest inflation rate (38 percent), in 2008-09 severity again has been observed when inflation rate augmented by 17 and economic growth declined to 0.4 percent (Pakistan Economic Survey, 2008-09, 2013-14). This high inflation is due to internal and external factors. In foreign factors exchange rate, global inflation, food prices, and, more importantly, world oil prices are factors affecting domestic price stability in developing countries like Pakistan.

    In general, consumer prices are very much linked with the oil prices, because oil products are not only used as a final product but are also used as an input in many of the production processes and economic activities. A change in the oil prices is assumed to be passing through to other goods prices directly or indirectly. Oil prices affect the consumption of consumers in many fields. The increase in the oil prices is reflected into increase in the producer prices that are finally pass-through to the consumer prices. Furthermore, it has been observed that an increase in oil prices have a significant impact on exchange rate and it also exerts pass-through adverse impact on the development process. The pass-through effect of global oil prices on domestic inflation deteriorates the living standard, causes political unrest and increases unemployment in developing countries like Pakistan.

    During the last five decades, the global economy has faced several big oil shocks. In 1973, world has faced first oil shock, when OPEC economies reduced oil exports due to Arab War against Israel. Resultantly, world oil prices moved up from $ 4.15 in 1973 to $ 9.07 in 1974. Second oil shock occurred in 1979, when Iran faced severe political instability that caused a massive reduction in oil production in Iran, resultantly oil prices shifted from $ 12.46 in 1978 to $ 35.24 in 1981.

    From 2000 to 2008 world oil prices created new records that severely affected the economy of every country of the world. In 2007-08, world oil prices have approached to ever highest $ 145 per barrel. But in the second quarter of 2014-15, oil price moved down to $ 44 per barrel, which is lowest in last 10 years. These oil price shocks affect economic growth, foreign trade, balance of payments, inflation and other economic variables adversely. Furthermore, an increase in oil prices may lead to slow economic growth, which results in an increase in domestic consumer prices and in turn affects the process of economic growth badly.

    The world oil shocks during 1970s and 2008 have attracted a lot of attention of researchers to investigate the impact of oil prices on macroeconomic indicators. Many empirical studies suggest a strong pass- through effect of oil prices on consumer prices. Gisser and Goodwin (1986) point out that macroeconomic variables are significantly affected by oil prices in United States. Both, 1973 and 1979 oil shocks have contributed significantly in an increase in price level in developing countries (Burbidge and Harrison, 1984). Whereas, Hooker (2002) investigates the pass-through effect of oil prices by estimating Phillips curve model. The study reveals that oil price pass-through effect appears to be negligible after 1980 in USA. Moreover, LeBlanc and Chinn (2004) find that crude oil prices have very small effects on consumer prices in developed economies.

    Different studies suggest that affects of oil prices on consumer prices and other economic activities vary for the different investigation periods and across the countries. This study is an attempt to extend the empirical literature on pass-through impact of global oil prices on domestic inflation for Pakistan using monthly data from January 2000 to December 2014.

  2. LITERATURE REVIEW

    Several theoretical and empirical studies have been conducted to investigate the effect of exchange rate, global inflation, energy prices, international food inflation and international crude oil prices on domestic inflation, and growth of different countries. Two consecutive oil crises and stagflation in the different countries during the 1970s has received considerable attraction of researchers and academicians to analyze the relationship...

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