determinants of inflation rate in pakistan

Determinants of Inflation Rate in PakistanTopics in Macro Economics

12/11/2013

Submitted to: Mr. Yousuf Razzak

Submitted by:

Sonya Arif

Anna Noor Ali

Sonia Mumtaz

Bilawal Karim

Table of ContentsINTRODUCTION...........................................................................................................................4

The factors that stimulated the recent inflation in Pakistan.........................................................5

Determinants of inflation rate in Pakistan 2

Political Instability:......................................................................................................................6

Non Government Sector Borrowing:...........................................................................................6

Hike in the import prices:.............................................................................................................6

Loose monetary policies (money supply):...................................................................................6

Decrease in economic growth :....................................................................................................6

Population Pressure :....................................................................................................................7

MEASURE TAKEN TO CONTROL THE INFLATION IN PAKISTAN.................................7

TREND ANALYSIS.......................................................................................................................8

PAKISTAN INFLATION RATE..................................................................................................8

INTERMEDIATE TARGETS OF INFLATION......................................................................10

LITERATURE REVIEWS............................................................................................................11

DETERMINANTS OF INFLATION IN PAKISTAN: AN ECONOMETRIC ANALYSIS USING JOHANSEN CO-INTEGRATION APPROACH........................................................11

Money, Inflation, and Growth in Pakistan.................................................................................12

Determinants of Recent Inflation in Pakistan............................................................................13

METHODOLOGY........................................................................................................................14

VARIABLES:............................................................................................................................14

RESULTS AND ANALYSIS........................................................................................................18

SUMMARY OF RESULTS.......................................................................................................20

CONCLUSION..............................................................................................................................21

BIBLIOGRAPHY..........................................................................................................................22

INTRODUCTION


Despite a good GDP rate in past few years, inflation has caused worries for the

economists of the country. It was found out that various shocks such as rise in Oil prices at the

Global level and many other commodities may have been responsible for these results.

Moreover, the money supply played a huge role in the rise of the inflationary pressures on the

country’s economic scenario. The article highlights that double digit inflation has also been

witnessed in the 80s which was due to Oil prices and structural changes in the country. Moreover

it highlights the factors such as GDP, import bill, exchange rate, private sector borrowing, real

demand and supply, and support price of wheat and government borrowing which can explain

the rate of inflation in the country.

The determinants of inflation in Pakistan are:

1. Government Sector Borrowing (GB): is the debt that a central government of a country

owes a ratio of Real Gross National Product (YN): refers to the market value of all the

products and services produced within a single year by labor and property supplied by the

residents of a country.

2. Real Demand relative to Real Supply (YD/YS): demand refers to a buyer's desire,

willingness and ability to pay for a certain quantity of a good or service. Real supply is

the amount of some product producers are willing and able to sell at a given price all

other factors being held constant.

3. Private Sector Borrowing (PB): The part of the economy that is not controlled by the

state, it is run by individuals and companies for profit.

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4. Import Prices in $ term (I): The import and export prices indexes are created by

compiling the prices of goods purchased in the U.S. but produced out of country

(imports).

5. Exchange Rate (E): the rate at which one currency will be exchanged for another between

two countries.

6. Government Taxes (T): is a financial charge or other levy imposed upon a taxpayer (an

individual or legal entity) by a state or the functional equivalent of a state such that

failure to pay is punishable by law.

7. Adaptive Expectations (CPI-1): In economics, adaptive expectations means that people

form their expectations about what will happen in the future based on what has happened

in the past.

The factors that stimulated the recent inflation in Pakistan

In Pakistan after the first four years of 2000 the inflation rate was maintained below 5% which

suddenly took a sharp rise to 9.3% in 2005-06.

Some of the cause of high inflation in Pakistan mentioned by the Press Information department of

Pakistan in are:

Loose Monetary Policies

Political Instability

Decrease in economic growth

Hike in import prices

Non Government Sector Borrowing

Population Pressure.

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Political Instability:

The most frequent and reluctant changes in the government, inconsistent policies, nuclear explosion

and other dramatic political and economic development spark the pressure on prices increasing the

inflation to 9.6%. This is the unstable scenario of 1990’s.

Non Government Sector Borrowing:

In the fiscal year of 2005-06 the non government sector borrowing boomed ,which went above 30%

and 23% respectively. Hence this rise in the non government sector borrowing contributed in the high

inflation in Pakistan in 2005-06.

Hike in the import prices:

Till 2004-05 the import prices were upto 13.6% which then suddenly jumped to 26.7% in 2005-06 in

Pakistan misleading the stability if inflation rate.

Loose monetary policies (money supply):

The money supply increases also became responsible for increase in price level. In the year 2003-04, a

drastic cut in the rate of interest was brought which led to a greater expansion in the money supply.

Such increase in money supply is attributed to :

greater increase in govt.’s non-productive expenditures

fall in domestic savings and investment

fall in taxable capacity.

Decrease in economic growth :

The negative growth rate of agriculture . sector in 2003 – 04 helped to promote wheat inflation in the


year 2004.

Hence the agriculture sector is surrounded by water-logging and salinity, agriculture diseases, pests

and insects, floods and droughts leading per capita yield very low. The country lacks heavy steel, iron

and automobile industry. As a result, the production levels remain low and also the population growth

effects the production level of Pakistan.

Population Pressure :

In the year 2005- 06, the birth rate in Pakistan was 1.9% with total population was 155 million. On the

basis of population, Pakistan is the 7th biggest country of the world hence greater population and

higher birth rate the ‘demand for goods and services is rising very rapidly which may lead to increase

the prices.

MEASURE TAKEN TO CONTROL THE INFLATION IN PAKISTAN

Inflation was under control from the fiscal year 2000 to 2004 which rise up to 9.3% in the year 2005

due to the rise in price of wheat and a surge in international price of oil.

The Government of Pakistan is aware of the adverse effect of inflation which then took following

measures to decrease inflationary pressure in the economy.

1. Increase in the supply of essential goods:

The regular monitoring the domestic products of essential goods and their prices in the market by

the government. The supply of essential goods is being improved.

2.high level committee established:

To keep a close watch on the supply and demand conditions of essential goods a high level

committee is established which is to monitor the price situation on daily basis.


3. Rise in the price of oil:

During the year 2004-05 there was a drastic increase in the oil prices internationally. The burden of

rise in oil prices was shifted to the consumers by the government.

4. Tightening Monetary policy:

The effective monetary policy was set up by the State bank of Pakistan to put down pressure on

general price level.

5. Import of Wheat:

There is a record production of wheat of 21.1 million tones in 2004-05 hence by import of wheat

the Government is maintaining reserves of wheat to stabilize prices of wheat in the market.

TREND ANALYSIS

PAKISTAN INFLATION RATE

The inflation rate in Pakistan was recorded at 10.90 percent in November of 2013. Inflation Rate in

Pakistan is reported by the Pakistan Bureau of Statistics. Inflation Rate in Pakistan averaged 8.03

Percent from 1957 until 2013, reaching an all time high of 37.81 Percent in December of 1973 and a

record low of -10.32 Percent in February of 1959. In Pakistan, most important categories in the

consumer price index are food and non-alcoholic beverages (35 percent of total weight); housing,

water, electricity, gas and fuels (29 percent); clothing and footwear (8 percent) and transport (7

percent). The index also includes furnishings and household equipment (4 percent), education (4

percent), communication (3 percent) and health (2 percent). The remaining 8 percent is composed by:

recreation and culture, restaurants and hotels, alcoholic beverages and tobacco and other goods and

services. This page contains - Pakistan Inflation Rate - actual values, historical data, forecast, chart,


statistics, economic calendar and news.

ACTUAL PREVIOUS HIGHEST LOWEST FORECAST DATES UNIT FREQUENCY

10.90 9.08 37.81 -10.32 10.65 | 2013/12 1957 - 2013 PERCENT MONTHLY 2007/2008=100

The trend in economic variables has the potential to impact inflationary tendencies in the

economy. The following trend analysis shows the inflation from period of 1973-2013 and it

shows that there are sharp turns. The period from 1972 to 1980 witnessed the highest inflation, of

15 percent. The high growth in CPI during this period was mainly the oil price shocks. The

inflation slowed down to 7.2 during 1980s. During 1990s increase in inflationary tendencies

occur due to increase in Money supply, rising wheat prices and depreciation of the exchange

rate. During the first four years of the new millennium, inflation remained under 5 percent and


then jumped to 9.3 percent in 2004-05. It settled at 8 percent during 2005-06. The growth in

wheat prices and strength of the exchange rate remained mixed. However, it seems that excessive

money flows towards the public and private sector, along with the import price hike in 2003-04

and 2005-06, as well as the rise in price of wheat in 2003-04 and 2004-05 pulled inflationary

pressure at an alarming level.

Trend in variables alone do not provide a complete picture and further econometric analysis is

required to find the role of these factors in affecting consumer prices.

INTERMEDIATE TARGETS OF INFLATION

The State Bank of Pakistan ensure the price stability and boost growth. In order to contain inflation within

the targeted level set by the Government, the SBP used money supply as an instrument/intermediate target. The

statistics reveal that money supply growth exceeded its target levels for four consecutive fiscal years 2002-2005

due to easy monetary policy stance to support the growth process. However, the expansionary monetary policy

resulted in rapid inflation reaching double digit in 2005.Since inflation is a tax on money holdings. Inflation tax for

the year 2005 is estimated at 61928 million or 0.98 percent of GDP. Before 2005 monetary policy was biased

towards supporting growth because inflation was at low level. With the rising inflation from 2005monetary policy

stance has tilted towards the containing of inflation [State Bank of Pakistan (2006)].

Money supply is the main determinant to measure Inflation.


LITERATURE REVIEWS

DETERMINANTS OF INFLATION IN PAKISTAN: AN ECONOMETRIC

ANALYSIS USING JOHANSEN CO-INTEGRATION APPROACH

This article shows the analysis that in the long run money supply, GDP, government

expenditures and imports contribute in increasing the CPI, and CPI decreases due to high

government revenues. The inflation in real times effect on real output, relative prices, taxes and

interest rate. The major problems faced by the society arise due to higher inflation. Due to higher

price level, the people need more money to make day to day transactions and every consumer


has to carry more money with them as value of money declines. Inflation discourages saving and

promotes consumption. The effect of inflation severity is more social than economic due to the

erosion of the real value of money the real value of money. The recent inflationary environment

in the country may be blamed to some extent for lower deposit growth and lower savings.

Historically, Pakistan is accustomed to lower inflation and thus has less tolerance towards higher

double digit inflation. In this backdrop persistence of high double digit inflation for third year in

a row has become intolerable and the government is pursuing combination of several policy

measures such as the control of the budget deficit through appropriate fiscal and monetary

policies, the improvement of agricultural productivity, the fostering of investment to stimulate

output and the constant vigilance on the market situation to ensure the adequate availability of

consumer goods to the common man at a reasonable price to bring inflation down to a tolerable

and sustainable level.

Money, Inflation, and Growth in Pakistan

This article analysis is that the money supply growth has been an important contributor to

the rise in inflation in Pakistan during the study period. This is to conclude that inflation is

Pakistan is a monetary phenomenon. This may be due loose monetary policy adopted by the

State Bank of Pakistan to boast the high priority of the growth objective. It is argued that the

policies to boast output growth through money supply only have short run effect on real output

but generate inflation. Indeed the recent act of tightening the monetary policy by the State Bank

of Pakistan supports the monetarist argument that the inflation in Pakistan is a monetary

phenomenon.

Causes of inflation in Pakistan has been investigated by a number of researchers have attempted

overtime [Bilquees (1988); Khan and Qasim (1996); Hussain (2006); Khan and


Schimmelpfennig (2006)]. These studies show that while monetarists’ argument those monetary

factors play dominant role in the long run inflation is valid [Khan and Schimmelpfennig (2006);

Bilquees (1988)] in the short run other factor such as food prices also effect inflation [Khan and

Schimmelpfennig (2006); Bilquees (1988); Khan and Qasim (1996)]. This paper attempts to

investigate the linkage between the money growth and inflation in Pakistan to test the validity of

monetarist’s stance that inflation is a monetary phenomenon.

Determinants of Recent Inflation in Pakistan

The State Bank of Pakistan has the explicit mandate to ensure price stability and promote growth. In

order to contain inflation within the targeted level set by the Government, the SBP used money supply as an

instrument/intermediate target.

The results from the correlation analysis indicate that there is strong relationship between the money growth and

inflation and the important conclusion that emerged from the analysis is that the money supply growth has been an

important contributor to the rise in inflation in Pakistan during the study period. This is to conclude that inflation is

Pakistan is a monetary phenomenon. This may be due loose monetary policy adopted by the State Bank of

Pakistan to boast the high priority of the growth objective. It is argued that the policies to boast output growth

through money supply only have short run effect on real output but generate inflation. Indeed the recent act of

tightening the monetary policy by the State Bank of Pakistan supports the monetarist argument that the inflation in

Pakistan is a monetary phenomenon. The important policy implication is that inflation in Pakistan can be cured

by sufficiently tight monetary policy. The formulation of monetary policy must consider development in the real

and financial sector and treat them as constraints on the policy.


METHODOLOGY

VARIABLES:

The data has been extracted partially from the World Bank website and partially from the

official website of the State Bank of Pakistan. The data used for the analysis is from the 1972-73

to the 2005-06 period. While designing the methodology, the prime consideration was to

incorporate all important demand-side, supply-side and policy variables and keep it straight and

effective in explaining the causes of inflation. The following equation was estimated:


According to the equation, the Consumer Price Index is dependent on, Government Sector

Borrowing (GB) as a ratio of Real Gross National Product (YN), Real Demand relative to Real

Supply (YD/YS), Private Sector Borrowing (PB) as a ratio of Real Gross National Product

(YN), Import Prices in $ term (I), Exchange Rate (E), Government Taxes (T) relative to Nominal

Value-Added in Manufacturing Sector GDP (YMS), Adaptive Expectations (CPI-1), Wheat

Support/Procurement Price (W) are used to explain Consumer Prices (CPI).

Dependent variable:

1. Consumer Prices (CPI): measures changes in the price level of a market basket of

consumer goods and services purchased by households.

Independent variables:

1.Government Sector Borrowing (GB) as a ratio of Real Gross National Product (YN),

2. Real Demand relative to Real Supply (YD/YS),

3. Private Sector Borrowing (PB) as a ratio of Real Gross National Product (YN),

4. Import Prices in $ term (I),

5. Exchange Rate (E),

6.Government Taxes (T) relative to Nominal Value-Added in Manufacturing Sector GDP

(YMS), 7.Adaptive Expectations (CPI-1),

8. Wheat Support/Procurement Price (W).

In this research variables are taken in logarithmic form. The Breusch-Godfrey Serial Correlation

LM test is used to identify the problem of serial correlation, the Breusch-Godfrey Serial

http://en.wikipedia.org/wiki/Consumer_Services

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http://en.wikipedia.org/wiki/Market_basket


Correlation LM test is utilized. Residual series is examined by using Augmented Dickey Fuller

Test. Ordinary Least Square (OLS)

method of estimation has been used for this analysis.

The variable Demand relative to supply pressures, represent the output gap. If the ratio is greater

than one this means it has an upward pressure on prices. Therefore its coefficient is expected to

have a has a positive sign.

Instead of taking money supply as a whole, the breakup of these two is used in order to get a

better picture of the role of government and private borrowing to explain inflation. The variable

government sector borrowing includes net foreign assets as well as other items. Whereas Private

sector borrowing also includes borrowing of autonomous bodies. Both these variables are

expected to have a positive coefficient since an increase in government and private borrowing

can have an inflationary nature.

The index of import prices in dollars has been used to represent that the external price shock is

independent of changes in exchange rate. When the prices of goods, such as petrol and raw

material increases it makes our imports costlier and therefore the cost of production increases.

The variable is expected to have a positive coefficient.

Exchange rate was expressed as rupees per dollar, this means the number will increase with the

increase in depreciation of Pakistani Rupee since there would be more rupees for a dollar.

More rupees for a dollar also means increased cost of imports. The variable again is assumed to

have a positive sign, indicating that the depreciation of the Pakistani Rupee would have an

inflationary effect on prices.


Fiscal policy can be an important determinant of inflation. Indirect taxes, such as sales tax

and excise duties raise the price of consumer goods. This creates inflationary pressure. On

the other hand, direct taxes reduce the take-home income and thus have an anti-inflationary

effect. If both taken together, coefficient’s sign can partially depict which kind of tax has a

more dominant role to play.

Rising prices create expectations for future inflation. The role of expectations is critical in

the determination of future prices. People expect higher salaries to compensate for expected

increase in prices, speculation in asset prices increases, credit meant for manufacturing sector

diverts to real estate and stock markets, and hoarders, profit seekers and rentiers become

active in expectation of higher prices in the future.

All this can have a devastating effect on prices. To incorporate these elements, we have included

the variable ‘lag of CPI’ in the model. This variable brought to have a positive correlation with

current consumer prices.

A substantial increase in support price of wheat is estimated to have an inflationary effect on

consumer prices, particularly food prices (Hasan et al., 1995). This effect is due to the fact that

wheat and wheat-related products account for 5.1 percent of the CPI basket.

The variable is expected to have a positive coefficient.


RESULTS AND ANALYSIS

The estimation results, presented in the table below, represent the correct signs of the

coefficients. According to the results, Government sector borrowing, non-government sector

borrowing, government taxes and adaptive expectations are statistically significant at less than 1

percent level. Whereas Real demand relative to real supply, exchange rate, and import prices are

significant at the level of 5 percent. Wheat prices are statistically insignificant at the

conventional level.

The estimated equation is supported by the diagnostics presented in table 2.

High R2 and Durbin Watson test support the model specification whereas Breusch-Godfrey

Serial Correlation LM Test and Augmented Dickey Fuller Test indicate the rejection of the


presence of serial correlation in the model. Since the variables are in the log form, the estimated

coefficients can be termed as elasticities. For instance, a 10 percent change in government sector

borrowing as a ratio to Gross National Product (GNP) and import prices will cause CPI to

change by 1 percent and 1.2 percent, respectively.


SUMMARY OF RESULTS

VARIABLE CONCLUSION

Government sector

borrowing

Government sector borrowing is significantly

related to inflation

non-government sector

borrowing

non-government sector borrowing is

significantly related to inflation

Government Taxes Government Taxes are significantly related to

inflation

Adaptive Expectations Adaptive expectations are significantly related

to inflation

Real demand relative to real

supply

Real demand relative to real supply are

significantly related to inflation

Exchange rate Exchange rate is significantly related to

inflation


Import Prices Import Prices is significantly related to

inflation

CONCLUSION

On the basis of our analysis we state that even though the expansionary monetary policy

did contribute positively towards GDP growth, but it resulted in a rise in consumer prices.

The growth in the flow of loose credit in the private sector resulted in upsetting the price

mechanism. Since money was available at almost no cost, this encouraged the speculators and

hoarders.

Adaptive expectations here played a prominent role as people started expecting higher prices in

future as land prices, house rents and food prices seemed to have no limits.

The main concern we have is that will the country be able to come out of this ever increasing

inflation in the presence of high expectations for inflation in future and a rising trade deficit.


BIBLIOGRAPHY

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determinants of inflation rate in pakistan