Table of Contents
1. Introduction 3
1.1. Objectives 4
2. Literature Review 5
3. Methodology or Model 7
4. Data Sources and Construction of Variables 8
4.1. Contraction of Variables:- 8
5. Estimation Technique 8
6. Empirical Results 9
7. Conclusion 11
This paper attempts to investigate the linkage between the excess money supply growth and inflation in Pakistan and to test the validity of the view that inflation is a monetary phenomenon. The results from the analysis indicate that there is a positive association between money growth and inflation. The money supply growth at first affects real GDP growth and at the second round it affects inflation in Pakistan. The important finding from the analysis is that the excess money supply growth has been an important contributor to the rise in inflation in Pakistan during the study period, thus supporting the argument that inflation in Pakistan is a monetary phenomenon. This may be due to the loose monetary policy adopted by the State Bank of Pakistan to show the high priority of the growth objective. The important policy implication is that inflation in Pakistan can be cured by a sufficiently tight monetary policy. The formulation of monetary policy must consider development in the real and financial sector and treat these sectors as constraints on the policy.
... . Thus this function of money encourages consumptions by households. Inflation adversely affects the function of money. With higher prices, money loses its value thus ... account a measure of value –Money allows us to measure ... act as a store of value –Money enables people to store their wealth in monetary terms. To act as a unit of ...
The expansionary economic policies of the government and the SBP over the last few years resulted in improvement in various macroeconomic indicators including Gross Domestic Product (GDP) growth, which remained above 6 percent during 2004-06. Despite this impressive performance of the economy, some worrisome factors have also appeared on the scene. The most significant of these factors is inflation, which remained above 8 percent during the last two years.
In 2004-05, average CPI inflation was 9.3 percent and on the basis of 12 month changes, inflation was recorded at 11 percent in April 2005. Several supply side and demand side factors could be responsible for this surge in inflation. Inflation can be a result of shocks to the supply of certain food items and to world oil markets. Rising oil prices can pose risk of increase in prices of almost all other commodities of the consumer basket. Such supply-side shocks are very volatile and can cause large fluctuations in food and oil prices. The effects of this on overall inflation at times can be so excessive that these cannot be countered through demand management, including monetary policy. However, greater emphasis in the recent debate on inflation remained on the demand side factors.
The demand side pressures were often considered as an outcome of the September 11, 2001 incident in the United States of America (USA) and a combination of expansionary monetary and fiscal policies. First, increased domestic demand due to remittances from abroad and liberal demand-management policies outpaced the domestic production, creating a positive output gap, which in turn put upward pressure on prices. Growth in private consumption remained above 10 percent on average during FY04 and FY06, depicting signs of demand side pressures on price level.
Second, the growing gap between domestic demand and domestic production was filled by a sharp increase in net imports, which grew by over 40 percent in FY05 and by 24 percent in FY06. In comparison to imports, exports increased by only around 10 percent in FY05 and by 13 percent in FY06. This resulted in a record increase in the trade deficit. A rising trade deficit can be a cause of expectation of high inflation in future. SPDC (2005) states that the ‘financing of the current account deficit is not an issue in the short run, but a continuing trend of a widening current account deficit will have adverse effects on expectations that could threaten hard-earned credibility on the macroeconomic front.’ The expectations effect is very important since there is a danger that the current high rate of inflation, whatever its source, can get locked into expectations of inflation. This can then become self-fulfilling through mechanisms such as wage contract renegotiations based on these expectations.
... that, its highest inflation rate which is measured by Consumer price index was recorded at 8. 00 percent in July 2008. ... the effectiveness of government economic policy. The government, business, labor, and private citizens uses price changes information provided by the ... 2007. Asset inflation mostly occurs during oil-price shock. This is usually as a result of gas and oil demand predictions done ...
Third, fiscal policy has remained expansionary in the last few years. Expansionary fiscal policy fuels domestic demand and puts pressure on the current account deficit. In other words, it widens the investment-saving gap, which has to be financed externally. Moreover, financing of fiscal deficit through money creation adds to inflationary pressures. On the
Other hand, government borrowing from the SBP also increased, which again can have serious consequences on the general price level.
Fourth, the expansionary monetary policy through high growth in money supply and loose credit policy was also believed to be contributing to high inflation.
Although expansion of credit is usual in expanding economies, the credit growth should not be allowed to reach unsustainable limits. The International Monetary Fund [IMF (2004)], through an extensive survey of developing countries, suggests that excessive credit growth in developing countries can have adverse effects on real variables.
Rising import prices were also considered as an important factor in creating inflation. The exchange rate, if depreciating, in this scenario can also put upward pressure on price levels.
Similarly, some people blamed indirect taxes for being the main cause of inflation. The wheat support price has also been identified as an important determinant of inflation in Pakistan.
In line with trends world-wide, Pakistan adopted liberal and market-oriented monetary policies and procedures in the 1990s. This involved a move to indirect tools of monetary policy management and a major departure from the age-old practice of relying on direct interventions, such as liquidity reserve ratios and credit ceilings and controls. Accompanying this policy change were gradual changes to the legal and institutional framework of monetary policy formulation, its targeting and operating procedures as well as development of infrastructure for treasury operation to allow for effective open market operations.
... pursuit of low inflation; (i. e. , price stability) through monetary policy undermines the ability of an economy to attain and sustain higher growth. A substantial ... presence of money illusion and expected inflation deviating from actual inflation. Based on this knowledge, and its subsequent critiques, the prevailing inflation / monetary policy controversy centres ...
A consensus among economists is emerging in support of the view that it is not a valid argument to focus exclusively on a single policy instrument and entirely neglect an important information variable because both the interest rate and monetary aggregates do matter in policy formation. Therefore, a well-specified money demand function is still important in this era of inflation targeting. It is essential to track both the interest rates and the money stock in order to assess precisely how monetary policy impacts upon the economy.
The question now arises as to what were the most significant explanatory factors for recent inflation trends in Pakistan? This paper attempts to answer this question.
Paper proceeds with chapter 2 a review of literature, including a discussion on the reasons, Chapter 3 is Methodology or Model, Chapter 4 is Data and Data Source, Chapter 5 is Estimation Technique, Chapter 6 is Empirical Results, Chapter 7 is Conclusion, Chapter 8 is References.
Over the past two years, monetary policy has been dominated by the growth in Net Foreign Assets (NFA) due to the external account surpluses. The focus of monetary policy has been on avoiding appreciation of Pak rupee so as to preserve export competitiveness. To pursue this objective, State Bank of Pakistan has been purchasing foreign currency2 from the kerb and inter-bank market. As a result, growth in money supply (M2) was high due to exceptional increases in the net foreign assets of the banking sector; M2 increased by 15.4 percent and 18.0 percent in FY02 and FY03.
Money demand is assumed to depend positively on income because of the transaction demand. Money demand also varies inversely with the rate of interest, owing to the speculative demand for money and because the amount of transaction balances held at any income level declines as the interest rate(the opportunity cost of holding cash balances) increases according to Froyen, Richard T (2004), Macroeconomics theories and policies, 7th edition, prentice hall, New York.
... that growth in money supply without equal growth in production will cause inflation. Meaning the government cannot print money to increase money supply as ... in the level of prices. Inflation causes the purchasing power of money to fall. Inflation is categorised in two ... inflation. Real asset holders win such as people owning rare artwork. Organised businesses and individuals will shift from monetary ...
Inflation adversely affects the overall growth, the financial sector development and the vulnerable poor segment of the population. There is clear consensus that even moderate levels of inflation damage real growth found Cecchetti (2000).
Inflation decreases the real income and also induces uncertainty. Considering such adverse impacts of inflation on the economy, there is a consensus among the worlds’ leading central banks that the price stability is the prime objective of monetary policy studied by King (1999) and the central banks are committed to the low inflation. Hence the central banks have adopted inflation as the main focus of monetary policy, targeting inflation explicitly or implicitly as and when required.
Maintaining the price stability is the responsibility of a central banks and it is accountable for achieving it. It is argued that sufficiently tight monetary policy maintained for sufficiently long time could halt even the most deeply rooted inflation studied by Friedman (1963).
The price stability is obtained when economic agents such as households and business stop to take inflation at the time of decision-making. In the words of Blinder, prices are stable when ordinary people in their ordinary course of business stop talking about inflation.
There are a number of theories including the demand-pull, the cost-push inflation, and the quantity theory of money explaining the causes of inflation. The possible sources of inflation include rising costs such as wages, profits, imported inflation—exchange rate, commodity prices, external shocks, exhaustion of natural resources and taxes. Quantity theory assumes that the changes in income arise due to the changes in prices and output is always at its permanent level. Therefore, the price level is determined by the money supply via the operation of real balance effect by Allsopp and Vines (2000).
Recent inflation has generated a heated debate among the policy maker about the sources of inflation in Pakistan.
... the economy. The idea of the money growth rule is contingent upon the relationship between the money supply and inflation. Therefore, the question arises whether ... difference between adjusted money growth and inflation, the link becomes evident. These graphs show the weight that changes to the money supply can have upon ...
The State Bank of Pakistan (the Central Bank) 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 statistics reveal that money supply growth exceeded its target levels for four consecutive 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 Rs 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 2005 monetary policy stance has tilted towards the containing of inflation State Bank of Pakistan (2006).
A review of monetary and fiscal developments during the last three years shows that the government and the State Bank are directly responsible for the monetary and financial conditions that are feeding inflation now and the full impact of those actions is yet to come through. It all followed the adoption of a managed float exchange rate regime by Pakistan necessitated by years of current account convertibility and a gradual liberalization of the capital By Khan M (2005).
It is natural that following a rapid growth in money supply, we are observing some stimulation of output, but at the same time, prices are rising and there is pressure for interest rates to rise as well. Because the impact of monetary expansion on prices comes with a lag, inflationary pressures can be expected to continue for some time, also because the continuing rapid pace of expansion in reserve money in 2004-05 will impact M2 in the coming months. This will further impact prices in the future by Hassan, imran (2006).
Causes of inflation in Pakistan have been investigated by a number of researchers and they showed that monetary factors play dominant role in the long run inflation.
This paper attempts to investigate the linkage between the money growth and inflation in Pakistan to test the validity of stance that inflation is a monetary phenomenon. The results of this exercise would be important for policy-makers to contain inflation within limits.
... economy. The relation of unemployment and inflation is known as Phillips curve. Importance of Pakistan NGOs on Solution Of Unemployment Problem ... Unemployment affects the daily life adversely. No job means no money, no money means no: ? Home ?Food ?Decent clothing ?Access to ... industrial sector. •The higher growth rate of population is the major cause of unemployment in Pakistan. The resources of the ...
Methodology or Model
We use quantity theory of money to formulate the theory of determination Inflation (prices).
The quantity theory of money states that there is a relationship between money supply (M) velocity of money (V), prices (P) and real income (Y) and can be written as an identity
MV = PY … … … … … … … (1)
The money supply determined out side the system that is it is exogenous, income velocity of money is independent of the other variables in the identity1, Y is real income.
Under these assumptions the equation of exchange can be written as the theory of price determination. The Equation 1 can be written into price equation as
P = MV/Y … … … … … … … (2)
Taking log of the equation, we can get
Log P = log M + log V – log Y … … … … … (3)
By differentiation of Equation 3 we can get the equation for inflation such as
1/P dP/dt= 1/M dM/ dt+1/V dV/ dt-1/Y dY/ dt … … … (4)
or gp = gm + gv – gy
(Growth rate of prices is equal to growth rate of money + growth rate of velocity – growth rate of output (GDP))
The equation shows that growth in prices (i.e., the rate of inflation) is determined by the growth in money supply, growth in velocity, and growth in real income. In a simple version of quantity theory, it is assumed that the real income grows at the long-run rate and the velocity of money remains constant. Under this assumption inflation is determined by the change in money supply. The velocity and income grow slowly and this behavior is independent of the behavior of money supply or prices.
Furthermore, the empirical evidence from Pakistan shows that the income velocity of money is not constant and the real income growth deviates from potential level of real income growth . Quantity theory identify that the money supply is the key factor that effect the changes in price level. By adding error term to capture effect of other variables we modify equation 4 to arrive at our model to analyze inflation in Pakistan as:
gp = â0 + âm gm + ây gv + âv gy + u … … … … … (5)
This equation elaborates the relationship between the price level and the factors that determine it.
m= money supply, p = price level, v = velocity of money
Data Sources and Construction of Variables
The quality of empirical research depends on the quality of data base. For this study / research, the data regarding all variables of 30 years and is taken form the Economic Surveys of Pakistan, Statistical Supplements, Past 30 years of Pakistan Economy and State Bank’s Annual Reports.
8 Contraction of Variables:-
Variables are defined as follows:
M = Cash balances are defined as by taking the M2 money supply in Rupees millions.
P = “P” implicit price deflator is taken to make the money supply real.
V = Velocity of money
Y = GDP (GDP for 1975-2005 years at the prices of 2000).
The technique used for this study is Ordinary least square (OLS).
As model is linear; the data was in continuous form and to minimize error term, OLS is (BLUE) the best linear unbiased estimation and is the simplest way to calculate the data if it’s in the linear form.
Equation: gp = c(1)+c(2)* gm +c(3)* gv + c(4) gy
|Variables |Coefficients |t-Statistic |
|Constant |13.2578 |14.25 |
|[Money supply, M2] |0.97938 |22.639 |
|[ GDP] |– 0.88172 |–11.425 |
|[Velocity ] |1.0598 |26.347 |
gp = – 1.09591* gy + 1.09289* gm + 1.17935* gv … … … (6)
(–12.5) (30.1) (28.3)
R- SQUARE = 0.96498
DUBIN WATSON STAT = 1.95
Note: – *, ** and *** show significance level at1%, 5% and 10% respectively and t-values are in the parenthesis.
The results reveal that the estimated parameters of the model maintains constancy over the period of study i.e., they are fully reliable. Furthermore, as can be seen from the table, the money supply growth contributes 90 percent to the explanatory variable. It implies that the money supply is the key factor that affected the inflation in Pakistan.
The results indicates that in the long run there is a one to one relationship between the rate of inflation and growth in money supply, growth in real income and growth in velocity of money. The result of one to one relationship between the growth rate of money supply and the rate of inflation is consistent.
Further, the results also confirm the monetarist’s proposition that money supply is the main factor that contributes towards the inflation in Pakistan. Other factors that contribute the inflation in Pakistan are money demand captured by the real GDP growth and the financial sector reforms indicated by the velocity growth.
The result reveals that there is proportional relationship between the excess money supply over the output growth and the velocity growth. Average money supply growth adjusted for output growth and velocity growth during 2000-2005 was 13 percent. It ranges from 6 percent in 2000 to over 19 percent during 2002 and 2003. It implies that excess money supply main cause of inflation in Pakistan.
The study tested that money supply has been the main determinant of inflation in Pakistan. For this purpose, an estimated relationship between the rate of inflation, money growth, growth in real income, and growth in velocity was instituted for 1960–2005 period.
The results reiterated the established assumption that there is a strong relationship between the money growth and inflation. The important implication emerged from the analysis is that the money supply growth has been prime contributor to the rise in inflation in Pakistan during the study period. Hence inflation is Pakistan is a monetary phenomenon. This may be due to loose monetary policy adopted by the State Bank of Pakistan to boost the high priority of the growth objective. It is argued that the policies to increase output growth through money supply only have short run effect on real output but it generates general price level.
The fluctuations in the velocity can be explained by the changing structure of the financial sector in Pakistan and due to the extensive reforms undertaken in this sector during last two decades.
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.
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Table – 1-: GDP, Prices , Money supply and velocity
|year |“Y” |Price = “ P ” |(Money supply) M2 |Velocity |
| | | | |(V=P*Y / M) |
|1974-75 |336.3955122 |0.987796766 |99.21496317 |3.349196418 |
|1975-76 |397.2751882 |0.981935289 |125.4510366 |3.109567982 |
|1976-77 |455.6352464 |0.983477437 |155.7823827 |2.876493327 |
|1977-78 |531.2829204 |0.992120056 |190.6851876 |2.764223313 |
|1978-79 |592.5352752 |0.984569924 |236.3389687 |2.468456276 |
|1979-80 |703.2778177 |0.995228385 |276.5201409 |2.531179263 |
|1980-81 |833.240693 |0.99768781 |312.712366 |2.658398492 |
|1981-82 |975.8179954 |0.993431444 |349.1229202 |2.776696184 |
|1982-83 |1096.251209 |0.99402911 |437.395504 |2.491350742 |
|1983-84 |1264.107947 |0.993326964 |489.3112163 |2.566204222 |
|1984-85 |1417.579669 |0.995929501 |550.5028809 |2.564581335 |
|1985-86 |1542.918717 |0.997025431 |631.61813 |2.435536799 |
|1986-87 |1714.795724 |0.998022537 |717.8306834 |2.384134335 |
|1987-88 |2024.322059 |0.997535254 |805.8050554 |2.505981573 |
|1988-89 |2303.551685 |0.998923101 |842.0792777 |2.732606126 |
|1989-90 |2565.248172 |0.997685084 |1011.482564 |2.530256012 |
|1990-91 |3059.396049 |0.997535012 |1170.503416 |2.607300956 |
|1991-92 |3629.41261 |0.998020017 |1383.936551 |2.617335623 |
|1992-93 |4013.530647 |0.999357507 |1596.977877 |2.511588945 |
|1993-94 |4706.472558 |0.99928951 |1827.791824 |2.573120524 |
|1994-95 |5637.001208 |0.998367781 |2153.008757 |2.613923595 |
|1995-96 |6412.070448 |0.998784286 |2371.184766 |2.700875654 |
|1996-97 |7355.499709 |0.998939681 |2483.694826 |2.958374941 |
|1997-98 |8015.054817 |0.998922889 |2775.106011 |2.885086798 |
|1998-99 |8794.114533 |0.999064961 |3468.279209 |2.533213494 |
|1999-00 |9415.639074 |0.999378658 |3852.102772 |2.442766795 |
|2000-01 |10241.6726 |0.999336534 |4197.018434 |2.438606778 |
|2001-02 |10830.23693 |0.999403606 |5277.976198 |2.050743966 |
|2002-03 |11864.82779 |0.999539874 |7833.146403 |1.513998063 |
|2003-04 |13875.06795 |0.999648166 |13906.26316 |0.997405705 |
|2004-05 |16187.23642 |0.999734103 |27819.01961 |0.581721876 |
|2005-06 |18970.15093 |0.999803557 |64515.35311 |0.293983114 |
 Government of Pakistan (GOP), Economic Survey 2005-06.