Determinants of Inflation Rate

in Pakistan
Topics in Macro Economics


12/11/2013


Submitted to: Mr. Yousuf Razzak

Submitted by:
Sonya Arif
Anna Noor Ali
Sonia Mumtaz
Bilawal Karim






Determinants of inflation rate in Pakistan 2

Table of Contents
INTRODUCTION .......................................................................................................................... 3
The factors that stimulated the recent inflation in Pakistan ........................................................ 4
Political Instability: ..................................................................................................................... 5
Non Government Sector Borrowing: .......................................................................................... 5
Hike in the import prices: ............................................................................................................ 5
Loose monetary policies (money supply): .................................................................................. 5
Decrease in economic growth : ................................................................................................... 5
Population Pressure : ................................................................................................................... 6
MEASURE TAKEN TO CONTROL THE INFLATION IN PAKISTAN ................................ 6
TREND ANALYSIS ...................................................................................................................... 7
PAKISTAN INFLATION RATE ............................................................................................... 7
INTERMEDIATE TARGETS OF INFLATION ........................................................................ 9
LITERATURE REVIEWS ........................................................................................................... 10
DETERMINANTS OF INFLATION IN PAKISTAN: AN ECONOMETRIC ANALYSIS
USING JOHANSEN CO-INTEGRATION APPROACH ........................................................ 10
Money, Inflation, and Growth in Pakistan ................................................................................ 11
Determinants of Recent Inflation in Pakistan ........................................................................... 12
METHODOLOGY ....................................................................................................................... 13
VARIABLES: ........................................................................................................................... 13
RESULTS AND ANALYSIS ....................................................................................................... 17
SUMMARY OF RESULTS ...................................................................................................... 19
CONCLUSION ............................................................................................................................. 20
BIBLIOGRAPHY ......................................................................................................................... 21





Determinants of inflation rate in Pakistan 3

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
countrys 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.

Determinants of inflation rate in Pakistan 4

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.
Determinants of inflation rate in Pakistan 5

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 1990s.
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
Determinants of inflation rate in Pakistan 6

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. I ncrease 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.
Determinants of inflation rate in Pakistan 7

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. I mport 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,
Determinants of inflation rate in Pakistan 8

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
Determinants of inflation rate in Pakistan 9

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.



Determinants of inflation rate in Pakistan 10












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
Determinants of inflation rate in Pakistan 11

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
Determinants of inflation rate in Pakistan 12

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
monetarists 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.


Determinants of inflation rate in Pakistan 13











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:

Determinants of inflation rate in Pakistan 14

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
Determinants of inflation rate in Pakistan 15

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.
Determinants of inflation rate in Pakistan 16

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, coefficients 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.

Determinants of inflation rate in Pakistan 17










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
Determinants of inflation rate in Pakistan 18

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.




Determinants of inflation rate in Pakistan 19





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
Determinants of inflation rate in Pakistan 20

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.



Determinants of inflation rate in Pakistan 21






BIBLIOGRAPHY