This paper examines the issue in the case of Pakistan using Johansen co integration analysis. The practical results suggest that in the long-run inflation is not related to budget deficit but only to supply of money, and supply of money has no causal connection with budget deficit. Therefore the finding shows that the hard government budget constraint does not find empirical support for Pakistan. The purpose of this paper is twofold, Firstly, to examine the long-run relationship among inflation, supply of money and budget deficit in Pakistan Secondly, to detect the direction of causality among these variables.
Conventional concepts suggest that persistently high budget deficits give rise to inflation. However, a practical fact does not provide convincing support for such a hypothesis. Practical facts indicates that the link from budget deficits to monetary expansion and then to inflation might be less crucial in determining the course of inflation. Furthermore, declining or intact seignior age revenue, i.e., lack of monetization in the face of increasing budget deficits presents an additional argument on that point. However, even when a central bank does not monetize the deficit, adjustments in the private sector to higher deficit policies may very well lead to inflation.
In general, there is little disagreement that in the long-run inflation is primarily a monetary phenomenon. Pakistan’s experience is not different in that respect as inflation is generally associated with monetary expansion.
During the 1960s, the overall inflation in Pakistan averaged 3.2 percent per annum. In the 1970s, it increased to an average of around 12.5 percent per annum. This acceleration in inflation was attributable to heavy devaluation of the rupee, a sharp rise in oil prices and large monetary expansion (average annual increase of 21 percent as against 4.8 percent GDP growth).
During the 1980s, the economy experienced a...