Money, Inflation & Growth in Pakistan

Topics: Inflation, Money supply, Monetary policy Pages: 17 (4379 words) Published: February 15, 2011
The Pakistan Development Review 45 : 2 (Summer 2006) pp. 203–212

Money, Inflation, and Growth in Pakistan
This paper attempts to investigate the linkage between the excess money supply growth and inflation in Pakistan and to test the validity of the monetarist stance that inflation is a monetary phenomenon. The results from the correlation analysis indicate that there is a positive association between money growth and inflation. The money supply growth at first-round 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 monetarist proposition 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.

JEL classification: E31, C22, C32 Keywords: Money Supply, Inflation, Growth, Quantity Theory, Monetary Policy, Pakistan 1. INTRODUCTION 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 [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 [King (1999); Blejer, et al. (2000)] and the central banks are committed to the low inflation [Goodfriend (2000)]. 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 [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. Abdul Qayyum is Associate Professor at the Pakistan Institute of Development Economics, Islamabad. Author’s Note: The author is thankful to Dr Nadeem Ul Haque, Vice-Chancellor, PIDE, Dr Faiz Bilquees, and other staff members for their invaluable suggestions and comments on an earlier draft of the paper.


Abdul Qayyum

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 [Allsopp and Vines (2000)]. Recent inflation has generated a heated debate among the policy maker about the sources of inflation in Pakistan. 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...
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