Inflation in Pakistan

Topics: Inflation, Monetary policy, Money supply Pages: 24 (7010 words) Published: January 5, 2011
The Pakistan Development Review 45 : 2 (Summer 2006) pp. 185–202

Inflation in Pakistan
Adnan
This paper examines the factors that explain and help forecast inflation in Pakistan. A simple inflation model is specified that includes standard monetary variables (money supply, credit to the private sector), an activity variable, the interest and the exchange rates, as well as the wheat support price as a supply-side factor. The model is estimated for the period January 1998 to June 2005 on a monthly basis. The results indicate that monetary factors have played a dominant role in recent inflation, affecting inflation with a lag of about one year. Private sector credit growth and broad money growth are also good leading indicators of inflation which can be used to forecast future inflation developments.

JEL classification: E31, C22, C32 Keywords: Inflation, Pakistan, Leading Indicators, Forecasting, Monetary Policy I. INTRODUCTION After remaining relatively low for quite a long time, the inflation rate accelerated in Pakistan starting in late 2003. Following the 1998-99 crisis, inflation was reduced to below 5 percent by 2000 and remained stable through 2003. Tight monetary policy combined with fiscal consolidation appears to have contributed to this low-inflation environment.1 Figure 1 shows that inflation follows broad money growth and private sector credit growth closely with a lag of about 12 months. With monetary growth picking up, inflation followed and increased sharply in late 2003, peaking at 11 percent year-on-year in April 2005. Average annual inflation stabilised around 8 to 9 percent by September 2005, and has receded somewhat since then. Controlling inflation is a high priority for policy-makers. High and persistent inflation is a regressive tax and adversely impacts the poor and economic development. The poor have little options to protect themselves against inflation. They hold few real assets or equity, and their savings are typically in the form of cash or low-interest bearing deposits. Thus, this group is most vulnerable to inflation as it erodes its savings. Moreover, high and volatile inflation has been found to be detrimental to growth [e.g.,

Mohsin Khan is Director of the Middle East and Central Asia Department of the International Monetary Fund. Axel Schimmelpfennig is an Economist in the International Monetary Fund’s Middle East and Central Asia Department. Author’s Note: The views expressed in this paper are those of the authors and do not necessarily represent those of the International Monetary Fund or its policy. This paper draws on previous work by Khan and Schimmelpfennig, “Inflation in Pakistan: Money or Wheat?”, published in the State Bank of Pakistan’s Research Bulletin–Papers and Proceedings Vol. 2, No. 1, available at http://www.sbp.org.pk/research/ bulletin/2006/Inflation_in_Pakistan_Money_or_Wheat.pdf, and in Bokil and Schimmelpfennig “Three Attempts at Inflation Forecasting,” available as IMF Working Paper 05/105 at http://www.imf.org/ external/pubs/ft/wp/2005/wp05105.pdf. 1 According to the State Bank of Pakistan (SBP) a change in the methodology of deriving the house rent index may also be partly responsible for the observed slowdown in headline inflation.

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Fig. 1. Pakistan: Inflation and Monetary Growth, 1999:1–2005:6 (Average annual growth in percent) 10 35 30 8 Credit growth (lagged 12 months, right axis) Broad money growth (lagged 12 months, right axis) 25 20 6 15 4 10 5 2 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Sources: National authorities; and IMF staff calculations.

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Khan and Senhadji (2001)] and financial sector development [e.g., Khan, Senhadji, and Smith (2006)]. High inflation obscures the role of relative price changes and thus inhibits optimal resource allocation. Understanding the factors that drive inflation is fundamental to designing monetary policy. Certainly in the long run, inflation is considered to...

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Annual inflation targets can vary depending on where inflation stands at the beginning.
Inflation in Pakistan
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