Impact of Inflation: Economic Growth of Pakistan

Background of problem/Problem development

Inflation has always been a subject of study in accordance with economic growth. Policymakers have always given inflation an important place while formulating policies. During the economic crisis in 1929 (Erman & Okuyan, 2008) Keynesian policies were implied to many countries that proved out to be effective. However, in accordance to those policies, there was an increase in total demand that increased the inflation. Inflation was not regarded as a problem during that period. As a matter of fact, people thought inflation to be posing a positive effect on economic growth. Phillips curve was a theory in those days that complemented the positive effect of inflation on economic growth by creating a low unemployment rate. In 1970s some countries experienced negative economic growth with high inflation rates followed by hyperinflation in Latin American countries in 1980s that caused a change in economists’ view towards the relationship of inflation and economic growth.

Today a general consensus of economists believes high rates of inflation to be rather creating problems than reducing them. According to a study (Li) impact of inflation on Monetary Policy varies for developing countries and developed countries.

Inflation in Pakistan has affected Monetary Policy ever since its existence. Different researchers have identified different causes for inflation such as political instability (Safdar & Farooq Saqib, 2009) and monetary variables such as money supply, interest rates and import prices (Schimmelpfenning & Khan, 2006). The aim of this study is to use statistical measures to test the relationship of these factors that cause inflation with economic growth during the aforementioned period in Pakistan.

Problem definition

In this study the relationship between inflation and Monetary Policy in Pakistan has been examined using data covering the period from 1991-2009T he relationship between these two variables has been one of the most important macroeconomic problems and a crucial one for the policymakers. The topic has been debated many times in the past by well known economists so there has been more than enough work already done on this topic and various theories have been developed over the years. In order to understand the relationship between inflation and economic growth, it is important to understand the basic concept of inflation and the factors that are bound to cause inflation. Sufficient data for the time period under consideration is available via many databases to conduct this research. It is very vital for the policymakers to understand the concept of inflation and how it can affect economic growth of a country especially in a developing country like Pakistan and inflation has indeed affected Pakistan’s economic growth over the course of years. In order to see whether the effect was positive or negative, there is a need to conduct this research.

Research objectives

To test the impact of “broad money” on “GDP growth rate”

To test the impact of “credit to private sector” on “GDP growth rate”

To test the impact of “imports” on “GDP growth rate”

To test the impact of “income per capita” on “GDP growth rate”

To test the impact of “investments” on “GDP growth rate”

To test the impact of “CPI” on “GDP growth rate”

To test the impact of “population” on “GDP growth rate”

To test the impact of “interest rate” on “GDP growth rate”

Definitions (Glossary and Operational in Table format)

Broad money: The amount of money in a country’s economy, measured by counting money kept by banks and people.

Net credit to private sector: Domestic credit to private sector refers to financial resources provided to the private sector, such as through loans, purchases of nonequity etc.

Imports: Goods that are produced abroad but purchased for use in the domestic economy.

Income per capita: Shows the income each person would have if GDP were divided equally.

Investments: Outlays made by individuals, firms, or governments to add to their capital.

CPI: The CPI or Consumer Price Index is a measure of the cost of goods purchased by an average household.

Population: Economically active population comprises all persons of either sex who furnish the supply of labour for the production of economic goods and services as defined by the United Nations System of National Accounts during a specified time-reference period.

Real interest rate: This measures the return on a loan as the increase in goods that can be purchased rather than as the increase in the nominal or the money value of the loan fund.

LITERATURE REVIEW

According to “What you should know about inflation” (Hazlitt, 1964) inflation can be defined as “Undue expansion or increase of the currency of a country, esp. by the issuing of paper money not redeemable in specie” or “A substantial rise of prices caused by an undue expansion in paper money or bank credit.” Different economists have identified several factors that cause inflation. The monetary variables including money supply and credit to private sector (Schimmelpfenning & Khan, 2006) are considered as one of the major factors contributing to the occurrence of inflation. In fact according to Hazlitt (1964) not only they are considered as one of the main causes of inflation but in truth the increase in money supply and credit is inflation itself. When money supply is increased, people have more money to spend and if, in turn, the supply of goods is not increased then prices of goods go up and each unit of currency becomes less and less valuable. Schimmelpfenning & Khan (2006) indicate that inflation occurs if money growth exceeds the real GDP growth and to reduce inflation, interest rates are to be increased which would reduce money demand and eventually inflation. According to another study (Qayuum, 2006), the relationship between excess money supply and inflation in Pakistan has been positive supporting the monetarist proposition that inflation in Pakistan is more of a monetary phenomenon probably due to a loose monetary policy by SBP which can be cured by implying a tight monetary policy. According to Abdul Qayyum, policy makers must consider development in financial sector while formulating policy and treat these sectors as constraints on the policy.

In Money, Output, and Inflation: Evidence from Pakistan (Malik, 2006), the author has conducted the research to answer the question why inflation has been high in some of the periods in regard to Pakistan. According to him, the answer lies in at least three factors; monetary policy actions, supply side factors and/or inflation in rest of the world (trading partner countries). This study focuses on the role of monetary policy actions in periods of high inflation. Malik’s findings also supplement the findings of Schimmelpfenning & Khan, Abdul Qayyum and Hizlitt that monetary policy actions have played the most crucial part during the high periods of inflation in Pakistan.

M. S. Khan (2002) in his research paper tackles the relationship between inflation and economic growth and inflation and financial deepening. His findings also notion a non-linear relationship between inflation and economic growth. His results provide strong support for the view taken in this paper that financial markets are an important channel through which inflation affects growth in a nonlinear fashion. Policy makers have realized the need to bring inflation down to single digit and keep it there to increase economic growth. According to Khan, inflation starts to exert a negative impact on economic growth once it surpasses 5-10% mark.

Some other factors have also been defined by different researchers such as income per capita, investments (Li), imports, interest rate (Schimmelpfenning & Khan, 2006), exchange rate (Gokal & Hanif, 2004), CPI (Malik, 2006) and population (Mubarik, 2005). According to Hazlitt (1964) there exists a relationship between income per capita and investment share of GDP. An increase in capital investment leads to an increase in per capita income of individual’s eventually increasing purchasing power of consumers. Again if the supply of products is not increased with the increasing income per capita and increasing demand for products, the value of each unit of currency decreases and hence leading way to inflation. According to Li, in countries with low to moderate inflation, inflation poses a positive impact on level of investment while in some cases; investment is the mode through which inflation adversely and non-linearly affects economic growth. Li has also identified a mechanism by which inflation has an adverse affect on economic growth through investment. First real returns to savings are reduced due to inflation causing an informational friction troubling the financial market. This friction might lead to credit rationing limiting the availability of investment capital i.e. the level of investment and this reduces the efficiency of allocation of resources to investment which affects the economic growth adversely or negatively in the long run. However, as mentioned above, in economies with low or moderate inflation, credit rationing in financial markets might not appear at all and the negative relationship between inflation and level of investment doesn’t take place.

Li in her study concludes that there exists a non-linear relationship between inflation and economic growth; however, it cannot be implied to all economies. This relationship between inflation and economic growth varies for developing and developed economies. Li argues that for developed countries, as inflation increases its negative impact on economic growth decreases, whereas the relationship between inflation and economic growth in developing countries is a bit complex. When level of inflation in developing countries is less than the first of the two threshold levels defined by Li, it has no effect on economic growth and in some cases this effect is even positive. In case of developing countries, moderate level of inflation lies between the two thresholds and has a negative effect on the economic growth through and through. Whereas, at high rates of inflation, the marginal effect of additional inflation is diminished rapidly but the negative effect remains. In relation to the study conducted by Li, Mubarik (2005) conducted a research in order to find a threshold level of inflation for Pakistan in particular. The research covered the dataset covering the periods from 1973 to 2000 using population growth rate, real GDP growth rate, consumer price index and investment share of GDP as main variables. Mubarik’s model suggested a threshold inflation level of 9% for Pakistan which means any level of inflation below 9% would be conductive.

In addition to all the other factors that have contributed in inflation, Khan & Saqib (2009) have mentioned another important factor that has contributed to the occurrence of inflation in Pakistan over the years i.e. political instability. Political instability is something that has prevailed ever since Pakistan came into existence. Khan & Saqib concluded after a careful empirical study that political instability and inflation are indeed positively correlated posing a negative impact on economic growth. A stabilized macroeconomic environment is required to control inflation which has always been absent in case of Pakistan. Constant changes in policies with change in governments have led to certain imbalances leading to variant inflation slowing the economic growth. The report suggests that if inflation is to be controlled in Pakistan for a sustainable economic growth, political stability is much needed to do so.

In Conclusion Inflation has a negative relationship with economic growth and to sustain economic growth, it is vital for policy makers to formulate policies to bring down and keep inflation in single digit. Monetary policies have played the most crucial part for all the inflation hikes in Pakistan. One reason for wrong monetary policies is political instability as no policy is sustained for a long time. Whenever a new government arrives, they eliminate previous policies and formulate new policies suiting their benefits. However, this relationship between inflation and economic growth is not universal and varies for developing and developed countries and policies should be formulated accordingly. In Pakistan, very often policy makers import policies from foreign economies which might be suitable for them but not for us.

Theoretical framework

Population

Inflation and Growth: An Estimate of the Threshold Level of Inflation in Pakistan (2005)

Consumer price index (CPI)

Money, Output and Inflation: Evidence from Pakistan (2006)

Broad money

Inflation in Pakistan (2006)

Credit to private sector

Inflation in Pakistan (2006)

Interest rate

Inflation in Pakistan (2006)

Monetary Policy

Inflation in Pakistan (2006)

Income per capita

Inflation and Economic Growth: Threshold Effects and Transmission Mechanisms

Investments

Inflation and Economic Growth: Threshold Effects and Transmission

Imports

Inflation in Pakistan (2006)

Exchange rate

Relationship Between Inflation and Economic Growth (2004)

Variable reference list

Dependent Variable

Monetary policy (Schimmelpfenning & Khan, 2006)

Independent Variables

Credit to private sector (Schimmelpfenning & Khan, 2006)

Broad money (Schimmelpfenning & Khan, 2006)

Imports (Schimmelpfenning & Khan, 2006)

Interest rate (Schimmelpfenning & Khan, 2006)

Income per capita (Li)

Investment (Li)

CPI (Malik, 2006)

Population (Mubarik, 2005)

Moderating Variable(s)

Exchange rate (Gokal & Hanif, 2004)

Research type

In order to conduct my research study the data I gather will be secondary in nature collected from reliable and consistent data sources and no primary data has been collected, hence my study will be referred to as secondary research.

Data type & Reference Period

Data type is purely secondary in nature as no primary data has been acquired.

Reference period for my research is from 1991-2009

Information gathering and sampling procedures

Data Sources

The data sources for my research study are as follows:

WDI

State bank of Pakistan

Economic survey of Pakistan

Data reliability and internal consistency

All three of the data sources that I will be using for data gathering for my research study are perfectly reliable and consistent as WDI is a database developed by World Bank and rest of the two sources i.e. SBO and Economic survey of Pakistan work under the government of Pakistan and publish data after careful and thorough research emitting the possibility of any error.

Data analysis tools and techniques

As my study concerns the study of impact of inflation on Monetary Policy so the most effective technique that can be used to determine this relationship under study is regression and this is the technique I will be using for my research study.

Simple regression: To measure the impact of each independent variable on the dependent variable effectively in detail

Multiple regression: To measure the cumulative effect of independent variables on the dependent variable and to obtain a single regression line for all variables.

Scatter plot: To obtain a graphical representation of the regression lines.

Research Hypothesis

Credit to private sector:

H0: To test the hypothesis that credit to private sector has insignificant impact on Real GDP growth rate

H0:β0=0

H1: To test the hypothesis that credit to private sector has significant impact on Real GDP growth rate

H1:β0≠0

Broad money:

H0: To test the hypothesis that broad money has insignificant impact on Real GDP growth rate

H0:β1=0

H1: To test the hypothesis that broad money has significant impact on Real GDP growth rate

H1:β1≠0

Imports:

H0: To test the hypothesis that imports have insignificant impact on Real GDP growth rate

H0:β2=0

H1: To test the hypothesis that imports have significant impact on Real GDP growth rate

H1:β2≠0

Income per capita:

H0: To test the hypothesis that income per capita has insignificant impact on Real GDP growth rate

H0:β3=0

H1: To test the hypothesis that income per capita has significant impact on Real GDP growth rate

H1:β3≠0

Investment:

H0: To test the hypothesis that investment has insignificant impact on Real GDP growth rate

H0:β4=0

H1: To test the hypothesis that investment has significant impact on Real GDP growth rate

H1:β4≠0

CPI:

H0: To test the hypothesis that CPI has insignificant impact on Real GDP growth rate

H0:β5=0

H1: To test the hypothesis that CPI has significant impact on Real GDP growth rate

H1:β5≠0

Population:

H0: To test the hypothesis that population has insignificant impact on Real GDP growth rate

H0:β6=0

H1: To test the hypothesis that population has significant impact on Real GDP growth rate

H1:β6≠0

Information gathering and sampling procedures

Data Sources

The data sources for my research study are as follows:

WDI

State bank of Pakistan

Economic survey of Pakistan

Data reliability and internal consistency

All three of the data sources that I will be using for data gathering for my research study are perfectly reliable and consistent as WDI is a database developed by World Bank and rest of the two sources i.e. SBO and Economic survey of Pakistan work under the government of Pakistan and publish data after careful and thorough research emitting the possibility of any error.

Data analysis tools and techniques

As my study concerns the study of impact of inflation on Monetary Policy so the most effective technique that can be used to determine this relationship under study is regression and this is the technique I will be using for my research study.

Simple regression: To measure the impact of each independent variable on the dependent variable effectively in detail

Multiple regression: To measure the cumulative effect of independent variables on the dependent variable and to obtain a single regression line for all variables.

Scatter plot: To obtain a graphical representation of the regression lines.