The Impact Of Oil Prices On Inflation

To illustrate the economy conditions of country, we use basic macroeconomics indicator. Inflation is one of the basic macroeconomic indicator. In the economy, this rate is used for the measurement of stability of price. Inflation comes from domestic purposes and from external factors as well in open economy countries. External factors become a source of increasing in world commodity prices. The population of Pakistan is increasing very rapidly and Pakistan has become the six largest country.

The price of oil and inflation are often seen as being connected in a cause and effect relationship. Oil prices increases continuously and inflation follows the same direction. It just happens because oil is a major input in economy, it is used in critical activities such as fueling transportation and heating homes and if input cost increases, so should the cost of end a plastic company will then pass on same or all this cost to consumer, which raises prices and inflation, also increases.

A salient feature of recent oil price hikes has been reduced impact that they seem to have had on general price levels worldwide when compared with the previous oil shocks. This situation results in the increase of oil price which results in the decline of output. Decline in inflation results due to decline in exchange rate. It becomes difficult for policy makers due to change in oil prices and it also creates difficulty for making decision in business. It has a adverse effect on the economy.

Enhancement in oil prices effect the consumer price index (CPI) directly by increasing its energy cost component, which includes price of CPI such as gas and electricity. As crude oil is converted into gasoline and fuel, so their prices follow the prices of oil closely. Energy cost increases due to increase in price oils because they are directly related to each other. The extent to which oil prices translates into higher overall inflation through high energy cost depends on their persistence. If they continue increase, they may lead to huge change in overall price level, that is to increase in overall inflation rate.

The high degree of dependence of oil producing countries and any irregularities in price and supply has adverse effect for an economy that import crude oil to cater to its often fragile industry.

Since 1970’s rapid change in prices are of concern in almost all the countries. In Pakistan, like all the developing countries, the domestic price level started rising from the mid 1970’s. In early 1980’s, the exchange rate started depreciating continuously. It leads to suggest a correlation between the two variables due to continuous devaluation of currency and inflation in 1980’s. In 1970’s the oil prices rose to vey high and 1980’s has not been far from the minds of public or of monetary policymakers. Rising oil prices were followed by the double digit inflation in developed countries in those early episodes. Central bank says that they are affirmative not to repeat this, amassing that they are in favor to held integrity with the public by maintaining low inflation and gaining steady and well anchored inflation prospect. The key measures policymakers usually focus on oils basic inflation it seems surprising since basic inflation exclude energy prices is that they are characteristically unstable e.g. once increasing rapidly and hitting a record high $145/barrel in July 2008 and then again fall back to $100/barrel in September. Temporary oil prices increase do not intend to pass through the prices of non energy foods and services when the central bank is creditable that is when inflation prospect are well anchored and therefore will not result in higher overall inflation rate.

Core inflation focuses the public attention on this measure is an indicator of what future inflation is going to be like. Those who set the prices and wages can find the core inflation may help in influencing the long run inflation expectations price of oil and exchange rate changes affect inflationary pressure from increase in the prices of oil.

As oil prices stabilize, as they have recent months, the corresponding pressure of inflation will disappear. As a result, both basic and overall measures of inflation may decrease with the overall inflation rate likely decrease towards the lower rate of basic inflation.

For the world inflation, 2010-11 is the most eventful year. The inflation poses serious threats to macroeconomics stability around the world. The worrying thing is that the recent spike in inflation is coming more from food inflation is likely for poverty situation. By ADB study, a 10% rise in flood inflation is llikely to deteriorate peverty situation by 2.7% points. Either increase in aggregate demand or a decrease in aggregate supply, inflation results. These two sources effect price level of an economy. Demand pull inflation arises from many factors like money supply, government expenditures, exports or gross domestic products etc. We can define cost push inflation as increase in general price level resulting from increase in cost of production. The main sources of cost push inflation may be decrease in aggregate supply that may be due to cost of production, increasing wages, higher imports, rising taxes, budget deficit or fiscal deficit.

OBJECTIVES OF STUDY

The basic purpose of this study is to determine the impact of oil prices on the inflation in Pakistan. The purpose of this research is to determine which factors are affecting that results an increase oil prices in Pakistan and how they can be controlled and what step should take to government to control the increase prices and remove the inflation and I hope this research will produce or increase my knowledge.

THEORETICAL FRAMEWORK

Inflation as a key indicator provides important insight on the state of the economy and the sound macroeconomic policies that govern it. A stable inflation not only gives a nurturing environment for economic growth, but also uplifts the poor and fixed income citizens who are the most vulnerable in society. The Government needs to be cautious about inflation and thus has taken various steps to release demand pressures on the one hand and enhance supplies of essential commodities on the other. To ease demand pressures, the State Bank of Pakistan (SBP) has continuously tightened the monetary policy over the last three years and more so in the current fiscal year, while to enhance supplies, the Government has relaxed its import regime. The CPI is the main measure of price changes at the retail level. It indicates the cost of purchasing a representative fixed basket of goods and services consumed by private households. In Pakistan, the CPI covers the retail prices of 374 items in 35 major cities and reflects roughly the changes in the cost of living of urban areas.

The monetary policy in Pakistan aims at stabilizing the domestic and external value of the currency to stabilize economic growth.

The high degree of dependence on oil producing countries and any irregularities in prices and supplies has a pervasive effect for an economy that imports crude oil to cater to its often fragile industry. Following the sharp surge in oil prices since 2003, developing countries that rely heavily on oil imports, are now faced with an increased threat to macroeconomic instabilities, with Pakistan as no exception. This brief note provides an overview of international oil price trends witnessed since 2002. Observations are also made on how domestic furnace and high speed diesel oil price trends move in consonance with the international oil prices. The need to focus on furnace oil and high speed diesel oil prices trends arises from the fact that of the total production by oil refineries of major components of crude oil, diesel constitutes the highest share of 31% with furnace oil comprising the second largest share of 29.4% in Pakistan (2006 to 07 estimates).

DETERMINANTS OF INFLATION

DEMAND PRESSURE

The demand pressure is one of the major determinant of the inflation. It is the combination of expansionary monetary and fiscal policy. The increased domestic demand due to remittances from abroad outpaced the domestic production creating a positive output gap which results an increased in prices and as a result inflation occurs.

GROWING GAP

Secondly the growing gap between domestic demand and domestic production was filled by a sharp rise in net imports. The imports increases more as compared to exports. So as aresult trade deficit occurs. A rising trade deficit results an increase in high prices in future. So the growing gap is one of the indicator if inflation.

FISCAL POLICY

Third, fiscal policy has remained expansionary in the last few years. Expansionary fiscal policy fuels domestic demand and puts pressure on the current account deficit. In other words, it widens the investment-saving gap, which has to be financed externally. Moreover, financing of fiscal deficit through money creation adds to inflationary pressures. On the other hand, government borrowing from the SBP also increased, which again can have serious consequences on the general price level.

MONETARY POLICY

Fourth, the expansionary monetary policy through high growth in money supply and loose credit policy was also believed to be contributing to high inflation. Khan and Axel (2006), using monthly data from January 1998 to June 2005, conclude that the lagged growth of private sector credit and lagged growth of money supply (M2) are two significant causes of inflation in Pakistan in recent years.

EXPANSION OF CREDIT

Although expansion of credit is usual in expanding economies, the credit growth should not be allowed to reach unsustainable limits. The International Monetary Fund [IMF (2004)], through an extensive survey of developing countries, suggests that excessive credit growth in developing countries can have adverse effects on real variables.

RISING IMPORT PRICES

Rising import prices were also considered as an important factor in creating inflation. The exchange rate, if depreciating, in this scenario can also put upward pressure on price levels. Similarly, some people blamed indirect taxes for being the main cause of inflation. The wheat support price has also been identified as an important determinant of inflation in Pakistan by Khan and Qasim (1996) and Hasan et al (1995).

IMPACT ON INFLATION

Higher oil prices directly lead to increase in food prices. As a result there was a substantial increase in head line inflation. The recent need to import food items like wheat, sugar etc and depreciation Pak rupees further led to an increase in food prices. Due to an increase in global oil price and import bill of food group, headline inflation is constantly going upwards. The impact of inflation would have been worse, had the government not offered subsidies in oil products and food commodities. The fig shows the inflation experienced in food prices since 2002-2003 in major groups.

Similarly to other developed countries, Pakistan is facing too much inflationary impact of rising food and oil prices which is due to demand pressure. Soaring oil prices with increased food prices have a negative impact on growth and increase the cost of inputs. Facing from such situation the low income households find it very difficult to protect themselves against inflation especially those living in urban areas.

IMPACT ON THE ECONOMY

Impact on Balance of Payment

The impact of high prices on international oil markets has disturbed the Pakistan economy and also the existing imbalances. The effect of international oil processes remain unlimited until early 2003-2004. This was due to sustainable level of world prices to domestic prices, favorable global conditions and increase in capital inflow. Indeed this can be attributed to increase in international oil prices, which was gradual. The recent increase in oil prices day by day has created a substantial gap between imports and exports in this figure.

Impact on Exports and Imports

Exports have increased by only 72% since 2002-03, whereas imports have increased by 227%. This huge gap results in deficit, which is growing at alarming levels. By the wind of 2007-08, total imports stood at around $40 billion, more than the twice of that exports. The acceleration seen in imports is largely being driven by a surge in international oil prices and the fact is that Pakistan is heavily dependent on oil imports.

This had a negative impact not only in BOP but also possess a threat of industrialization and technological improvements to the manufacturing sectors which results in decorating the exports which as a negative effect on the economy.

However the inflation depends upon the following factors, and the reasons for rising of inflation are as follows:

• Decelerating economic growth
• Loose Monetary policy
• Output set backs
• Higher duties and taxes
• Depreciation of Pakistan rupee
• Frequently adjustment in administered prices of gas, electricity and POL.
• Political instability

LITERATURE REVIEW

Study of impact of oil prices on inflation have been conducted by many macroeconomic economists nationally as well as internationally. These all are different from each other either from country to country, sample size, time period or from selection of variables. In this section, few of them are comprehensively summarized as below;

The Matteo Monera is of the view that sharp increases in the oil prices are generally seen as the major contributor to business cycle. The recent high prices of oil in the international markets cause very problems and also bring possible slowdowns in the economic performance of the most developed countries. The several authors have considered the direct channel of transmission of energy prices increases and the other authors have argued that economic downturn arises from the monetary policy response to the inflation due to increase in the oil prices. In this paper a structured cointegrated VAR model has been considered for G-7 countrieas in order to study the effect of oil prices shocks on output and prices and the reaction of monetary variables to external shocks. The empirical analysis shows that , for most of the countries considered , there seems to be an impact of unexpected oil prices fluctuations on interest rate, suggested a contactionary monetary policy response directed to fight inflation. In turn, increases in interest rates are transmitted to real economy by reducing output growth and the inflation rate.

Similarly, results by Bernanke, Gentler and Watson (1997) clearly support this view explaianing that if, following an oil price shock, the Federal reserve had not increased interest rates, the economic downturns that hit U.S may be largely avoided. In particular, they show that th U.S economy respond differently to an oil price shocks leads to increase in federal fund rate and decline in real GDP. When the federal fund rate is held constant, BGW find that that oil prices shock result an increase in real GDP and of the inflation rate. According to these three authors, these results show that the importance of real effects of oil prices shock due to monetary policy response.

Michael Leblanc is an article discussed the recent rise in oil prices and shrinking of the existing resources. He analyzed that the impact of energy on economic growth is not the same as of all the resources. He assumed that the inflation which is directly related with the oil prices and analyzed the results. Results in his research show that if there is less increase in oil prices then inflation rate rises to a very high proportion. The two things are discussed in this paper. First one is that the effect of increasing oil prices on inflation. And finally he reaches that results that both have positive relationship between oil prices and inflation.

Jockos Rauvata in his article discussed that both inflation and increase in oil prices have positive effect on the economy. He is of the view that when oil prices increases inflation also increases in large proportion as compared to oil prices. He tries to study the relationship between oil prices and inflation and also want to know what are the causes of increase in price. The results shows that there exist positive relationship between oil prices and inflation.

Ramiz ur Rehman; Muhammad Ateeq ur Rehman; Awais Raoof (2010) in their study investigates the relationship between the interest rate, exchange rate and inflation. a simple multiple regression model is applied to see the relationship of inflation and interest rate with exchange rate as inflation and interest rate are taken as independent and exchange rate is taken as dependent variable. a monthly based data is examined for this purpose for Pakistan and united Kingdom. The results of this study reflect that there is a significant positive relation between inflation and exchange rate of UK and Pakistan but significant negative relation of interest rate and exchange rate of Pakistan and UK.

Brown and Yucel, for example, constucted a vector autoregressive (VAR) model of the U.S economy similarly to BGW model and he found that the rise in oil prices shock the economy responds with the reduction in real GDP and rise in interest rates and in the price level. Since the decline in real GDP and the rise in deflator are similar in magnitude, so that nominal GDP remains relatively constant, the findings that confirms to Robert Gordon`s def of the Monetary neutrality- the federal reserve seems to have been neutral to oil price increases. Since they observec taht if the federal fund rate is held constant after an oil price increase in real GDP, the price level and nominal GDP increases , they argued that U,S monetary poicy has probably had no role in worsenig the effect of past oil price shocks.

Atif Ali Jaffri (2009) investigates the exchange rate changes on consumer prices in Pakistan for both short run and long run and find that the exchange rate changes has very little effect on consumer prices in Pakistan. The impact of foreign inflation on domestic inflation is positive and statistically significant. This study is for the period 1995M1 to 2009M3.

Jeannine Bailliu and Eiji Fujii (June 2004) study on the exchange rate pass-through and the inflation environment in industrialized countries It is much different from other studies in the sense that it uses the panel data approach. Panel data set of 11 industrialized countries over the period from 1977 to 2001 is used to check the hypothesis that exchange rate pass-through declines with a shift to a low inflation by a change in the monetary policy. Evidence supports this hypothesis. also pass-through to import, producer, and consumer price inflation declined in many industrialized countries in the early 1990s for inflation stabilization.

Berument and Tasc (2002) investigated effect of oil prices in Turkey and found that when wages and other three factors of income (profit, interest, rent) are to be adjusted to general price level that includes the oil prices increases, the inflationary effect of oil prices become significant.

LeBlanc and Chin (2004) estimate the effect of oil prices on inflation for United States, United Kingdom, France, Germany and Japan using an augmented PHILLIPS CURVE framework. Statistical estimates suggests that current oil process increases likely to have only a modest effect on inflation in the U.S, Japan and Europe. Oil prices increases as much as 10 percentage points will lead to direct inflationary increases of about 0.1-0.8 percentage points in the U.S and E.U. Inflation in Europe traditionally thought to be more sensitive to the oil prices than in U.S is unlikely to show any difference in the sensitivity from than in the united states. He used a Dynamic stochastic general equilibrium model, which is tailored to reflect the characteristics of African economies. He quantified the effect of increase in oil prices on the main macroeconomics variable. Bouakez (2007) argues that high oil prices shocks would lead to an increase in inflation by much greater magnitude under managed than under a fixed exchange rate regime.

The Moses Kipyui in his article discussed the effect of oil prices on inflation. He is of the view that increase in oil prices and inflation are directly proportional to each other. This study approaches the Phillips curve to estimate the pass-through. It is found that oil prices have significant effect on inflation with pass-through of 0.05 in the short run and 0.1 in the long run employing that 10 percent increase in oil prices result 5 percent increase in inflation in the short run and 1 percent in the long run. It is also found that exchange rates have a significant influence on inflation with a pass through of 0.32 in the short run and 0,64 in the long run. The result is that when oil prices increases the inflation increases in the larger extent.

Siddiqui, Rehana; Akhtar, Naeem (December 22, 1999) done a case study of Pakistan in which they see the impact of exchange rate on prices. They want to examine the impact of changes in the monetary and real variables and changes in foreign prices on domestic prices of a country. To check the causality between changes in the exchange rate and domestic prices they applied the unit root test and error correction mechanism. The results of all variables show non stationary. Also they didn’t find any unidirectional or bi directional relationship between the two variables but they find that the money supply and level of activity effects domestic prices. The exchange rate and domestic prices also links with the oil prices shocks and inflation.

According to Kenyan, in his article discussed, he is of the view that oil prices seems to be highly correlated with inflation. The relationship between changes in inflation, changes in oil prices in dollars, changes in oil price in domestic currency and changes in nominal exchange rate. The relationship between these variables seems to be strong which also shows that increase in oil prices have direct effect on inflation. Because the economy is depend on the oil.

Khan and Gill (2010) have focused on the determinants of inflation in Pakistan using different price indicators i-e CPI, WPI, SPI, and GDP deflator. They have adopted time series data from 1971 to 2005 for the analysis. OLS method has been applied for the estimation of values of coefficients. The explanatory variables that are budget deficit, exchange rate, wheat prices, imports and money supply are found to be directly affecting all the price indicators while interest rate is indirectly related to all the explained variable in Pakistan.

Ahmad, Eatzaz; Ali, Saima Ahmed (September 22,1999) determines the simultaneous role of inflation and exchange rate in Pakistan by considering temporary and permanent shocks that how two variables are being adjusted and what is the pattern of two variables in response of these shocks. The shocks which they consider are real and monetary shocks and also the import prices, export prices and foreign exchange reserves. They find that the relationship between the price level and exchange rate is not unidirectional. Movements in the exchange rate occur mostly due to changes in the price inflation thus exchange rate cannot be used as independent instrument in the presence of inflation. Hence, they conclude that both the inflation and exchange rate are the interrelated with each other.

Gregorio, Launderretche and Neilson (2007) find a decline in pass-through from the price of oil to general price level. They find a fall in the average estimated passthrough for industrial economies and lesser degree for emerging economies. The effect of oil shocks on inflation has weakened for most of the twelve countries in the sample. Among the factors that might help to explain this decline in the reduction of oil intensity of economies. Around the world , a reduction in exchange rate pass-through, a more favorable inflation environment and the fact that current oil price shock is largely the result of strong demand. These factors help to explain why oil shocks had limited inflationary effects. Chen (2009) uses data for 19 industrial countries and a state space approach to estimate time varying oil price pass-through coefficients and find evidence of declling pass-through of almost 19 countries. The study investigated some potential explanations for pass-through and concludes that an appreciation of domestic currency, a more active monetary policy in response to inflation and a high degree of trade openness are major causes of declining oil pass-through.

Laryea and Sumaila (2001) have examined the major determinants of inflation in Tanzania. For this analysis, they have udes time series data from 1992-1998 on quarterly basis. OLS method has been applied to have this estimates. The analysis demonstrates that money supply and exchange rate have positive impression on inflation (CPI) while GDP has negative impact on inflation of Tanzania.

MODEL SPECIFICATION, METHODOLOGY

AND DATA COLLECTION

To examine the effect of inflation on oil prices, this paper utilizes a regression approach to see whether there exists any relationships between the variables or not. The model is based on these variables:

• Inflation Rate
• Oil Prices
• Money supply
• Real Effective Exchange rate
• Unemployment

Data

In this study the annual data for the period 1980 to 2010 is used. Time series data is used here for analysis.

Data Sources

And the main sources of data are

• WDI : World Development Indicator
• IFS: International Financial Statistics

Regression Methodology

To analyze the impact of oil prices on inflation in Pakistan, I used the annually data from 1980 to 2010. The price of oil and inflation are often seen as being connected in a cause and effect relationship. As oil prices move up or down, inflation follows in the same direction. The reason why this happens that oil is a major input in the economy, it is used in critical activities such as fueling transportation and heating homes and if input cost increases , so should the cost of end products. Inflation and Exchange rate also shows positive relationship, as it plays a very vital role in determining the monetary policy. So, it’s very necessary to control the inflation to safeguard the economy. According to the Quantity Theory of Money, when money supply increases, the price level increases which results in inflation. The quantity theory of money states that there exists positive relation between the quantity of money in an economy and price level of goods and services sold out. According to this theory, if the money quantity in an economy doubles, the price level will also be doubled and then it causes the inflation. That’s why consumer pays twice for the same amount of the good or service.

Monetarists say that a speedy rise in the supply of money leads to a swift rise in inflation. Money growth that surpasses the economic output growth causes inflation as there is much excessive money left behind for too little production of goods and services. In order to control the inflation, money growth must fall below economic output growth.

During the procedure of planning and decision making in any empirical analysis related to economics, regression technique helps a lot as it tackles the problem of uncertain circumstances and helps to understand the nature of relationship between underlying variables and in model building.

In this paper for regression analysis OLS Regression analysis is used because of its mathematical simplicity and its results are also very simple and easy to understand.

Model Specification

In this part the specification of the appropriate method for the analysis is necessary in order to prove that wheather the oil prices is going to affect the inflation rate in the economy, for this we need to develop a particular model for it. Following from the discussion and theoretical literature, the equation can be summarized as follows,

inf = β0 + β1 inft-1 + β2 opt + β3 reer+ β4ms+ β5un+ εt

Where,

inf = Difference of Inflation determined by CPI

ms = Difference of Money Supply M2

op = difference of yearl oil prices

er = Difference of exchange rate

un= Difference of unemployment

εt= Error term

Where εt is the white noise disturbance term following the assumptions of classical linear regression model.

Usually the data is non-stationary. For the purpose of testing for the stationary of data and determination of the order of integration of each variable, the Augmented Dickey Fuller (ADF) test of Unit Roots [Dickey and Fuller (1979, 1981)] is performed on the univariate time series. Phillips and Perron (PP) test for unit root is also performed which is similar to ADF test .

EMPIRICAL RESULTS

Test for Stationarity

The data are transformed into the logarithmic form on the basis of preliminary analysis. This transformation reduces the variability of variance of the data. At the first step, the ADF and Philips Perron unit root tests is applied to all the variables to test for the stationarity of these variables. The test is applied to both the original series (in log form) and to the first differences. The results, indicate that all the series are non-stationary at their level, that is they are random walk series. They become stationary after employing difference operator of degree one. That is, these series are integrated of order one, I (1).

The ADF unit root test can be represented by the following equation

Where X is the any variable in the model to be tested for unit root and εt is the purely white noise error term.The test is based on the null hypothesis, (H0) : Xt is not I(0), If calculated ADF statistic is less than the critical values from Fuller’s table , then the null hypothesis (H0) is rejected and the series are stationary . Phillips and Perron (PP) unit root test results are also presented.

The results for the unit root tests are given below,

RESULTS AND DISCUSSION

The above table shows that there exists a positive relationship between inflation and oil prices. The value of r2= 0.90 whisch shows that 90% of the variations in inflation is determined by oil prices and other variables. So this regression line fits the data very well. The estimated coefficient of inflation is 0.531%, this shows that inflation increase by 0.53% if the oil prices increase by 1%. There are many other factors which depends on the inflation. The relationship between inflation and money supply is positive and the relation between inflation and unemployment is negative because of the Phillips Curve.

CONCLUSION

In this paper, we use a regression model on annual data from 1980 to 2009. The finding of the paper suggests that

The oil prices have a significant effect on inflation especially in the case of CPI.

Results show that there is an impact of oil prices on inflation.

It is revealed that the inflation rate is determined by the oil prices, real effective exchange rate, and money supply It is observed that even the prices of oil rises, the inflation rises more as compared to oil prices. The result is in line with the results of Qayyum (2001) regarding the significance and importance of the determinants of money demand in Pakistan. The most striking result is the high coefficient of inflation rate. The dominant role of inflation rate in affecting real M2 demand implies that economic agent prefer to invest in the real sector rather than to hold money. Furthermore, the high coefficient of the rate of inflation suggests that a one percentage point increase in inflation results in a 13 percent decrease in real M2. Therefore, it implies that the variability of inflation make the M2 targeting in Pakistan very difficult.