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Pakistan Monetary policy effectiveness in controlling inflation

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 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 and the central banks are committed to the low inflation. Hence the central banks have adopted inflation as the main focus of monetary policy, targeting inflation explicitly or implicitly as and when required.


The objective of the thesis is 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 thesis will examine that whether the monetary policy adopted has been effective to control the rate of inflation. In my thesis I would like to analyze the money supply and inflation rates in Pakistan in order to prove the hypothesis.


Hypothesis 1

Null Hypothesis: Monetary policy is effective in controlling inflation in Pakistan.

Alternative Hypothesis: Monetary policy is not effective in controlling inflation in Pakistan.

Hypothesis 2

Null Hypothesis: Inflation is a monetary phenomenon.

Alternate Hypothesis: Inflation is not a monetary phenomenon.


This paper examines the role played by the monetary policy in controlling prices. Whether the policy makers have been successful in predicting the behavior of prices effectively or not. For this purpose the model is considered having monetary variables like monetary assets and monetary expansion and inflation as a dependent variable. The model is estimated for the period of 1950-2005. It tries to measure the effective of monetary policy during different regimes.

The results indicate that correlation between monetary assets and inflation is not that strong for Pakistan which means that the monetary policy has not been that effective in predicting the price movements in Pakistan. There is a strong need for adjustments by the policy makers.

Another result that I got from the study is that monetary expansion and inflation are related significantly and they tend to determine the direction of one another at times but inflation is also related to other factors.

These days economies of all countries whether underdeveloped, developing as well developed suffers from inflation. Inflation or persistent rising prices are major problem today in world. Because of many reasons, first, the rate of inflation these years are much high than experienced earlier periods. Second, Inflation in these years coexists with high rate of unemployment, which is a new phenomenon and made it difficult to control inflation.

Economic policies tend to increase the general public welfare and monetary policy supports this broad objective by focusing its efforts to promote price stability. The objective of monetary policy in Pakistan, as laid down in the SBP Act of 1956, is to achieve the targets of inflation and growth set annually by the Government.

In recent years money supply increased rapidly and some researchers thought this increase in money supply was going to translate quickly into inflation. But inflation did not grow much and empirical evidence shows that shocks to the petrol and meat supply mainly affected inflation.

In the long-run the relationship between money supply and price is very strong and

their correlation is almost one. Lucas (1995) emphasized the long-term relationship

between money and prices in his Nobel Prize lecture by mentioning McCandless and

Weber (1995).

For the short-term relationship, empirical evidence of relationship between money growth and inflation is weak and unclear. A variety of studies on money demand yield very dissimilar results. As result, it is difficult to establish a straight relationship between these two variables in the short-term.

This paper tries to measure the relationship between money growth and inflation for

Pakistan. The paper consists of following sections: Introduction, The need to control inflation and the monetary policy in Pakistan, Literature Review, Empirical results, conclusion and recommendations.

The need to control inflation

Price stability is key to long run growth prospects. Effective management and prediction inflation expectations is required to ensure that the prices are stable. With stable prices, economic decisions can be made with less uncertainty and therefore markets can function without concern about unpredictable fluctuations in the purchasing power of money.

On the other hand, high and unanticipated inflation lowers the quality of the signals coming from the price system as producers and consumers find it difficult to distinguish price changes arising from changes in the supply and demand for products from changes arising from the high level of general inflation. High inflation lowers the effectiveness of the market system.

High and unanticipated inflation makes it impossible to plan for relatively longer outlook, creating incentives for households and firms to shorten their decision horizons and to spend resources in managing inflation risks rather than focusing on the most productive activities.

The competing goals of growth and price stability, which may seem to be at odds

with each other, in fact boils down to a single objective i.e. price stability. In this backdrop,

there is no surprise that most of the central banks aim at maintaining low and stable inflation.

Central banks place more weight and demonstrate increased willingness on controlling

inflation relative to output growth, and financial and exchange rate stability.

Effectiveness of monetary policy in Pakistan

Generally, historical evidence does reflect that Pakistan has been a high inflation and high

interest economy given its inherent structural weaknesses. The role and effectiveness of

monetary policy appears more visible in the 2000s when financial sector reforms started

bearing fruits in terms of a more market based money and foreign exchange markets.

Entering the 21st century, the loose monetary policy stance in the face of low inflation, low

growth and low twin deficits, along with structural measures to open up the economy and

alleviate some first round constraints, triggered the economy on a long term growth trajectory of above 7 percent.

Monetary policy stance was however altered as the inflationary pressures started to build up in 2005. At the end of the fiscal year, the economy, which had been showing sustained

steady growth since FY01, registered a historically high level of growth (9 percent), average inflation rose sharply (9.3 percent) and the external current account balance turned into deficit (-1.4 percent of GDP).

Coinciding with these developments, the fiscal module started to show signs of stress as the fiscal balance was converted into a deficit and the stock of external debt and liabilities, which had been declining since FY00 after the Paris Club rescheduling, began increasing. These indicators largely capture the high and growing aggregate demand in the economy on account of sustained increase in peoples’ income.

With the emerging domestic and global price pressures, SBP tightened its monetary policy

after a prolonged gap of a few years. The efforts to rein-in inflation, however, proved less

effective due to a rebound in international commodity prices and a rise in domestic food

bearing fruits in terms of a more market based money and foreign exchange markets.

Entering the 21st century, the loose monetary policy stance in the face of low inflation, low

growth and low twin deficits, along with structural measures to open up the economy and

alleviate some first round constraints, triggered the economy on a long term growth trajectory of above 7 percent.

Realizing the complications of monetary management and adverse global and domestic

economic developments, the implementation of SBP monetary policy during FY06 varied

significantly from the preceding fiscal years. In addition to the rise in the policy rate, the

central bank focused on the short-end of the yield curve, draining excess liquidity from the

inter-bank money market and pushing up short-tenor rates. Consequently, not only did the

overnight rates remain close to the discount rate through most of the year, the volatility in

these rates also declined. These tight monetary conditions along with the Government’s administrative measures to control food inflation helped in scaling down average inflation from 9.3 percent in FY05 to 7.9 percent in FY06, within the 8.0 percent annual target.

For FY07, the government set an inflation target of 6.5 percent. To achieve this, a further moderation in aggregate demand during FY07 was required as the core inflation witnessed a relatively smaller decline in FY06, indicating that demand-side inflationary pressures were strong. In this perspective, SBP further tightened its monetary policy in July 2006 raising the CRR and SLR for the scheduled banks; and its policy rate by 50 basis points (bps) to 9.5 percent. Moreover, proactive liquidity management helped in transmitting the monetary tightening signals to key interest rates in the economy. For instance, the Karachi Inter Bank Offer Rate (KIBOR) of 6 month tenor increased from 9.6 percent in June 2006 to 10.02 percent at end-June 2007 and the banks’ weighted average lending and deposits rates (on outstanding amount) increased by 0.93 percentage points and 1.1 percentage points, respectively, during FY07.

In retrospect, it appears evident that monetary tightening in FY07 did not put any adverse

impact on economic growth, as not only was the real GDP growth target of 7.0 percent for

FY07 was met; the growth was quite broad based. At the same time, the impact of the

monetary tightening was most evident in the continued deceleration in core inflation during FY07. One measure of core inflation, the non-food non-energy CPI, continued its downtrend from YoY high of 7.8 percent in October 2005, to 6.3 percent at end-FY06, and to 5.1 percent by the end of FY07. However, much of the gains from the tight monetary policy on overall CPI inflation were offset by the unexpected rise in food inflation.

On the downside, however, broad money supply (M2) grew by 19.3 percent during FY07,

exceeding the annual target by 5.8 percentage points. Slippages in money supply growth

largely stemmed from an expansion in NFA due to the higher than expected foreign

exchange inflows.

The pressure from the fiscal account was due to mismatch in its external budgetary inflows and expenditures. With the privatization inflows and the receipts from a sovereign debt offering at end-FY07, the Government managed to end the year with retirement of central bank borrowings, on the margin. By end-FY07, SBP holdings of government papers were still around Rs 452 billion, despite a net retirement of Rs 56.0 billion during the year. Another major aberration in FY07 emanated from the high level of SBP refinancing extended, for both working capital and long-term investment, to exporters. Aside from monetary management complexities, these schemes have been distorting the incentive structure in the economy.

FY08 was an exceptionally difficult year. The domestic macroeconomic and political

vulnerabilities coupled with a very challenging global environment caused slippages in

macroeconomic targets by a wide margin.

After a relatively long period of macroeconomic stability and prosperity, the global economy faced multifarious challenges: (i) hit by the sub prime mortgage crisis in U.S in 2007, the international financial markets had been in turmoil, the impact of which was felt across markets and continents; (ii) rising global commodity prices, with crude oil and food staples prices skyrocketing; and (iii) a gradual slide in the U.S dollar against major currencies. Combination of these events induced a degree of recessionary tendencies and inflationary pressures across developed and developing countries. Policy-makers were gripped with the dual challenge of slowdown in growth and unprecedented rising inflationary pressures.

The external current account deficit and fiscal deficit widened considerably to unsustainable level (8.4 and 7.4 percent of GDP). The subsidy payments

worth Rs 407 billion by Government, which account for almost half of the fiscal deficit,

shielded domestic consumers from high international POL and commodity prices and

distorted the natural demand adjustment mechanism. While the government passed on price increase to consumers, the rising international oil and other importable prices continued to take a toll on the economy.

Rising demand has cost the country dearly in terms of foreign exchange spent on importing

large volumes of these commodities. Rising fiscal deficit and lower than required financing

flows resulted in exceptional recourse of the Government to the highly inflationary central

bank borrowing for financing deficit. At the same time the surge in imports persisted.

As a result, inflation accelerated and its expectations strengthened due to pass through of

international oil prices to the domestic market, increases in the electricity tariff and the

general sales tax, and rising exchange rate depreciation. These developments resulted in a

further rise in headline as well as core inflation (20 percent weighted trimmed measure) to 25 percent and 21.7 percent respectively in October 2008.

Considering the size of macroeconomic imbalances and the emerging inflationary pressures, SBP remained committed to achieve price stability over the medium term and thus had to launch steeper monetary tightening to tame the demand pressures and restore macroeconomic stability in FY09. SBP thus increased the policy rate from 13.5 to 15 percent.

Literature Review

If inflation is considered as a monetary phenomenon then it is the responsibility of the central bank and the fiscal authorities to achieve price stability. If inflation is caused primarily by food price increases, it would appear that the Ministry of Agriculture should play a key role in containing inflation.

Analysis of Money, Inflation and growth in Pakistan (Abdul Qayyum) shows that excess money supply growth has been an important contributor to the rise in inflation in Pakistan during the study period, the study used Correlation analysis with the Country of study being Pakistan.

In my research I will try to find the correlation between the monetary assets and inflation, and determine whether the policy makers have been successful to use monetary assets as a measure to predict interest rates.

Economic Growth, Inflation, and Monetary Policy in Pakistan: Preliminary Empirical Estimates AHMED M. KHALID*states the State Bank of Pakistanis also under pressure to discuss and design a policy that could provide a stable and sustainable economic growth as well as address the necessary conditions to be part of the global economy.

Is Inflation in Pakistan a Monetary Phenomenon (M. ALI KEMAL) finds that an increase in money supply over the long-run results in higher rate of inflation and thus provides support for the quantity theory of money. It establishes that inflation is essentially a monetary phenomenon. However, the money supply does not instantly influence the price levels; the impact of money supply on inflation has a considerable lag of about 9 months. While the study shows that the money supply works through the system in less than a year, it also points out that the system takes rather long to converge to equilibrium if shocks appear in any of the three variables, viz., GDP, money supply, and prices.

Primary objective of this research is to check the long-run relationship and short-run dynamics between the money and inflation. In the long run money supply impacts the inflation rates. QTM holds in the long Run, which implies that inflation is a monetary phenomenon. In the short run, the impact of money on inflation is not instant; it affects inflation with lags of about 3 quarters.

In the long-run the relationship between money supply and price is very strong and

their correlation is almost one. Lucas (1995) emphasized the long-term relationship

between money and prices in his Nobel Prize lecture by mentioning McCandless and

Weber (1995).

Certainly in the long run, inflation is considered to be-as Friedman (1963) stated-always and everywhere a monetary phenomenon. However, other authors have pointed to supply-side developments in explaining inflation. This structuralist school of thought holds that supply constraints that drive up prices of specific goods can have wider repercussions on the overall price level.

In Pakistan, increases in the wheat support price have been blamed for inflation. As such, the question “money or wheat” is not merely academic, but has profound implications for economic policy. If inflation is a monetary phenomenon, it is the responsibility of the central bank and the fiscal authorities to achieve price stability. If inflation is caused primarily by wheat support price increases, it would appear that the Ministry of Agriculture should play a key role in containing inflation.

In this paper, I would study the relationship between inflation and monetary expansion, to prove that it is not entirely a monetary phenomenon but it is affected by other factors as well.

Data Sources and limitations

The data covers the period 1950-2005 on a yearly basis. The choice of sample enables us to study the long run relationship between money supply and inflation and short run effects. The period covers the whole monetary policy stance under different rules, and then we also analyze it in periods of different economic growth. We use annual data from 1949-50 to 2004-2005 to investigate the relations between money and prices in Pakistan.

The principal data source is 50 Years of Pakistan in Statistics; prepared by the Federal Bureau of Statistics. The other data sources include the regular issues of Economic Survey by Finance Division and Monthly Bulletin by State Bank.

Before proceeding further, i would like to point out that the analysis is based on fifty years of Pakistan during which the country has undergone a series of economic and political changes. In particular, there have been significant improvements in the monetary sector as well as its impact on economy in the 1990’s.


The tests used will be



Graphical Analysis


The model used would analyze the inflation against two variables of money supply monetary expansion and monetary assets.

Money supply is considered as independent variable.

Inflation is considered as dependent variable.

Empirical Results

Correlation test

The correlation between monetary assets and inflation during entire 50 year periods has been as such

For a perfect correlation the correlation coefficient should have been + 1 but in this case the correlation coefficient is coming out to be 0.034 which is very near to 0 which shows that the monetary policy is not being effective in predicting the rates of inflation.

In the long run money supply is able to determine inflation but in short term it is determined much by the other factors of economy. The linear relationship between monetary assets and inflation is not that strong. There is small correlation which means in the long run it is effective but not in the short run.

For effective monetary policy the correlation between money supply and inflation should be one but here the correlation is much less and is nearer to O.

Regression Test between monetary assets and inflation

This table displays R, R squared, adjusted R squared, and the standard error. R is the correlation between the observed and predicted values of the dependent variable. The values of R range from -1 to 1. The sign of R indicates the direction of the relationship (positive or negative). The absolute value of R indicates the strength, with larger absolute values indicating stronger relationships.

R squared is the proportion of variation in the dependent variable explained by the regression model. The values of R squared range from 0 to 1. Small values indicate that the model does not fit the data well. Here the model doesn’t fit the data well the R square is very small.

The larger the F The larger the F (the smaller the p-value) the more of y’s variation the line explained so the less likely H0 is true. We reject when the p-value < ¡.

The F statistic is the regression mean square (MSR) divided by the residual mean square (MSE). If the significance value of the F statistic is small (smaller than say 0.05) then the independent variables do a good job explaining the variation in the dependent variable. If the significance value of F is larger than 0.05 then the independent variables do not explain the variation in the dependent variable. Here the F value is greater that 0.05 which means it is not explaining the dependent variable.

Inflation= 6.504 + 0.00* monetary assets

The beta coefficient tells how strongly independent variable is related with dependent variable. R2 is a statistic that will give some information about the goodness of fit of a model. In regression, the R2 coefficient of determination is a statistical measure of how well the regression line approximates the real data points. An R2 of 1.0 indicates that the regression line perfectly fits the data. The variation explained by monetary assets in inflation is not much which tells us that the policy has not been that effective. The correlation between the monetary assets and the inflation has not been much significant.

Monetary expansion and inflation has significant relationship and at times one determine the other this means that we have to accept hypothesis that it is a monetary phenomenon but add that it is affected by other factors as well like oil and food prices.

Why Inflation is alarming and needs to be controlled

High and persistent inflation is a regressive tax adversely impacting the poor and economic prospects. The poor hold few real assets or equity, and their savings are typically in the form of cash or low-interest bearing deposits; this group is most vulnerable to inflation as it erodes savings. Moreover, high and volatile inflation has been found to be detrimental to growth and financial sector development. High inflation obscures the role of relative price changes thus inhibiting optimal resource allocation.

Inflation hurts growth once it exceeds a certain threshold. A number of empirical studies have established that the relationship between inflation and growth is nonlinear. At low levels of inflation, inflation has either no impact or a positive impact on growth. However, once inflation exceeds a certain threshold, it has an adverse impact on long-run growth.

High inflation also inhibits financial development. Financial market institutions

are intermediaries that reduce frictions between savers and investors (including

adverse selection, moral hazard, or conflicting time preferences). Inflation makes

this intermediation more costly because inflation tax lowers long-run real returns.

As a result, credit is rationed and financial depth is reduced. As in the case of

growth, there appears to be a threshold beyond which inflation adversely affects

financial sector developments, while there are no negative effects at low levels of


The adverse effect of inflation on financial development is one mechanism by which inflation can hurt growth. For example, Loayza and Ranciere (2005) find a positive long-run relationship between financial development and growth in a sample of 75 countries.

In Pakistan, periods of low inflation are associated with high growth rates and vice

versa. Between 1978 and 1991, inflation was 8 percent on average and real per capita growth averaged 3 percent. Between 1992 and 1997, inflation increased on average to 11 percent, while real per capita growth fell substantially and averaged only 1 percent.

Finally, between 1998, inflation was reduced again to an average of 5 percent, and

real per capita growth displayed a dramatic recovery. Of course, there are other

factors that determine growth in the short-run and in the long-run [e.g. van Rooden

(2005)]. Nonetheless, Pakistan’s growth performance has been best when inflation

was contained to 8 percent or lower.


Hypothesis 1

Null Hypothesis: Monetary policy is effective in controlling inflation in Pakistan.

Alternative Hypothesis: Monetary policy is not effective in controlling inflation in Pakistan.

Result: Reject Null Hypothesis and Accept Alternate Hypothesis.

Hypothesis 2

Null Hypothesis: Inflation is a monetary phenomenon.

Alternate Hypothesis: Inflation is not a monetary phenomenon.

Result: We accept our hypothesis but add here that inflation in Pakistan is not entirely a monetary phenomenon, it is a monetary phenomenon in long run, but in short run it is affected by other factors as well like food and oil prices.

The rejection of first hypothesis shows that there need to be steps taken by policy makers to combat the inflation rates. The empirical results presented in this paper show that monetary factors determine inflation in Pakistan. Broad money growth and private sector credit growth are the key variables that explain inflation developments with a lag of around 12 months. A long-run relationship exists between the CPI and private sector credit. The food price affects inflation in the short run, but not in the long run.


The following areas need attention and are key for effective monetary


Effectiveness of monetary and fiscal coordination would be helpful.

For effective analysis of developments and policy making, timely and quality

information is extremely important. Information is not available with desired frequency and timeliness. Also there are concerns over the quality of data. Unlike many developed and developing countries, data on quarterly GDP, employment and wages, etc. is not available in case of Pakistan. Moreover, the data on key macroeconomic variables is usually available with substantial lags. This constrains an in-depth analysis of the current

economic situation and evolving trends, and hinders the ability of the SBP to

develop a forward-looking policy stance.

Unlike many countries, both developed and developing, there is no prescribed limit

on government borrowing from SBP. Borrowing from the central bank injects liquidity in the system through increased currency in circulation and deposits of the government with the banks. In both cases, the impact of tight monetary stance is diluted as this automatic creation of money increases money supply without any prior notice. Improve the effectiveness of monetary policy is to prohibit the practice of government borrowings from the SBP.

Another issue is to make a clear distinction between exchange rate management

and monetary management. It is impossible to pursue an independent monetary and exchange rate policy as well as allowing capital to move freely across the border. Since the SBP endeavors to achieve price stability through achieving monetary targets by changes in the policy rate, it is not possible to maintain exchange rates at some level with free capital mobility. This can only be achieved by putting complete restrictions on capital movements, which is not possible. SBPs responsibility is to ensure an environment where foreign exchange flows are driven by economic fundamental and are not mis-guided by rent seeking speculation.

In conclusion, it is imperative that above steps be taken urgently. Over the period, however,

this needs to be complemented with much deeper structural reforms to synchronize and

reform the medium term planning for the budget and monetary policy formulation process.

Several studies and technical assistance have provided extensive guidance in this area, but

the lack of capacities and short term compulsions have often withheld such reforms. What is important is to recognize that a medium term development strategy, independently worked out, would help minimize one agency interest which has often been a source of coordination difficulties. It would also help the budget making process more rule based than the incrementally driven process to satisfy conflicting demands.

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