Is Is Inflation a fiscal Inflation a fiscal phenomenon in Pakistan?phenomenon in Pakistan?

By

Hamna AhmedDepartment of Economics,

University of Warwick.

To answer this question we will To answer this question we will be looking at the following be looking at the following variables:variables:

Fiscal deficits Fiscal deficits

D = G – t

Seiniorage Seiniorage S = M – M(-1)/P

Price levelPrice level

MotivationMotivation

Inflation in Pakistan:Inflation in Pakistan:PersistentPersistent

Ever-increasingEver-increasing

A serious challengeA serious challenge

ObjectiveObjective

A simple model has been designed to assess:

Direct Impact of d on p: d aggregate demand p

Indirect Impact of d on p: d s by printing money p

A Step-wise ApproachA Step-wise Approach

Step IStep IA preliminary model – any meaningful A preliminary model – any meaningful long-run relationship between deficit & long-run relationship between deficit & seiniorage?seiniorage?

Step IIStep IIThe final model – all three variables tested The final model – all three variables tested jointlyjointly..

Channel 1 Channel 1 direct direct

Channel 2 to 3 Channel 2 to 3 indirect indirect

32Fiscal Deficits

InflationSeigniorage

Direct & Indirect Impact Direct & Indirect Impact illustratedillustrated

1

MethodologyMethodology

Johansen approach to co-integration Johansen approach to co-integration analysisanalysis

Interested in long-run dynamics Interested in long-run dynamics only only

because…. because…. DataData – annual time series,– annual time series,

Sample period: 1956 – 2005,Sample period: 1956 – 2005,

Source: IFS repository.Source: IFS repository.

Model SpecificationModel Specification

Model Specification – log-linearModel Specification – log-linear

p = α + β* d + γ*s + µwhere:

p = ln(P)d = ln(G - )s = ln(Ṁ/P) = ln(Ṁ) – ln(P)β= elasticity of p w.r.t deficitsγ = elasticity of p w.r.t. seigniorage

Preliminary Model – Preliminary Model – Estimation Estimation

The following VAR modeled to discern a long-The following VAR modeled to discern a long-run relationship between deficit and run relationship between deficit and seigniorage:seigniorage:

y(t) = μ + ∏(1)y(t-1) + ∏(2) y(t-2) + ℮(t)y(t) = μ + ∏(1)y(t-1) + ∏(2) y(t-2) + ℮(t)

wherewhere

y(t)′ = (y(1t), y(2t))y(t)′ = (y(1t), y(2t))

y(1t) = seinioragey(1t) = seiniorage

y(2t) = deficity(2t) = deficit

℮ ℮ (t) ′ = (℮(1t), ℮(2t)(t) ′ = (℮(1t), ℮(2t)

Preliminary Model – Results Preliminary Model – Results

Johansen approach yields a stable long-run Johansen approach yields a stable long-run relationship between deficit and seiniorage given relationship between deficit and seiniorage given by:by:

s = 0.447d + residuals = 0.447d + residual (C1)(C1)

To finance a 1% increase in fiscal deficit in the To finance a 1% increase in fiscal deficit in the long run, seigniorage would increase by 0.447% long run, seigniorage would increase by 0.447%

on average, on average, ceteris paribusceteris paribus..

The Final Model – Results The Final Model – Results Again a VAR estimatedAgain a VAR estimated

The Johansen procedure yields a stable long-run The Johansen procedure yields a stable long-run relationship at 5% level of significance:relationship at 5% level of significance:

p = 0.0349d + 1.1535s + residualp = 0.0349d + 1.1535s + residual (C2)(C2)

A 1% increase in deficit increases expected inflation by A 1% increase in deficit increases expected inflation by 0.0349% 0.0349% ceteris paribus.ceteris paribus.

A 1% increase in seigniorage increases expected inflation A 1% increase in seigniorage increases expected inflation by 1.1535% by 1.1535% ceteris paribusceteris paribus. .

Summary & FindingsSummary & Findings

In Pakistan, inflation is highly elastic to monetary In Pakistan, inflation is highly elastic to monetary expansion:expansion: a a 1% 1% in seiniorage (money creation) in seiniorage (money creation) 1.15%1.15% price hike, price hike, ceteris paribus.

Direct impact of d on pDirect impact of d on p::

a 1% in deficits 0.0349% in expected inflation, in expected inflation, ceteris paribus.

Indirect impact of d on pIndirect impact of d on p:: a 1% in deficits 0.447% in seiniorage in seiniorage 0.516% price hike, 0.516% price hike, ceteris paribus.

Policy ImplicationPolicy Implication

FISCAL ADJUSTMENT IS FISCAL ADJUSTMENT IS NECESSARYNECESSARY

FOR UNDERTAKING A FOR UNDERTAKING A

PRICE STABILIZATION POLICY PRICE STABILIZATION POLICY

IN PAKISTANIN PAKISTAN

ConclusionConclusion

Apparent cause of inflation may be Apparent cause of inflation may be monetary but true dynamics of macro-monetary but true dynamics of macro-economic instability go deeper - economic instability go deeper - persistence of fiscal deficit financed persistence of fiscal deficit financed largely if not entirely by seiniorage.largely if not entirely by seiniorage.

Effective stabilization policy must be Effective stabilization policy must be designed in accordance.designed in accordance.