Abstract:
This study examines inflation and the choice of monetary policy regime in Pakistan.
Using the annual series of 1970-71 to 2008-09 and the monthly series of 1990:M1-
2007:M9, the study employs unstructured VAR, Time Varying Parameter and State
Space models for understanding the dynamics of inflation and monetary policy in
Pakistan. It is observed that the Consumer Price Index (CPI), the official measure of
inflation in Pakistan, has not only an upward bias but also has methodological
deficiencies. Further, the study investigates the direction of causation between the CPI,
money supply, exchange rate, interest rate, oil prices, and fiscal deficit to conclude that
there exists bidirectional causality between the CPI and call money rate. Analysis of
determinants of inflation shows that inflation in Pakisan is monetary in nature: inflation,
interest rate and money supply move together. The study then goes on to find that
inflation generates negative shocks and it can, therefore, hamper growth. It infers that
there is no evidence of the accelerationist hypothesis in Pakistan. Furthermore, it is
shown that forward-looking expectations of households and businesses play an
important role in causing inflation in the country. In this context, the study provides
information on the issue of volatility and uncertainty arising from unstable monetary
rules. It confirms that the State Bank of Pakistan does not have an aggressive policy for
controlling inflation and minimzing output gap. The study thus seeks to contribute to the
debate on discretionary versus rule-based monetary policy to explore what suits best the
case of Pakistan. It also comments on the choice of instruments for controlling inflation.
Finally, the study concludes that the fact that Pakistan has faced a volatile but moderate
inflation rate in the period under review makes her a potential candidate for inflation
targeting.
