IMPACT OF INTEREST RATE, TRADE DEFICIT AND IMPORT PRICES ON INFLATION IN PAKISTAN

IMPACT OF INTEREST RATE, TRADE DEFICIT AND IMPORT PRICES ON INFLATION IN PAKISTAN
Business Graduate, Iqra University, Gulshan Campus

Abstract
State Bank of Pakistans expansionary economic policies has resulted in great economic performances but it has also made Consumer Price Index to rise. This event has again triggered the debate on inflation and its determinants. Some researchers put the blame of inflation on monetary and fiscal policies, imports, mismanagement and administered prices. This paper investigates the determinants of Inflation in Pakistan by adopting an economic framework and using data from 1999 to 2010. Regression analysis was applied to find correlation and the results indicate that the significant determinant of inflation in this period are import prices and trade deficit, where as affects of interest rate proved to be insignificant. Keywords: Inflation, interest rate, imports, determinants, Pakistan

1.1 Introduction:
Policy makers of macroeconomics always aim to have an economy that is sustainable in its growth and has low inflation. That is why; inflation is one of the topics which have been researched a lot in past years. Inflation has serious impacts on an economys growth and income distribution. When inflation is high, prices become high and the variability in prices becomes frequent which brings uncertainty for future. People when investing in projects are uncertain about the profits in inflation. Hence, society becomes conserve and people avoid and restrain themselves from investing in order to prevent risks. This lower level of investment effects the growth of the economy. Moreover it also impacts exports of that country because the exports become costly. It will also disturb the tax system and effects lender and borrowers profit. In order to deal this situation, companies will need more resources. One of the reasons behind inflation is considered to be the increasing prices of imports. It is also believed that when currency depreciates prices become higher. Likewise, indirect taxes are also believed to be related with it. If inflation rises due to any of the believed reason, it will affect the poor badly. In inflation, the poor is not able to save anything after spending on just food. Fixed income earners suffer and those with variable pays enjoy profits. In long run, excess supply of money is one of the main causes of inflation. But other factors such as monetary and fiscal policies and structural problems also contribute to inflation. 1 Inflation is not a solitary phenomenon but it affects other inter-related economic sectors of Pakistan. Hyperinflation is more disastrous as it impacts the growth of economy drastically. Due to less domestic production and more demand, imports are increasing. This imports grew to 40 % in 2005. As compared to imports, Pakistans exports is increasing very slowly that is why Pakistan is in trade deficit. This trade deficit can cause inflation in long term. In short run, financing this deficit does not cause any problem but if this trade deficit continues to grow then it will severely affect the economy and its growth in long run.

1 Khan and Schimmelpfennig, (2006)

4 Depreciating Pakistani Rupees or exchange rate is also considered to be a reason for inflation. Exchange rate means rupees per dollar. In current scenario Pakistani Rupee is depreciating causing cost of imports to increase. When cost of imports increases, prices of goods also increases causing inflation. Interest rates also effects inflation because it is the price of money. When borrowers lend money they take its price in the form of interest rates. If the interest rates set by the State Bank of Pakistan are high then it means money is expensive and so it will be short in supply lowering inflation up if it is cheaper because of low interest rates then supply of money will increase causing inflation. Interest Rate (as % of GDP) 6.8 5.9 6.1 4.8 4 3.4 3.4 4.4 5.1 5.2 4.3 Trade Deficit (as % of GDP) 1.76 0.41 0.53 1.23 4.12 6.67 6.76 9.12 13.5 5.8 3.8

Year 1999-000 000-2001 2001-2002 2002-2003 3003-2004 2004-2005 2005-2006 2006-2007 2007-2008 2008-2009 2009-2010

CPI (Growth %) 3.58 4.41 3.54 3.1 4.57 9.28 7.92 7.77 12 22.35 11.49

Import prices(growth) 9.3 4.07 -3.63 18.18 27.59 32.11 40.15 8.92 30.86 -12.87 -3.89

1.2 Historical Data:

Source: Economic Survey of Pakistan

50 40 30 20 10 0 -10 -20 00 01 02 03 04 05 06 07 IP IR 08 09 10

CPI TD

1.3 Research Objectives:

The main objectives of this study are:

This research will contribute to the knowledge about the reasons of inflation in Pakistan. It will help in analyzing the historical trends of inflation in Pakistan. It also states some policy implications about inflation according to the results.

1.4 Research Question:

It will answer the following question: Are interest rate, import prices and trade deficit significant determinants of inflation in Pakistan?

2.1 Review of Theoretical Literature:

Kemal (2006); contradicts with Hussain (2005) as he, after the economic analysis of Pakistan proposed that inflation in Pakistan is due to the increase in money supply over the long run and so he conforms to the Quantity Theory of Money. He analyzed that in Pakistan government prints more money than needed in order to make its revenue and so this excess money in long run causes the inflation. This is the main reason of inflation in Pakistan and all other factors like

6 exchange rate, rising import prices, interest rate also contribute to it too. Hence, the blame for inflation is on the monetary policy of Pakistan.

Hussain (2005); analyzed that inflation is not always bad for the economy. In Pakistan, if inflation is 3 to 6 % it is considered to be good for the economy. It increases the wages, increases investment and so production is also increased. But if inflation rises from 6 % then it will harm the economy. People will be uncertain about their expected profits and losses. People restrain from investing in such an economy. This negatively impacts investment and growth of the economy. Scheibe and Vines (2005); revealed that there is a positive relationship between inflation, output gap and exchange rates. Inflation has a strong relation with real GDP in Pakistan as well. But it depends in which state the economy is at the time. If the economy is growing in such a way that it is able to fulfil the demands because its potential output or productive capacity is growing then high growth without inflation is possible. Even it can happen when the output gap i.e. difference of actual and potential output is negative but the economy has the capacity to cope up with the pressure of demand. But when there is no capacity available and the economy has full employment level then if the economy grows more it will bring inflation with it. If the productive capacity is not expanded at this stage and demand is growing then in long run it will bring rapid inflation. The economy will be severely impacted by this prolonged rising inflation. Easterly and Fischer (2001); analyzed that inflation makes the poor poorer. Moreover, it also increases the gap between the poor and the rich. If this inflation causes to increase the prices of food mainly then the poor are hurt even more. It also redistribute income and fixed income earners borne losses while those with variable pays are not affected much by it. Khan and Qasim (1996); used the time series data from 1971-1995 and found out the major determinants of inflation in Pakistan. They separated food and non food inflation and found out that increased money supply in Pakistan plays a crucial role in increasing inflation. Other than money supply, currency devaluation, value addition in agricultural sector, increased prices of wheat, electricity and imports also contribute to inflation in Pakistan.

2.2 Review of Empirical Studies:

There are many different theories about the causes of inflation according to various schools of thought. Quality Theory of money and Quantity Theory of Money are two most important and vast debates on the causes of inflation. Quality theory of money focuses on the expectation of the buyer for the currency and its value or purchasing power. Quantity Theory of Money which explains the effect of increased money supply. Then the debate of demand-pull and cost-push factors started. In Keynesian era inflation was caused by increase in aggregate demand or supply. Inflation due to increases in aggregate demand is called demand pull and supply shocks bring cost-push inflation. But monetary policy can play important role in controlling these types of inflation. In 1950, the wages were falling continuously and so Keynesian economist started finding new explanation about the phenomenon. This investigation brought a new concept which was Phillips Curve2.Then Lipsey, Sameulsom and Robert Solow (1960), further added to this concept. This concept suggests that inflation and unemployment are negatively related. They proposed that there is a trade off between the two. After this, relationship between inflation and growth was also studied3 and in Pakistan it is a hot subject of discussion4. During 1970s and 1980s, inflation becomes the most important topic for the macroeconomist policy makers and classical economists. They tried to find out new explanations to challenge Keynesian concepts. They came up with the Monetarist Model5. This concept has deep roots in classical theory of economics. Friedman presented its model and Schwartz tested it in 1973. This model was Quantity Theory of Money. According to this model money supply was the main reason for inflation. Inflation is always a monetary phenomenon. This statement became popular. Monetary policy and not fiscal policy can control inflation.
2 Invented by A.W. Phillips, (1950) 3 Barro, (1995) 4 Ahmed and Khan, (2005) 5 Friedman, (1968-1971)

From 1958 to 1976, economist worked on finding new explanation for the inflation and they came up with a new model called Structuralist Model6. Supply factors like prices of food, wages, prices of imports and administered prices are the determinants of inflation according to this model. It also states that in long run productivity variability, economic growth, wages and income elasticity can explain inflation. Due to the erosion of trade barriers, studying causes of inflation has become more complex. All above mentioned factors can not alone describe the causes of inflation in a country.

3.1 Modelling Framework:

This is a quantitative research and is explanatory in nature as it explains the relationship between independent variable; import prices, trade deficit, interest rate and dependent variable; Inflation. It is a correlation research design as it investigates whether any significant relationship exist between above mentioned dependent and independent variables. The data used in this research is secondary data of interest rate, trade deficit, import prices and inflation from the year 1999 to 2010. The modelling framework of this paper is based on empirical literature review. To investigate the relationship between interest rates, import prices and trade deficit on inflation, following function is used: CPI = f (IR, IP, TD) The historical data of growth in inflation rates, import prices, trade deficit and import prices from 1999 to 2010 has been taken. In order to find out whether significant relationship exists between independent variables import prices, trade deficit, interest rate and dependent variable Inflation, tool used is regression analysis by using software EViews. The regression model used is as follows: CPI = 0 + 1 IR + 2 IP + 3 TD + t

6 Sunkel (1958), Streeten (1962), Olivera (1964), Baumol (1967) and Maynard and Rijckeghem (1976)

9 In above equations, independent variable is inflation (CPI), which depends on interest rate (IR), import prices (IP) and trade deficit (TD) and t is error term.

3.2 Model Hypothesis:

H 1: Growth in trade deficit has insignificant relationship with inflation.
H 2 : Import prices have insignificant relationship with inflation.

H 3 : Interest rates have insignificant relationship with inflation.

4. Estimation of Results:
Descriptive analysis of data shows that Mean values for inflation, interest rate, trade deficit and import prices are 8.18%, 4.855%, 4.88%, 13.78% respectively. High mean values for inflation, import prices and trade deficit are not a good indicator for economy. The maximum rate of these variable attained are 22.35, 6.8, 13.5 and 40.15 for CPI, interest rate trade deficit and import prices respectively while minimum are , 3.1, 3.4, 0.41 and -12.87. The distribution of measurements lacks symmetry and hence it is skewed. As the mean values are greater than the median values of these variables, the data is skewed to the right and hence it is a positively skewed distribution. The standard deviations of import prices, interest rate and trade deficit are large at 17.31082 , 1.099421, and 4.044393 respectively showing that observations for these variables are more spread out from their mean. Since Jarque berra are 4.738478 and p value is more than 5 % we accept the null hypothesis that data is normally distributed which fulfils the assumption of good regression line. The maximum values for CPI, trade deficit and Import prices are 22.35 %, 40.15 %, 13.5% respectively while minimum values for them are 3.1, -12.87 and 0.41 percent which shows that range of these variables are having large dispersion in the data. The kurtosis of CPI is leptokurtic as its value is greater than 3. Interest rate, trade deficit and import prices are plattykurtic as their values are less than 3.

Table 4.1 DESCRIPTIVE ANALYSIS:

10 CPI Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis 8.182727 7.770000 22.35000 3.100000 5.687917 1.428765 4.474119 IR 4.854545 4.800000 6.800000 3.400000 1.099421 0.272308 2.075449 TD 6
5 4.881818 4 3

IP 13.70818 9.300000 40.15000 -12.87000

5 Series: CPI Sample 2000 2010 Observations 11 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 15 20 8.182727 7.770000 22.35000 3.100000 5.687917 1.428765 4.474119 4.738478 0.093552

4.120000 13.50000 2 0.410000

0 1

4.044393 0.755709 2.834981

17.31082 0.040462 1.742383

10

Jarque-Bera Probability

4.738478 0.093552

0.527726 0.768079

1.059491 0.588755

0.727902 0.694925

Sum Sum Sq. Dev.

90.01000 323.5240

53.40000 12.08727

53.70000 163.5712

150.7900 2996.645

Observations

11

11

11

11

5 4 3 2 1 0 0.0 2.5 5.0 7.5 10.0 12.5 15.0 Series: TD Sample 2000 2010 Observations 11 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 4.881818 4.120000 13.50000 0.410000 4.044393 0.755709 2.834981 1.059491 0.588755

11
3.2 2.8 2.4 2.0 1.6 1.2 0.8 0.4 0.0 -20 -10 0 10 20 30 40 50

Series: IP Sample 2000 2010 Observations 11 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 13.70818 9.300000 40.15000 -12.87000 17.31082 0.040462 1.742383 0.727902 0.694925

3.2 2.8 2.4 2.0 1.6 1.2 0.8 0.4 0.0 3.0 3.5 4.0 4.5 5.0 5.5 6.0 6.5 7.0 Series: IR Sample 2000 2010 Observations 11 Mean Median Maximum Minimum Std. Dev. Skewness Kurtosis Jarque-Bera Probability 4.854545 4.800000 6.800000 3.400000 1.099421 0.272308 2.075449 0.527726 0.768079

Table 4.2, Correlation Matrix shows that trade deficit and import prices are negatively related to inflation (CPI). Strong positive correlation exists between trade deficit and inflation rate. Strong negative correlation exists between import prices and interest rates.

Table 4.2 Correlation Matrix:

CPI CPI 1.000000 IR -0.197422 TD 0.499063 IP -0.294305

12

IR TD IP

-0.197422 0.499063 0.294305

1.000000 -0.439562 -0.581214

-0.439562 1.000000 0.442977

-0.581214 0.442977 1.000000

Table 4.3, Regression Analysis shows that R-squares is 66%, which means 66% of the total variation in dependent variable i.e. inflation, can be explained by this model and 34% of the total variation in inflation remained unexplained. Trade deficit and import prices significantly impacts inflation as their t statistics are significant at the value of 2.767025 and -2.919814 respectively. Interest rate has insignificant t-statistics and hence does not significantly impacts inflation in Pakistan. The p-value of F-statistics is significant at 0.04. Durbin Watsons value of 2.355917 shows that there is no autocorrelation in the model. The regression coefficients show that one unit increase in trade deficit will increase inflation by 0.985425 and a unit increase in import rates will cause inflation to rise by 0.268 units. As t-statistics of interest rate is insignificant it will not impact inflation.

Table 4.3 REGRESSION ANALYSIS:

Dependent Variable: CPI Method: Least Squares Date: 05/03/12 Time: 02:31 Sample: 2000 2010 Included observations: 11 Variable Coefficient Std. Error 8.279560 1.443359 0.356132 t-Statistic Prob.

C IR TD

16.18409 -1.881965 0.985425

1.954704 -1.303879 2.767025

0.0915 0.2335 0.0278

13 IP R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat 0.268157 0.091840 -2.919814 0.0223 8.182727 5.687917 5.862736 6.007426 4.563686 0.044975

0.661690 Mean dependent var 0.516699 S.D. dependent var 3.954230 Akaike info criterion 109.4515 Schwarz criterion -28.24505 F-statistic 2.355917 Prob(F-statistic)

From the above results we can say that trade deficit is the major determinant of inflation in Pakistan and after trade deficit import prices are the second determinant of the inflation rate in Pakistan. CONCLUSION AND POLICY IMPLICATIONS: This study was done to examine that what factors effect inflation in Pakistan. The analysis was done by on the basis of time series data from 1999-2010. Regression analysis and descriptive analysis was done to derive results. It is evident from the results that trade deficit and import prices effects the inflation in Pakistan where as interest rate was proved to be insignificant. On the basis of this study, it is recommended for the government to make policies to reduce trade deficit by increasing exports and if the import prices are high then it should make steps towards minimizing imports.

6. Direction for Further Research: Further research can be done to explain the relationship between inflation and economic growth of the country and whether this inflation, trade deficit and increasing cost of import pricing are impacting the GDP of the country.

14

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