Pakistan Monetary policy effectiveness in controlling inflation

Pakistan M maventary constitution effectiveness in lockling largeness fanfare untowardly affects the boilers suit issue, the fiscal sector development and the vulnerable poor segment of the population. T present is clear consensus that even moderate levels of splashiness damage real reaping lump decreases the real income and also induces uncertainty. Considering such adverse impresss of pompousness on the economy, in that location is a consensus among the worlds leading central banks that the cost stability is the prime objective of financial policy and the central banks are committed to the funky flash. Hence the central banks get down adopted largeness as the main focus of financial policy, targeting inflation explicitly or implicitly as and when required.MotiveThe objective of the thesis is to investigate the linkage amidst the excess nones tag on growth and inflation in Pakistan and to test the validity of the monetarist office that inflation is a moneta ry 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 property supply and inflation rates in Pakistan in order to prove the hypothesis. hypothesis guess 1Null scheme Monetary policy is effective in controlling inflation in Pakistan.Alternative hypothesis Monetary policy is not effective in controlling inflation in Pakistan.Hypothesis 2Null Hypothesis Inflation is a monetary phenomenon.Alternate Hypothesis Inflation is not a monetary phenomenon.IntroductionThis 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 dep fetch upent variable. The model is estimated for the geological period of 1950-2005. It tries to cadence the effective of monetary policy during different regimes.The results indicate that correlation amongst monetary assets and inflation is not that conceptive 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. some other result that I got from the study is that monetary expansion and inflation are related importantly and they tend to de conditionine the direction of one another at times just now inflation is also related to other factors.These days economies of all countries whether underdeveloped, developing as well developed suffers from inflation. Inflation or firm rising prices are major problem today in world. Beca habit of m all reasons, maiden, the rate of inflation these years are lots mellow than experienced antecedent periods. Second, Inflation in these years coexists with lofty rate of unemployment, which is a new pheno menon and made it difficult to control inflation.Economic policies tend to increase the general earthly concern welfare and monetary policy supports this broad objective by focusing its efforts to promote price stability. The objective of monetary policy in Pakistan, as fixed 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 change magnitude rapidly and some researchers thought this increase in money supply was going to translate quickly into inflation. But inflation did not grow ofttimes and a posteriori evidence shows that shocks to the petrol and meat supply mainly bear upon inflation.In the dogged- form the relationship among money supply and price is very strong andtheir correlation is al nigh one. Lucas (1995) show the long- bourne relationshipbetween money and prices in his Nobel Prize lecture by mentioning McCandless(prenominal) andWeber (1995).For the on the spur of the momen t-term relationship, empirical evidence of relationship between money growth and inflation is weak and unclear. A variety of studies on money lead yield very miscellaneous results. As result, it is difficult to establish a straight relationship between these two variables in the unequal-term.This paper tries to measure the relationship between money growth and inflation forPakistan. 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 inflationPrice 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, frugal 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 unanticip ated 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 lease 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 copulati only longstanding outlook, creating incentives for households and firms to shorten their decision horizons and to spend imagings 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 oddswith 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 controllinginflation relativ e to output growth, and financial and switch over rate stability.Effectiveness of monetary policy in PakistanGenerally, historical evidence does reflect that Pakistan has been a high inflation and highinterest economy given its inherent structural weaknesses. The role and effectiveness ofmonetary policy appears more visible in the 2000s when financial sector reforms started baby buggy fruits in terms of a more market ground money and foreign exchange markets.Entering the 21st century, the loose monetary policy stance in the face of low inflation, lowgrowth and low twin deficits, along with structural measures to open up the economy andalleviate some first round constraints, triggered the economy on a long term growth trajectory of above 7 pct.Monetary policy stance was however change as the inflationary pressures started to build up in 2005. At the end of the pecuniary year, the economy, which had been showing sustainedsteady growth since FY01, registered a historically high lev el of growth (9 percent), fair(a) inflation rose sharply (9.3 percent) and the outdoor(a) 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 more often than not capture the high and growing aggregate demand in the economy on account of sustained increase in peoples income.With the rising domesticated and world(a) price pressures, SBP tightened its monetary policyafter a prolonged gap of a few years. The efforts to rein-in inflation, however, proved lesseffective due to a forswear in world-wide commodity prices and a rise in domestic foodbearing 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, lowgrowth and low twin deficits, along with structural measures to open up the economy andalleviate 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 domesticstinting developments, the implementation of SBP monetary policy during FY06 variedsignificantly from the preceding fiscal years. In addition to the rise in the policy rate, thecentral bank focused on the short-end of the yield curve, draining excess liquid from theinter-bank money market and pushing up short-tenor rates. Consequently, not only did theovernight rates remain close to the discount rate by most of the year, the irritability inthese rates also declined. These tight monetary conditions along with the Governments 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 supercharge backup in aggregate demand during FY07 was required as the core inflation witnessed a relatively pettyer 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 infection 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 monetar y tightening in FY07 did not put any adverseimpact on economic growth, as not only was the real GDP growth target of 7.0 percent forFY07 was met the growth was quite broad based. At the same time, the impact of themonetary tightening was most evident in the continued retardation 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, lots 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 more often than not stemmed from an expansion in NFA due to the higher than expected foreignexchange 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 two working upper-case letter 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 governmentalvulnerabilities coupled with a very challenging global environment caused slippages inmacroeconomic targets by a wide margin.After a relatively long period of macroeconomic stability and prosperity, the global economy faced multifarious challenges (i) hit b y 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 value Rs 407 billion by Government, which account for almost half of the fiscal deficit,shielded domestic consumers from high international POL and commodity prices anddistorted the natural demand adjustment mechanism. While the government passed on price incr ease 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 importinglarge volumes of these commodities. Rising fiscal deficit and lower than required financingflows resulted in exceptional recourse of the Government to the highly inflationary centralbank borrowing for financing deficit. At the same time the surge in imports persisted.As a result, inflation accelerated and its expectations streng indeeded due to pass through ofinternational oil prices to the domestic market, increases in the electricity tariff and thegeneral sales tax, and rising exchange rate depreciation. These developments resulted in afurther 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 remai ned 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 ReviewIf 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 endorser 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 posit whether the policy makers have been succes sful 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 nominate Bank of Pakistanis also under pressure to discuss and innovation a policy that could provide a stable and sustainable economic growth as well as address the necessary conditions to be parcel 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 second basely 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 t o converge to equilibrium if shocks appear in any of the tether 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 andtheir correlation is almost one. Lucas (1995) emphasized the long-term relationshipbetween money and prices in his Nobel Prize lecture by mentioning McCandless andWeber (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 schoo l 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, merely 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 limitationsThe information covers the period 1950-2005 on a yearly basis. The choice of stress enables us to study the long run relationship between mone y 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 1990s.MethodologyThe tests used will beCorrelationRegressionGraphical AnalysisModelThe model used would analyze the inflation against two variables of mon ey supply monetary expansion and monetary assets.Money supply is considered as independent variable.Inflation is considered as dependent variable.Empirical ResultsCorrelation testThe correlation between monetary assets and inflation during entire 50 year periods has been as suchFor 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 inflationThis 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 mutant 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 proceed the data well. Here the model doesnt work 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 ys 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 (MS E). 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 assetsThe 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 b etween 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 require to be controlledHigh 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 volatilisable 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 institutionsare intermediaries that reduce frictions between savers and investors (includingadverse selection, moral hazard, or conflicting time preferences). Inflation makesthis 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 ofgrowth, there appears to be a threshold beyond which inflation adversely affectsfinancial sector developments, while there are no negative effects at low levels ofinflation.The adverse effect of inflation on financial development is one mechanism by which inflation can hurt growth. For example, Loayza and Ranciere (2005) f ind 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 viceversa. 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 unassailablely and averaged only 1 percent.Finally, between 1998, inflation was reduced again to an average of 5 percent, andreal per capita growth displayed a dramatic recovery. Of course, there are otherfactors that determine growth in the short-run and in the long-run e.g. van Rooden(2005). Nonetheless, Pakistans growth performance has been best when inflationwas contained to 8 percent or lower.ConclusionHypothesis 1Null Hypothesis Monetary policy is effective in controlling inflation in Pakistan.Alternative Hypothesis Monetary policy is not effective in controlling inflation in Pa kistan.Result Reject Null Hypothesis and Accept Alternate Hypothesis.Hypothesis 2Null 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.RecommendationsThe following areas need assistance and are key for effective monetarymanagement.Effectiveness of monetary and fiscal coordination would be helpful.For effective analysis of developments and policy making, timely and qualityinformation 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 currenteconomic situation and evolving trends, and hinders the ability of the SBP todevelop a forward-looking policy stance.Unlike many countries, both developed and developing, there is no prescribed limiton government borrowing from SBP. Borrowing from the central bank injects liquidity in the system through increased currency in circulation and deposits of the government wi th 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 managementand 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 andreform the medium term planning for the budget and monetary policy formulation process.Several studies and technical assistance have provided extensive guidance in this area, butthe 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 assurance 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 carry out conflicting demands.