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com

Sehrish Rustam

MS-Banking and Finance Student, Department of Management Sciences, COMSATS Institute of

Information Technology, Abbottabad, Pakistan.

Nazish Bibi

MS-Banking and Finance Student, Department of Management Sciences, COMSATS Institute of

Information Technology, Abbottabad, Pakistan.

Khalid Zaman (corresponding author)

Assistant Professor, Department of Management Sciences, Room No: 319, Block-A,

COMSATS Institute of Information Technology, University Road,

Tobe Camp, Abbottabad campus, Pakistan.

E-mail: khalidzaman@ciit.net.pk or khalid_zaman786@yahoo.com

Telephone (O): +92-334-8982744; Fax: +92-992-383441

Saiqa Bibi

MS-Banking and Finance Student, Department of Management Sciences, COMSATS Institute of

Information Technology, Abbottabad, Pakistan.

Adeela Rustam

MS-Banking and Finance Student, Department of Management Sciences, COMSATS Institute of

Information Technology, Abbottabad, Pakistan.

Aqil Waqar

MS-Banking and Finance Student, Department of Management Sciences,

COMSATS Institute of Information Technology, Abbottabad, Pakistan.

Zahid-Ul-Haq

MS-Banking and Finance Student, Department of Management Sciences,

COMSATS Institute of Information Technology, Abbottabad, Pakistan.

Abstract

A lack of price stability exerts harmful effects on the economy not only through changes in the price level

but also through increased price level uncertainty. This paper investigates whether fiscal policy may have

an impact on price volatility or not? The study further evaluates the short- and long-run impact of fiscal

deficit and reserve money supply on price level in Pakistan. Dynamic short-run causality effects of fiscal

deficit and seignorage towards price stability are also investigated in this study. Data is analyzed by

autoregressive distributed lag model over a period of 1980-2010. The result indicates that if there is one

percent increase in budget deficit, price level increases up to 0.11 percent, which shows that high fiscal

deficit affecting inflationary expectations in the long-run. Result of the short-run causality test indicates that

causality running from money supply to price level in Pakistan. The overall impact of the fiscal deficit on

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inflation operates through both increases in aggregate demand as well as associated growth in broad money.

Thus, the role of money in inflation becomes obvious, but that process is largely conditioned by the fiscal

deficit.

Keywords: Fiscal deficit, Seignorage, Price level, Cointegration, Bounds testing, Pakistan.

JEL Classification: E31, H50, H60.

1. Introduction

The impact of budget deficit on inflation depends on the way it is financed. Fiscal deficit is usually

financed through seignorage, borrowing from abroad, domestic borrowing or through consumption of fiscal

reserves. According to Dorndusch et al (1990), the budget deficit is a principal determinant of money

growth and inflation in developing countries where money creation is the only way to finance government.

Gupta (1992) opine that deficits are inflationary in the context of monetarist framework. This is because

when monetization takes place, it will lead to an increase in money supply which leads to inflation in long

run. According to Easterly and Hebbel (1993), money creation causes inflation. However, economic theory

suggests that the strength of relationship between government budget deficit and inflation depends on the

dependency between monetary and fiscal policy. Government budget deficit and inflation are empirically

linked in countries where seignorage is an important component of deficit financing. However the link is

weaken in the case of countries where monetary authorities are independent.

Presently, Pakistan economy is passing through a critical stage. The major road blocks to growth in

Pakistan seems to be increasing which includes increasing unemployment rate, high inflation, incidents of

terrorism, falling foreign and local investment and the power shortage. The last global crisis (2008-09) has

placed Pakistan in a week starting positions .As a result of unforeseen negative exogenous domestic and

external shocks, the fiscal and external deficits widened and inflation, already high, was accelerated. In

2008, Headline inflation hit an unheard of 27% while core inflation also soared to new high of 18%.The

economy of Pakistan is caught in both the cost-pull and demand-pull inflation. According to Economic

Survey of Pakistan (2009-10), the total public debt stood at an estimated Rs8, 160 billion whish is 379% of

total revenue for the year. The rupee denominated debt amounted to 31% of GDP and foreign currency

denominated debt equals to 25% of GDP. In a report of Standard Bank, it was highlighted that Vietnam was

running a largest budget deficit of 11.8% in 2009, followed by India 10.7, Srilanka 9.8, Thailand 6.8,

Malaysia 6.5, and Pakistan 5.2%. The Fiscal Year 2010-11 of Pakistan is likely to end up with a fiscal

deficit of around 6% of GDP against the governments original target of 4% of GDP. During this economic

crisis, fiscal stimulus emerged as a key universal instrument of hope. Fiscal stimulus are normally the

government measures involving increased public spending and lower taxation, aimed at giving a positive

jolt to economic activity. The fiscal stimulus is basically designed for improving the infrastructure which in

turns help in the creation of jobs and improved standard of living.

The above discussion confirms a strong linkage between fiscal policy and inflation. In this paper an

analysis has been carried out to find a statistical relationship between fiscal policy and inflation in Pakistan

using secondary data from 1980-2010. This paper limited to the following variables:

Fiscal Instrument: Fiscal policy is concerned with all those arrangements which are adopted by

government to collect the revenue and make the expenditures so that economic stability could be

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attained without inflation and deflation, There are five major instruments of fiscal policy namely,

government expenditure; taxes, both direct and indirect; deficit financing i.e., government

borrowing and printing of new notes etc; subsidies and transfer payments like unemployment

allowances, stipends and scholarships etc. According to Romer and Bernstein (2009), the

overriding objective of the stimulus efforts is to spur job creation by increasing aggregate demand,

particularly in the short run. Because private consumption constitutes about two-thirds of GDP, the

typical argument has stimulus raise consumption demand, the demand for labor, and employment.

It is ironic that the consumption response to an increase in government spending is the linchpin in

the transmission mechanism for fiscal stimulus. Economic theory and empirical evidence do not

universally support the idea that higher government purchases raise private consumption (Davig

and Leeper, 2009).

Price Stability: According to Rother (2004, p.6], a lack of price stability exerts harmful effects on

the economy not only through changes in the price level but also through increased price level

uncertainty. High volatility of inflation over time raises such price level uncertainty. In a world

with nominal contracts this induces risk premia for long-term arrangements, raises costs for

hedging against inflation risks and leads to unanticipated redistribution of wealth. Thus, inflation

volatility can impede growth even if inflation on average remains restrained.

Seignorage: Seignorage is the amount of real purchasing power that a government can extract

from the public by printing money. According to Minea and Villieu (2007), in countries with

developed financial systems, most of the seigniorage is retrieved by the banking system, and

constitutes a seigniorage flight for the central bank. On the contrary, in financial repressed

economies, most of the seigniorage is collected by the central bank and can be used for

government finance. Therefore share of seigniorage that is collected by the central bank, which is

closely (inversely) related to the money multiplier, can be interpreted as a measure of financial

repression.

The objective of this paper is to empirically examine the role of fiscal policy and seignorage on price level

in Pakistan by using time series data from 1980-2010. The more specific objectives are:

i.

To estimate whether there is a long-run relationship between fiscal deficit and seignorage on

price level in Pakistan.

ii.

To estimate the dynamic short-run causality effects of fiscal deficit and seignorage towards

price stability in Pakistan.

The study arrange in the following manners: after introduction, Section 2 provides Literature Review. Data

Source and Methodological Framework are included to share vision with the reader in Section 3. Results

and Discussion are in the Section 4. Summary and Conclusion of the study are in the last.

2.

Literature Review

Several studies have been conducted on determination of relationship between fiscal deficit and inflation.

Sargent and Wallance (1981) examines that financially dominant governments running persistent deficits

would finance those deficits sooner or later through money creation, consequently leading them to inflation.

However, King and Plosser (1985) analyze the determinants of seigniorage in the United States and twelve

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other countries. They found no significant causality between fiscal deficits and changes in base money and

inflation. Catao and Terrones (2001) empirically examine the panel of 23 emerging countries during the

period 1970-2000. They found that one percent reduction in ratio of fiscal deficit to GDP result in reduction

of inflation by 11/2 to 6% points in the long-run. Solomon and Wet (2004) found a strong positive

relationship between inflation and budget deficit in case of Tanzania. They suggested that inflation can be

controlled by efficient fiscal policies. Narayan and Seema (2006), examine the relationship between budget

deficit, money supply and inflation in Fiji, by using sophisticated econometrics techniques. The results

reveal that there is a statistically significant impact of deficits on inflation. Further, they found

unidirectional causality running from money supply to inflation and bi-directional causality between money

supply and the deficit in the context of Fiji.

Sahan (2010) found no long run relationship between budget deficit and inflation in case of developed

countries by surveying EU countries and Turkey for period 1990-2008. However Turkey has a long term

relationship among inflation and budget deficit for the respective period. Mukhtar and Zakaria (2010)

analyzed that there is no long run relationship between budget deficit and inflation in the case of Pakistan

for the period 1960-2007. They observed that increase in money supply is the major cause of inflation in

Pakistan. Samimi and Jamshidbaygi (2011) surveyed this relationship in Iran using the quarterly data

covering the period 1990-2008. For that purpose they used simulation equation model, including four

structural equations for budget deficit, monetary base, money supply and inflation. The results indicate a

positive and significant impact of the budget deficit on monetary variables and as a result on inflation.

Yasmin and Umaima (2010) analyzed the effects of government spending on aggregate economic activity

of Pakistan for period 1971-2008. They found that as government debt builds up with fiscal expansion, the

rising risk of default or increased inflation reinforce crowding out through interest rates. Khundrakpam and

Pattanaik (2010) examine the impact of fiscal stimulus on potential inflationary risks in India over a sample

period of 1953-2009. The results suggest that one percent increase in fiscal deficit could cause 0.6% point

increase in inflation. They further suggest that potential inflation risk should work as an important

motivating factor to ensure a faster return to fiscal consolidation path. Oladipo and Akinbobola (2011)

examine the nature and direction of causality among the budget deficit and inflation in Nigeria. The results

found that there was no casual relationship from inflation to budget deficit, while it is significant in the case

of from budget deficit to inflation. Further they showed that exchange rates fluctuations and budget deficit

can affect inflation directly or indirectly. Habibullah et al (2011) examine budget deficit and inflation in

thirteen Asian developing countries, namely; Indonesia, Malaysia, the Philippines, Myanmar, Singapore,

Thailand, India, South Korea, Pakistan, Sri Lanka Taiwan, Nepal and Bangladesh. By applying Granger

causality within the error-correction model (ECM) framework for period 1950-1999 on annual data, they

concluded that budget deficits are inflationary in developing countries.

The results of various studies are mixed or even conflicting considerably, mainly due to dissimilarities in

methodology or data period. Table 1 reports the selected recent studies and their results of empirical

relationship between fiscal policy and price level.

[Table1 here]

In appraising the previous studies, the empirical soundness of the fiscal policy and price level hypothesis is

assorted and indistinct for the case of Pakistan. These sets of inconsistent findings could be due to the

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different sets of econometric methodologies used, such as single equation (OLS), vector autogression

(VAR) model, cointegration procedures and Granger causality frameworks. There are drawbacks to these

techniques. The OLS is not sufficient in studying causality or a cointegration relationship, while the other

three methodologies entail the underlying time series to have the same order of integration. Thus, the

present study examine the short and long-run relationship in the context of Pakistan via autoregressive

distributed lag (ARDL) model, or Bounds testing approach which was proposed by Pesaran et al. (2001).

Cointegration technique is used for analysis. The Auto-Regressive Distributed Lag (ARDL) model is used

to calculate short-run and long-run estimates. Short-run elasticities are calculated using the Wald-F

statistics. This study extends the existing literature on fiscal-price relationship by identifying the direction

of causality between reserve money and price level in the context of Pakistan.

3.

The study uses annual observations for the period of 1980-2010. The data is obtained from World

Development Indicators published by the World Bank (2010) and State Bank of Pakistan, Annual report

(2009-10). All these variables are expressed in natural logarithm and hence their first differences

approximate their growth rates. The data trends are available for ready reference in Figure 1.

[Figure 1 here]

To examine the impact of fiscal deficit and seigniorage on price level, we have estimated a simple nonlinear fiscal-price model which has been specified as follows:

(1)

Where

i.

ii. BD represents absolute values of Budget Deficit i.e., Government Revenues minus Government

Expenditures GR GE as percentage of GDP,

iii. M0 represents reserve money, percentage growth rate and

iv. represents error term.

The more extended form of equation (1) which is used in the ARDL framework would represent in below

sections. All the variables in this paper and their data definitions are shown in Table 2. It should be noted

that all the data are the annual items and are transformed in to logarithmic values for further investigation.

[Table 2 here]

Figure 2 shows conceptual framework for the study. There are two classical thoughts have been emerged in

this framework. According to Fiscalists, aggregate demand leads to inflation, while monetarist opines that

money supply leads to inflation.

[Figure 2 here]

3.1.

Econometric Procedure

This section summarizes the autoregressive distributed lag (ARDL) model, or bounds testing approach

(Pesaran et al., 2001), which we take up to check the existence of short and long-run relationships between

fiscal deficit, reserve money supply and inflation in the specific context of Pakistan. Econometric theory

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designate a set of variables is cointegrated if there is a linear combination among them without stochastic

trend. In this case, a long-run relationship subsists between these variables. However, this implication is

only valid if the obligation of the same order of integration has been met. Assume an explanatory variable,

which is stationary at level is regressed with another variable, which is non-stationary at level but is firstdifference stationary, then this will capitulate a spurious regression and thereby give a deceptive and erratic

conclusion.

3.1.1.

The use of the bounds technique is based on three validations. First, Pesaran et al. (2001) advocated the use

of the ARDL model for the estimation of level relationships because the model suggests that once the order

of the ARDL has been recognized, the relationship can be estimated by OLS. Second, the bounds test

allows a mixture of I(1) and I(0) variables as regressors, that is, the order of integration of appropriate

variables may not necessarily be the same. Therefore, the ARDL technique has the advantage of not

requiring a specific identification of the order of the underlying data. Third, this technique is suitable for

small or finite sample size.

Following Pesaran et al. (2001), we assemble the vector autoregression (VAR) of order p, denoted VAR (p),

for the following growth function:

p

Z t = + i z t i + t

(2)

i =1

where z t is the vector of both x t and y t , where y t is the dependent variable defined as price level

(CPI), xt is the vector matrix which represents a set of explanatory variables i.e., budget deficit (BD) and

reserve money supply (M0) and t is a time or trend variable. According to Pesaran et al. (2001), y t must be

I(1) variable, but the regressor xt can be either I(0) or I(1). We further developed a vector error correction

model (VECM) as follows:

p i

p 1

i =1

i =1

z t = + t + z t 1 + t yt i + t xt i + t

(3)

as:

= YY YX

XY XX

The diagonal elements of the matrix are unrestricted, so the selected series can be either I(0) or I(1).

If YY = 0 , then Y is I(1). In contrast, if YY < 0 , then Y is I(0).

The VECM procedures described above are imperative in the testing of at most one cointegrating vector

between dependent variable y t and a set of regressors xt . To derive model, we followed the postulations

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made by Pesaran et al. (2001) in Case III, that is, unrestricted intercepts and no trends. After imposing the

restrictions

YY = 0, 0

and

= 0,

p

i =1

i =0

r

( M 0 ) t i + u t ..........................................................................................(4)

i =0

Where

i.

ii.

Government Expenditures GR GE as percentage of GDP and

iii.

Equation (4) also can be viewed as an ARDL of order (p, q, r). Equation (4) indicates that price level tends

to be influenced and explained by its past values. The structural lags are established by using minimum

Akaikes information criteria (AIC). From the estimation of UECMs, the long-run elasticities are the

coefficient of one lagged explanatory variable (multiplied by a negative sign) divided by the coefficient of

one lagged dependent variable (Bardsen, 1989). For example, in equation (4), the long-run inequality,

investment and growth elasticities are ( 2 / 1 ) and ( 3 / 1 ) respectively. The short-run effects are

captured by the coefficients of the first-differenced variables in equation (4).

After regression of Equation (4), the Wald test (F-statistic) was computed to differentiate the long-run

relationship between the concerned variables. The Wald test can be carry out by imposing restrictions on

the estimated long-run coefficients of price level, budget deficit and reserve money supply. The null and

alternative hypotheses are as follows:

H 0 : 1 = 2 = 3 = 0

The computed F-statistic value in Table 3 will be evaluated with the critical values tabulated in Table CI

(iii) of Pesaran et al. (2001). According to these authors, the lower bound critical values assumed that the

explanatory variables xt are integrated of order zero, or I(0), while the upper bound critical values assumed

that xt are integrated of order one, or I(1). Therefore, if the computed F-statistic is smaller than the lower

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bound value, then the null hypothesis is not rejected and we conclude that there is no long-run relationship

between price level and its determinants. Conversely, if the computed F-statistic is greater than the upper

bound value, then price level and its determinants share a long-run level relationship. On the other hand, if

the computed F-statistic falls between the lower and upper bound values, then the results are inconclusive.

[Table 3 here]

4.

Economic time-series data are often found to be non-stationary, containing a unit root. Ordinary Least

Squares (OLS) estimates are efficient if variables included in the model are stationary of the same order.

Therefore, first we check the stationarity of all variables i.e. CPI, BD and M0 used in the study. For this

purpose the study employed Augmented Dickey-Fuller (ADF) and Phillips Perron (PP) unit root test.

Table 4 gives the results of ADF and PP unit root tests.

[Table 4 here]

Based on the ADF and PP unit root test statistics, it shows that out of three variables, two variables i.e., CPI

and BD have unit root. Both variables are non-stationary at the level but stationary at their first difference

i.e., I (1), while M0 is stationary variable at their level i.e., I (0) variables. Noticeably, the mixture of both

I(0) and I(1) variables would not be possible under the Johansen cointegration procedure. This gives a good

justification for using the bounds test approach, or ARDL model, which was proposed by Pesaran et al.

(2001). Figure 3 shows the plots of CPI, BD and M0 in their first difference forms, which sets the analytical

framework as regarding the long-term relationship between fiscal-price variables.

[Figure 3 here]

The estimation of Equation (4) using the ARDL model is reported in Table 5. Using Hendrys general-tospecific method, the goodness of fit of the specification, that is, R-squared and adjusted R-squared, is 0.723

and 0.630 respectively. The robustness of the model has been definite by several diagnostic tests such as

Breusch- Godfrey serial correlation LM test, ARCH test, Jacque-Bera normality test and Ramsey RESET

specification test. All the tests disclosed that the model has the aspiration econometric properties, it has a

correct functional form and the models residuals are serially uncorrelated, normally distributed and

homoskedastic. Therefore, the outcomes reported are serially uncorrelated, normally distributed and

homoskedastic. Hence, the results reported are valid for reliable interpretation.

[Table 5 here]

In Table 5 the results of the bounds co-integration test demonstrate that the null hypothesis of against its

alternative is easily rejected at the 1% significance level. The computed F-statistic of 9.852 is greater than

the upper critical bound value of 5.06, thus indicating the existence of a steady-state long-run relationship

among CPI, BD and M0.

The estimated coefficients of the long-run relationship between CPI, BD and M0 are expected to be

significant, that is:

Equation (5) and Table 6 indicates that if there is one percent increase in budget deficit, price level

increases up to 0.11 percent. However, money supply has a negative and significant impact on price level,

which shows that money supply does not contribute to increase price level in the long-run. While in the

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short-run, money supply has a positive impact on price level. The results indicate that the overall impact of

the fiscal deficit on inflation operates through both increases in aggregate demand as well as associated

growth in broad money. Thus, the role of money in inflation becomes obvious, but that process is largely

conditioned by the fiscal deficit

[Table 6 here]

5. Conclusion

This paper examined the empirical relationship between fiscal deficit and inflation over the period of 19802010. The direct impact of fiscal deficit through primary expansion in reserve money was studied by using

a concept of seigniorage. The result indicates that if there is one percentage point increase in the level of

fiscal deficit is estimated to cause as much as 0.11 percentage point increase in CPI, suggesting the

possibility of high fiscal deficit affecting inflationary expectations in the long-run. The overall impact of the

fiscal deficit on inflation operates through both increases in aggregate demand as well as associated growth

in broad money. Thus, the role of money in inflation becomes obvious, but that process is largely

conditioned by the fiscal deficit. Result of the short-run causality test indicates that causality running from

money supply to price level in Pakistan. The government officials, policymakers and private investors

could be benefit from this study because it provides useful information regarding the fiscal deficit and price

level in the context of Pakistan.

References

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King, R. & Plosser, C. (1985). Money, deficit and inflation, Carnegie Rochester Conference Series on

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Development

Economists.

Online available

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at

www.sciencerecord.com

Study

King

and

Plossers

(1985)

Catao

and

Terrones

(2001)

Solomon and

Wet (2004)

Narayan and

Seema (2006)

Variables

Methodology adopted Country

Period

used

Fiscal deficit OLS Regression and United States 1980-1985

base money VAR model

&120 Others

and inflation

Countries

Fiscal deficit Pooled mean group Panel of 23 1970-2000

&inflation

estimation

(PMGE), emerging

mean group estimation countries

(MG)

Budget

Cointegration

Tanzania

1967-2001

Deficit,

analysis

Gross

domestic

product and

Inflation

Budget

OLS, FMOLS, DOLS Fiji

1970-2005

deficit

estimator and Granger

inflation and causality

money

supply

Sahan (2010)

Budget

Deficit(

Govt. Debt

& GDP) And

CPI

(Inflation)

Hadri test

Turkey

1990-2008

Mukhtar and

Zakaria

(2010)

consumer

price index

(CPI),

money

supply (M2)

and

government

budget

deficit (BD)

Budget

deficit

inflation

seigniorage

Cointegration

technique,

Granger

Causality Tests

Pakistan

1960-2007

Bounds test

India

1953-2009

Khundrakpam

and Pattanaik

(2010)

113

No

significant

causality b/w fiscal

deficit and inflation

Long

run

relationship

between

fiscal

deficit and inflation

Strong

positive

relationship

between inflation

and budget deficit

Significant impact

of

deficit

on

inflation

unidirectional

causality between

money supply and

inflation

Bi

directional

causality between

money supply and

deficit

No

long

run

relationship

between

budget

deficit inflation in

developed countries

while

Long

run

relationship exists

in Turkey

Monopoly

major

cause of inflation

No

long

run

relationship exits

Positive relationship

Between

fiscal

deficit on Monterey

variables

and

inflation

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Samimi and

Jamshidbaygi

(2011)

Budget

deficit

,monetary

base , money

supply and

inflation

Simulation techniques

Iran

1990-2008

Positive impact of

budget on monetary

variables and on

inflation

Yasmin and

Umaima

(2010)

Government

spending

Per

captia

,consumption

per

captia

GDP

per

captia, debt

to GDP ratio

, long term

interest rate

and

real

exchange

rate

Vector Autoregressive

model

Pakistan

1971-2008

Government debt

builds with inflation

and fiscal expansion

which

increases

inflation

Oladipo and

Akinbobola

(2011)

Inflation

rates

exchange

rates

GDP

and budget

deficit

Nigeria

Source

Authors

survey

,2008

No

casual

relationship

From inflation and

budget deficit

While Significant

from budget deficit

to inflation

and error correction

model (ECM)

Asian

development

countries

1950-1999

inflationary

in

developing

countries.

Habibullah

etal (2011)

Budget

deficit

inflation and

money

supply

Source: Authors compiled.

114

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Figure 1: Data trend for price level (CPI), budget deficit (BD) and reserve money (M0) during

1980-2010

BD

CPI

10

24

9

percentage of GDP

20

16

%

12

8

7

6

5

4

3

4

0

1980

1985

1990

1995

2000

2005

2010

2

1980

1985

1990

1995

2000

2005

2010

Years

Years

MO

30

25

20

15

10

5

0

1980

1985

1990

1995

Years

2000

2005

2010

Variable

CPI

BD

Definitions

Sample period

Variable reference

It

denotes 1980-2010

Mukhtar & Zakaria

Pakistans inflation

(2010)

indicator,

calculated

in

annual percentages

of consumer prices

It

denotes 1980-2010

Solomon and Wet

Pakistans budget

(2004) and Sahan

deficit in absolute

(2010)

values

i.e.,

Government

Revenues

minus

Government

Expenditures

GR GE

115

base of World

Bank

as

percentage of GDP

M0

denotes

Pakistans reserve

money represented

in its percentage

growth rate

Source: Authors prepared.

M0

Data source

WDI (2010) Data

base of World

Bank

1980-2010

Khundrakpam and

Pattanaik (2010)

State Bank Of

Pakistan Annual

Report (2010)

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Fiscal Deficit

Inflation

Demand Pressure

Seigniorage

Source: Self extract

Source: Self Extract

Lower Bound Value

Upper Bound Value

Critical value

1%

3.74

5.06

5%

2.86

4.01

10%

2.45

3.52

Note: Critical Values are cited from Pesaran et al. (2001). Table CI (iii), Case 111: Unrestricted intercept

and no trend.

Table 4: Unit Root Estimation

Augmented Dickey-Fuller (ADF) Test

Level

First Difference

Variables

Constant

Constant

CPI

-2.102 (0)

-2.304 (0)

-7.145* (0)

-7.456* (0)

BD

-1.990 (0)

-2.679 (0)

-5.939* (0)

-5.891* (0)

M0

-6.305* (0)

-6.353* (0)

-7.753* (1)

-7.595* (1)

Level

First Difference

Variables

Constant

Constant

CPI

-2.228 (3)

-2.325 (3)

-7.068* (3)

-7.443* (3)

BD

-2.005 (1)

-2.612 (3)

-6.896* (8)

-7.426* (9)

M0

-6.481* (2)

-6.547* (2)

-29.096* (28)

-28.224*(28)

Note: The null hypothesis is that the series is non-stationary, or contains a unit root. The rejection of the null hypothesis is based on

MacKinnon (1996) critical values i.e., at constant: -3.670, -2.963 and -2.621 are significant at 1%, 5% and 10% level respectively.

While at constant and trend: -4.296, -3.568 and -3.218 are significant at 1%, 5% and 10% level respectively. First Difference: at

constant: -.3689, -2.971 and -2.625 are significant at 1%, 5% and 10% level respectively and at constant and trend: -4.323, -3.580

and -3.225 are significant at 1%, 5% and 10% level respectively. The lag length are selected based on SIC criteria for ADF unit root

test, this ranges from lag zero to lag one. However, the lag length based on Bandwidth for PP unit root test, this ranges from lag one to

lag 28.

116

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CPI

BD

16

12

2

1

0

4

-1

0

-2

-4

-8

1980

-3

1985

1990

1995

2000

2005

-4

1980

2010

1985

1990

1995

2000

2005

2010

MO

20

10

-10

-20

-30

1980

1985

1990

1995

2000

2005

2010

Dependent Variable: Log (CPI) t

Variable

Coefficient

t-Statistic

Prob. value

log(CPI ) t 1

0.934

11.818

0.000

log( BD) t 1

-0.104

-5.52

0.000

log( M 0 ) t 1

0.279

1.82

0.084

-0.367

-0.864

0.397

log(CPI ) t 1

0.632

3.264

0.003

log( BD) t 1

0.156

2.547

0.047

log( M 0 ) t 1

0.331

2.557

2.557

MA(1)

-0.929

-9-058

0.000

11. Model criteria / Goodness of Fit:

R-square = 0.723; Adjusted R-square = 0.630; Wald F-statistic = 9.852 [0.000]*

111. Diagnostic Checking:

JB = 0.284 [0.867]; LM-1 = 0.711 [0.409]; LM-2 = 0.843 [0.445]; ARCH (1) = 0.331 [0.569]; ARCH2 = 0.323 [0.726]; White Heteroscedasticity = 1.322 [0.291]; Ramsey RESET = 2.009 [0.155]

Note: Probability values are quoted in square brackets. MA and ARCH denote LM-type Breusch-Godfrey Serial Correlation LM and

ARCH test, respectively, to test for the presence of serial correlation and ARCH effect. JB and RESET stand for Jarque-Bera

Normality Test and Ramsey Regression Specification Error Test, respectively.

117

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Table 6: Long-run elasticities and short-run elasticities of price level in Pakistan: Based on

equation (4)

1. Long-Run Estimated Coefficient

Variable

Coefficient

BD

0.111*

M0

-0.298*

11. Short-run Causality Test (Wald Test F-statistic):

BD

M 0

0.403

6.538 *

(0.010)

(0.532)

The dynamic short-run causality among the relevant variables is shown in Table 6, Panel II. The causality

effect can be acquired by restricting the coefficient of the variables with its lags equal to zero (using Wald

test). If the null hypothesis of no causality is rejected, then we wrap up that a relevant variable Grangercaused price level. From this test, we initiate that only money supply is statistically significant to Grangercaused price level at a 1% significance level. To sum up the findings of the short-run causality test, we

conclude that causality running from money supply to price level in Pakistan.

118

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