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Measuring the Impact of Fiscal Policy on Price Level in Pakistan


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.

Data Source and Methodological Framework

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:

log(CPI ) = 1 + 2 log BD + 3 log( M 0 ) +

(1)

Where
i.

CPI represents Inflation, consumer prices (annual %),

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.

Bound Testing Approach

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)

where is the first-difference operator. The long-run multiplier matrix

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,

the fiscal-price hypothesis function can be stated as the

following unrestricted error correction model (UECM):


p

i =1

i =0

(CPI ) t = 0 + 1 (CPI ) t 1 + 2 ( BD) t 1 + 3 ( M 0 ) t 1 + 4 (CPI ) t i + 5 ( BD) t i +


r

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

i =0

Where

is the first-difference operator and u t is a white-noise disturbance term.


i.

CPI represents Inflation, consumer prices (annual %),

ii.

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


Government Expenditures GR GE as percentage of GDP and

iii.

M0 represents reserve money, percentage growth rate and

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

(no long-run relationship)

Against the alternative hypothesis

H 0 : 1 2 3 0 (a long-run relationship exists)


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.

Results and Discussion

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:

log(CPI ) t = 0.367 + 0.111 * log BD t 1 0.298 * log( M 0 ) t 1 ...............................................(5)


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.

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Study
King
and
Plossers
(1985)
Catao
and
Terrones
(2001)
Solomon and
Wet (2004)

Narayan and
Seema (2006)

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Table 1: Comparison of results in selected recent studies


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)

LLC test, IPS test and


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

Results & finding


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

Granger causality test

Nigeria

Source
Authors
survey
,2008

No
casual
relationship
From inflation and
budget deficit
While Significant
from budget deficit
to inflation

Granger causality test


and error correction
model (ECM)

Asian
development
countries

1950-1999

Budget deficit are


inflationary
in
developing
countries.

Habibullah
etal (2011)

Budget
deficit
inflation and
money
supply
Source: Authors compiled.

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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

percentage growth rate

30
25
20
15
10
5
0
1980

1985

1990

1995
Years

2000

2005

2010

Source: WDI (2010) and SBP (2010)

Variable
CPI

BD

Table 2: Variables and data definitions


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

WDI (2010) Data


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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Figure 2: Research framework

Fiscal Deficit

Inflation
Demand Pressure

Seigniorage
Source: Self extract
Source: Self Extract

Table 3: Bounds test for cointegration analysis


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 and Trend

Constant

Constant and Trend

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)

Phillips-Perron (PP) Test


Level

First Difference

Variables

Constant

Constant and Trend

Constant

Constant and Trend

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.

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Figure 3: Data trends at their first differences


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

Table 5: Estimated Model Based on Equation (4)


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.

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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)

* represent significant at 1% level. Figures in brackets refer to marginal significance values.


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.

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