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Research Paper

The Impact of Fiscal deficit and Money Supply on Inflation in Pakistan.

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Supervisor Course Submission Date By

: Sir Imtiaz Arif : : Advanced Research Methodology 22 August 2010

: Muhammad Mansoor (2565) (MBA Evening)

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Table of contents
Abstract--------------------------------------------------------------------------------------- 3 Introduction ------------------------------------------------------------------------------ 4
Topic--------------------------------------------------------------------------- 5 Purpose of Study--------------------------------------------------------------- 5

Literature Review---------------------------------------------------------------------- 6 Methodology----------------------------------------------------------------------------10

Data Required-----------------------------------------------------------------10 Source of Data-----------------------------------------------------------------10 How to use data -------------------------------------------------------------- 11

Sample size------------------------------------------------------------------ 11
Statistical Techniques---------------------------------------------------------11 Statistical tool-----------------------------------------------------------------11 Modeling Framework---------------------------------------------------------11

Research Variables---------------------------------------------------------12

Data Analysis--------------------------------------------------------------------------12 Conclusion and Recommendation --------------------------------------------- 15 Reference------------------------------------------------------------------------------ 18

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ABSTRACT
This report attempts to investigate the linkage between excess fiscal deficit and money supply affect on inflation in Pakistan. The results obtained using multiple regression analysis technique shows that there is a positive association between fiscal deficit and money supply on inflation. The expansionary economic policies of the government and of the central bank (State Bank of Pakistan SBP), which on one side resulted in impressive economic performance, stimulated a rise in the Consumer Price Index (CPI) on the other hand. The important findings from the analysis are that excess fiscal deficit and money supplu contributes to increase the level of inflation in Pakistan. This is may be due to loose monetary policy of the state bank of Pakistan and loose credit control. The important policy implication is that the inflation in Pakistan can be cured by contractionary monetary and fiscal policy. Although there are certain other variables which are also main contributors to the recent inflation in Pakistan like: increase in the electricity prices, unstable oil prices, hoarding, and political instability.

Keywords: Inflation, Money Supply, Fiscal Deficit and Pakistan

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The Impact of Fiscal Deficit and money supply on Inflation in Pakistan

INTRODUCTION
Inflation is one of the most researched topics in economics because it has serious implications for growth and income distribution. Inflation is a monetary phenomenon what factors determine the inflation rate has also been widely debated all over the world. When inflation crosses reasonable limits, it has negative effects. It reduces the value of money, resulting in uncertainty of the value of gains and losses of borrowers, lenders, buyers and sellers. The increasing uncertainty discourages saving and investment. For Pakistans economy, inflation can be bad if it crosses the limit of six percent, and can be extremely harmful if it crosses the double digit level. After remaining relatively low for quite a long time, the inflation rate accelerated in Pakistan starting in late 2003. Following the 1998-99 crisis, inflation was reduced to below 5 percent by 2000 and remained Stable through 2003. Controlling inflation is a high priority for policy-makers and state bank of Pakistan play a role in developing and implementing the policies the can hinder or reduce inflationary pressure. In case of Pakistan monetary and fiscal both policies was the main cause to increase the level of inflation. In Pakistan fiscal policy and the monetary policy has remained expansionary in the last few years. Expansionary fiscal policy fuels domestic demand and puts pressure on the current account deficit. It widens the investment-saving gap, which has to be financed externally. On the other hand expansionary monetary policy increase the food inflation rise the price of oil and directly affect the budget deficit. Financing of fiscal deficit through money creation adds to inflationary pressures. Increased government borrowing from central bank can have serious consequences for general price level. When government faces budget deficit it has three sources to finance its budget deficit. Government takes public debt by issuing bonds and borrow from banking system, secondly government takes loans from foreign countries

[5] like IMF and World bank and even it deficit is not fulfilled then government asks the State bank of Pakistan to print new currency notes. In this way when this money is injected in the economy it increase the money supply. Inflation can only be reduced when this amount of borrowed money is utilized in increasing the production of goods and services to cater the increased demand of goods and services. But here in the case of Pakistan the case is totally contrary instead of investing that loan in the developmental projects and in improving the industries of Pakistan money supply is increased in the economy and prices of goods and services are increased which ultimately results into increase inflation. The recent practical example of this case is the 750 million dollars loan schedule of IMP for Pakistan from which first tranches has been received. The inflation has multiplied its figure to it self and we are facing the pressure of inflation. Second thing is expansionary monetary policy- high growth in money supply and loose credit policywas believed to be contributing to high inflation. Although expansion of credit is usual in expanding economies, excessive credit growth can have adverse effects on real variables. This topic has huge scope in Pakistan to study the factors which contribute to inflation and will help us take corrective actions and policy implications. The details of topic and objective have been illustrated below. Topic: Objective: Pakistan. Hypothesis: Change in Inflation does not depend on the Fiscal deficit and money supply. Impact of Fiscal deficit and money supply on Inflation in Pakistan. To find out the relationship between fiscal deficit, money supply and inflation in

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PURPOSE OF STUDY
Our objective and purpose of study is to find out the relationship between fiscal deficit, money supply and inflation in Pakistani Scenario and to analyze does fiscal deficit and money supply contribute to inflation and how does it effects the performance of an economy. Then we will see how fiscal policy and monetary policy adjusts such imbalances in the economy.

Literature Review
Increase in the budget deficit has a huge role in triggering money supply in the economy which is then followed by an upsurge in inflation (Qayyum, Summer 2006) Economists say that huge government budget deficit lead the government to borrow more from the banking system in order to finance that deficit. According to them this is not a healthy sign for the economy. They are of view that budget deficit in the economy shows that the aggregate demand (AD) is higher than aggregate supply (AS) and there is not enough potential in the economy to increase its production capacity in the short run to meet AD. Therefore, to fulfill that demand government extends money supply in the economic system by borrowing money from the banks, local institutions or by printing more money. In this way a new equilibrium is achieved where the aggregate demand curve meets the aggregate supply curve at a new point.

This is done in order to achieve higher AS. Hence, to get higher AS price has to be increased so that AS can meet AD at a new point. In this way they state that due to increase in government budget deficit, money supply in the economy increases due to which price inflation occurs.

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To further support the theory we can also take the discussion of (Agha & Khan, 2006) in which he described that to tackle the increase in budget deficit government either prints money or borrows from the banking system.

If analyze the trend in inflation, money growth and real GDP growth found average rate of inflation, money growth, real GDP growth and velocity of money to be 8.1 percent, 13.9 percent, 5.5 percent and 2.9 respectively. According to the analysis the velocity of money however shows a decreasing trend in Pakistan over the period of 1973 till 2005, which depicts that it is not constant over the period of study (Qayyum, Summer 2006). Such fluctuations in the velocity of money are due to changing the structure of financial sector in Pakistan and due to the extensive reforms undertaken in the financial sector. The process of monetization, the spread of the money economy and the expansion of commercial banking is responsible for the downward trend in the velocity. He calculated the correlation among money growth, real GDP growth, Inflation and velocity of money and found positive correlation between his variables especially money growth and inflation. It also implies that money growth this year affects the rate of inflation in the next year.

Five equations to better understand the whole scenario. In the first equation it indicates that a 10 percent increase in foreign reserves (TR) will increase each in money supply (M2) by 1.5 percent. Domestic financing of budget deficit (GBNB) will raise money supply by 1.51 percent, and commercial bank credit (CR) will increase the money supply by 6.4 percent. So around 64 percent change in money supply is triggered by commercial bank credit and 15 percent by both (GBNB) and international reserves (TR). Equation 2 depicts that as the level of income increases

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by 10 percent it increases the demand for money by 11 percent. There equation 3 is price equation which reveals that a 10 percent increase in the lagged money supply and import prices will increase the price level by 4.8 percent and 5 percent respectively. The fourth equation shows the impact of government expenditure and impact on level of output (Chaudhary & Ahmad, Winter 1995). Furthermore, government expenditures are also a source of inflation because the government is forced to finance deficit resulting from non-commodity producing expenditure such as transfer payments, food subsidy, and the greater participation in social services. Their empirical results concluded that financing of the government budget deficit through domestic sources leads to increase in money supply and eventually increase the inflation. Their findings that long run positive relationship between budget deficit and money supply or inflation exists are consistent with other past researchers like: De Silva (1977); Protopapadakis and Siegal (1987) and Haan and Zelhorst (1990).

Analyze the impact of money supply on inflation in short run as well as in long run. He used three variables CPI, GDP and Money supply and analyzed the impact of money supply over three quarters. His empirical findings reveal that the three variables are dependent on each other. His equation shows a positive long run relationship between inflation and money supply. His observation implies that in the short run the policy of achieving more employment and output may be optimal but in the long run it only contributes to the inflation (Kamel, 2006). Negative association between inflation and output implies that any increase in output in the short run resulting from demand stimulus results in a decline in the output and higher prices over long run. His findings revealed that in the long run money supply impact inflation and supported the monetary phenomenon.

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Money growth and inflation due to private sector debt shows the inflation affect over a period of 12 months (Nasir, Ahmad, Ali, & Rehman, EuroJournals Publishing, Inc. 2010). While a new and amazing fact of short run inflation in Pakistan was found to be the Wheat prices (food inflation) but in the long run they concluded the inflation is due to non-food variables. Their model included the variables such as CPI, money growth, private sector debt and wheat support prices. The equation showed relation among CPI inflation as a function of private sector credit growth, GDP growth, and average annual wheat support prices. Starting in early 2003, monetary conditions were very accommodating, private sector credit growth picked up, and disequilibrium in the CPI-private sector credit relationship emerged. More over these findings are likely to reflect the impact of the 1998/99 debt crisis on the Pakistani economy and the reforms that followed. Macroeconomic stabilization and financial sector reforms can be expected to have affected estimated parameters. Moreover, De Grauwe and Polan (2005) show that standard quantity theory of money relationships are hard to identify in countries with inflation of less than 10 percent. The situation of inflation in Pakistan is due to expansionary fiscal policy through high growth in money supply and loose credit policy was believed to be contributing to high inflation in Pakistan (Khan, Bukhari, & Ahmed, 2006). According to their empirical findings in the case of Pakistan annual inflation was above 11 percent in 11 of the past 32 years of their research period. Average real per capita income growth rate was 2.8 in the year having less than 11 percent inflation as compared to the year having high inflation which recorded an average 1.5 percent growth in real per capita income. Their arguments on the above discussion suggest that inflation in Pakistan can be bad if it crosses 6 percent and harmful if it reaches to double digit inflation.

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Recently Pakistan is on the verge of inflation of 8.9%. During 2001-04, inflation was very low. Interestingly, support price of wheat was not raised during 2001-03. CPI shot up again in 200405 when inflation reached 9.3 percent. It dropped slightly to 8 percent in (2006). Nongovernment sector borrowing was the second most important factor. The growth in nongovernment sector borrowing was above 30 percent while it was 23 percent in 2006. This growth is reflected in the contribution of inflation.

METHODOLOGY
The methodology used for this research is on the basis of hypothesis testing. A multiple regressive analysis model was used to identify and asses the relative contribution of fiscal deficit and money supply on inflation. The model developed and applied for Pakistan, shows that an increase in fiscal deficit and money supply in increases the level of inflation. The increase in Inflation was due to the fact that government takes foreign and domestic loans and even prints money from state bank of Pakistan to finance its budget deficit when this money is injected in the economy it increases the money supply and causes a surge in the inflation.

1.

DATA REQUIRED

For the analysis annual data of Fiscal deficit ,annual data of Money Supply M2 and Consumer price index CPI for measuring inflation is required.

2.

SOURCES OF DATA

The data of fiscal Deficit has been gathered from State Bank Library and data of Consumer Price Index has been collected from Economic Survey of Pakistan.

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3.

HOW TO USE DATA

Fiscal deficit data has been used in billions of rupees and Consumer Price index is used for assessing Inflation. CPI is converted on one Base year 2000. 4.

SAMPLE SIZE

Sample size is 30. Thirty years data of Fiscal Deficit and Consumer Price index from year 1980 to 2009 is used. 5.

STATISTICAL TECHNIQUE

Multiple Regression Analysis Technique is used to check the dependability of Inflation on Fiscal deficit and how much these are associated with each other. 6.

STATISTICAL TOOL

SPSS software is used to analyze the data.

MODELLING FRAMEWORK
The model to investigate the interaction of fiscal deficit and inflation is derived using the production function frame work. Consider the following function: INF= f (FD) + f (M2) + Study illustrates on variable FD with INF the dependent variable. Therefore the model is: INF = + 1 FD + 2 FD +

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RESEARCH VARIABLES Dependant: Independent: Independent: Where: INF: Inflation FD: Fiscal deficit M2: Money Supply : error Change in Inflation Fiscal deficit Money Supply

DATA ANALYSIS Reliability Test

Reliability Statis tics Cronbac h's Alpha Bas ed on Standardized Items .980

Cronbac h's Alpha .242

N of Items 3

As according to the reliability of data is 98% its mean data is reliable.

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Inte r-Item Corre lation M atrix Inf lation Fis.Def ic it M2 Inf lation 1.000 .931 .977 Fis.Def ic it .931 1.000 .916 M2 .977 .916 1.000

The covariance matrix is calc ulated and us ed in the analy sis.

It is the relation between the all variables.

b Model Sum m ary

Model 1

R .982 a

R Square .964

A djusted R Square .961

Std. Error of the Estimate 10.20613

F Change 356.580

Sig. F Change .000

DurbinWats on .113

a. Predictors: (Constant), M2, Fis .Def icit b. Dependent Variable: Inf lation

The adjusted R Square value shows the 96% dependability of inflation on fiscal deficit and money supply which depicts that there are several other reasons which are also the cause of increasing the level of inflation. The value of Durbin Watson shows auto autocorrelation

between times series and dependant variable, As a rough rule of thumb, if Durbin-Watson is less than 2.0, there may be cause for alarm. But in this case our Durbin Watson is 1.113 which is no sign of alarm.

ANOVAb Model 1 Sum of Squares 74286.315 2812.457 77098.773 df 2 27 29 Mean Square 37143.158 104.165 F 356.580 Sig. .000 a

Regression Residual Total

a. Predictors: (Constant), M2, Fis .Def icit b. Dependent Variable: Inf lation

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Lower the significance level stronger the evidence and the data depicts more accuracy. Our significance level is .000 which is under 0.05 which shows that our predictor fiscal deficit accurately predicts the dependant variable inflation. The number of degrees of freedom is a measure of how certain we are that our sample population is representative of the entire population. The more degrees of freedom, usually the more certain we can be that we have accurately sampled the entire population. In our case of regression analysis, our degree of freedom is 29, which means the sample population is certain with relation to our entire population.

a Coe fficients

Unstandardiz ed Coef f icients Model 1 (Cons tant) Fis.Def ic it M2 B 30.745 7.90E-005 2.89E-005 Std. Error 2.620 .000 .000

Standardized Coef f icients Beta .224 .772 t 11.734 2.453 8.435 Sig. .000 .021 .000

a. Dependent Variable: Inf lation

The value of predictor fiscal deficit is 30.745 and both the coefficients and under the significance level.

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a Res iduals Statistics

Minimum Predicted V alue 34.8535 Std. Predicted V alue -.872 Standard Error of 1.925 Predicted V alue A djusted Predic ted V alue 35.6903 Residual -13.20354 Std. Residual -1.294 Stud. Res idual -2.135 Deleted Residual -36.10264 Stud. Deleted Res idual -2.298 Mahal. Distance .064 Cook's Dis tance .000 Centered Leverage V alue .002 a. Dependent V ariable: Inf lation

Max imum 225.5893 2.897 8.138 248.5426 15.42720 1.512 1.541 16.03506 1.583 17.471 2.652 .602

Mean 78.9747 .000 2.902 79.9280 .00000 .000 -.037 -.95334 -.036 1.933 .111 .067

Std. Deviation 50.61222 1.000 1.437 53.26471 9.84791 .965 1.045 12.20178 1.066 3.640 .480 .126

N 30 30 30 30 30 30 30 30 30 30 30 30

We selected the thirty years data from 1980 to 2009 on fiscal deficit, money supply and inflation and tried to analyze the relationship among these variables that how fiscal deficit impacts on inflation. It can be concluded that inflation in Pakistan depends on fiscal deficit to a significant extent. Although there are certain other factors present which are also contributors to inflation besides money supply and fiscal deficit like: increase in the electricity charges, increase in oil prices, wheat procurement price and political instability.

CONCLUSION
A cursory look at key macroeconomic indicators shows downfall of the economy. Inflation has fallen near to 12 percent in the first quarter of 2010 (quarterly report of SBP) and will remain 12 percent by the end of 2010. External current account is negatively altering its projected trajectory. The real sector is also showing signs of improvement as the large scale manufacturing

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(LSM) stage a recovery after a protracted declining phase. However, a close inspection of these encouraging developments together with a pragmatic assessment of prevailing security situation in the country and fiscal uncertainties invite caution and further analysis. The fiscal scenario of Pakistan is showing worst scenario the government has gone into an agreement with IMF for the loan of 750 million dollar. IMF is dictating its terms to the government electricity prices has been increase in the in the June of 2010 according to the IMF instructions the value added tax will be imposed on industries. Value added tax puts its impact on the sensitive price index and the prices of sensitive goods like wheat, milk and other food item will increase. When this value added tax will be imposed the organization will bear the 50 percent burden and remaining 50 percent burden of this value added tax will be transferred to general consumers which will further increase the level of inflation in Pakistan. The government is applying tight fiscal policy to limit the fiscal deficit or even to reduce it. Though the government estimates government will collect sixty billion rupees annually through this value added tax which will help the government to stagnant the fiscal deficit or may be to reduce it. Apart from influencing commodity prices, the recovering global economy is expected to revive global trade and flow of liquidity across borders, which bodes well for Pakistans exports and private financial flows. The recent strong inflow of workers remittances and a substantially improved external current account deficit of $1.1 billion in the first four months of FY10 may allow Pakistans economy to absorb the likely swelling of import bill induced by a nascent domestic recovery and higher international oil prices. However, the strength and sustainability of its overall balance of payments crucially depends on resumption of foreign financial flows. Of these, portfolio inflows have picked up, direct investment has fallen, and official inflows, other than IMF, remain lower compared to projections. Looking forward, the magnitude and timing of

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expected non-IMF foreign inflows remain uncertain and could increase the challenges of SBPs liquidity management and governments budgetary financing. Public sectors steady borrowing requirements have the potential to raise the Net Domestic Assets (NDA) of the banking system. Though broadly respecting the pre-announced T-bill auction targets, Ministry of Finance has realized Rs.91 billion for budgetary support against maturities of Rs37 billion in the four auctions held so far in second quarter of-FY10. Moreover, retirement of earlier borrowings for wheat procurement has been less than expected and to some extent neutralized by fresh borrowings for other commodities like rice, sugar, and fertilizer. Moreover, the credit availed by public sector enterprises continues to increase as well. In conclusion, the overall level of risk and uncertainty in the economy has increased considerably given the present law and order situation. As a consequence, the pressure on the fiscal position, especially from the financing side, has escalated and growth in the real economy is limited. Striking a balance between monetary and financial stability and real economic activity has become increasingly difficult. The government should opt for tight monetary and fiscal policy for to reduce money inflation in economy in order to control over inflation.

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References

Agha, A. I., & Khan, M. S. (2006). An Empirical Analysis of Fiscal Imbalances. SBP Research Bulletin , Vol. 2, No. 2 1 - 20. Chaudhary, M. A., & Ahmad, N. (Winter 1995). Money Supply, Deficit, and Inflation. The Pakistan Development Review , 945956. Kamel, M. A. (2006). Is Inflation in Pakistan a Monetary Phenomenon. The Pakistan Development Review 45 , 213-220. Khan, A. A., Bukhari, S. K., & Ahmed, Q. M. (2006). Determinants of recent inflation in pakistan. Research Report No. 66 , 1-18. Nasir, M., Ahmad, A., Ali, A., & Rehman, F. (EuroJournals Publishing, Inc. 2010). Fiscal and Monetary Policy Coordination: Evidence from. International Research Journal of Finance and Economics , 202-213. Qayyum, A. (Summer 2006). Money, Inflation, and Growth in Pakistan. The Pakistan Development Review , 203212.