DOES VOLATILITY IN GOVERNMENT BORROWING LEADS TO HIGHER INFLATION? EVIDENCE FROM PAKISTAN

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1 DOES VOLATILITY IN GOVERNMENT BORROWING LEADS TO HIGHER INFLATION? EVIDENCE FROM PAKISTAN à Adnan Haider Modeling and Forecasing Division Moneary Policy Deparmen Sae Bank of Pakisan Safdar Ullah Khan Core Research Division Research Deparmen Sae Bank of Pakisan ABSTRACT This sudy analyzes he impac of volailiy in governmen borrowing from cenral bank (GBCB) on domesic inflaion in Pakisan. This paper uilizes Generalized Auo Regressive Condiional Heroskedasiciy (GARCH) model o esimae volailiy in GBCB using monhly daa from July 199 o June 007. The empirical resuls, based on auo regressive disribued lag (ARDL) wih bound esing echnique sugges ha domesic inflaion in Pakisan is relaed wih volailiy in governmen borrowing from cenral bank in he long run. Furhermore, error correcion model (ECM) esimaes show ha in he shor run, inflaion is also affeced by volailiy in GBCB. Keywords: inflaion, governmen borrowing, volailiy, GARCH, ARDL, ECM JEL Classificaions: E31, E60, E6 Draf Version: December 007 Corresponding Auhor- Views expressed here are hose of he auhors and no necessarily of he Sae Bank of Pakisan. Any errors or omissions in his paper are he responsibiliy of he auhors. Auhor welcomes commens and suggesions.

2 1. INTRODUCTION A common criicism of his sress on he budge defici is ha he daa rarely shows a srong posiive associaion beween he size of he budge defici and he inflaion rae. 3 (Blanchard and Fischer, 1989, p. 513) Hisorical lieraure recognizes inflaion as a moneary vis-a -vis fiscal phenomenon wih momenous socio-economic and poliical consequences. Generally, inflaion refers o a susained increase in general price level as measured by an index such as consumer price index (CPI) or gross domesic produc (GDP) deflaor. I may be eiher demand-pull or cos-push. 1 Economiss idenify inflaion wih differen caegories depending on he degree of variabiliy in inflaion. For insance, when he general price level is rising by 5% or less, hey call i creeping inflaion. This creeping inflaion provides healh o he economy by generaing he forces of dynamism. If he prices become sagnan, he economic growh will sop in he economy. When he general price level is rising by a rae beween 5 o 10%, i is labeled as a siuaion of walking inflaion. This walking inflaion gives a signal ha somehing is wrong in he economic managemen process and proper remedial measures have o be iniiaed. If he increase in general price level is above 10%, he siuaion is called running inflaion which becomes hyper inflaion when i shooing more han 50%. Presumably, inflaion generaes welfare cos of economic agens (i.e., inflaion ax) and inflaion volailiy is considered as a key source of desabilizing misakes. I frequenly varies and hus increases uncerainies for macroeconomic environmen. Roher (004) argue ha high variabiliy of inflaion over ime makes expecaions over he fuure price level more uncerain. In a world wih nominal conracs his induces risk-premia for long-erm arrangemens, raises coss for hedging agains inflaion risks and leads o unanicipaed redisribuion of wealh. To some prominen economiss inflaion is always and everywhere a moneary phenomenon in he long run. Tha is why almos all over he world cenral banks are enrused upon o ame inflaion. For all he cenral banks aking care of inflaion is a leas one of he objecives of moneary policy. Same is he case wih he Sae Bank of Pakisan (SBP) being cenral bank of he counry. SBP Ac, 1956 confers upon i o regulae money and credi in he counry in such a way ha mainains moneary sabiliy (which leads o price sabiliy) while fosering he uilizaion of counry s resources in he bes naional ineres. A general consensus among macroeconomis is ha inflaion occurs when he rae of growh of he money supply is higher han he growh rae of he economy. This phenomenon, 1 Demand-Pull Inflaion is siuaion ofen described as oo much money chasing oo few goods. According o his view, an excess of aggregae demand over aggregae supply will generae inflaionary pressures in prices. Cos-Push Inflaion is caused by wages increase by union pressures and profi increase by producers. The basic cause of cos-push inflaion is ha he money wages increase more rapidly han he produciviy of labor. Cos-push inflaion may be due o upward adjusmen of wages o compensae rise in he cos of living index. An increase in he prices of domesically produced or impored raw maerials may lead o cos-push inflaion. Anoher cause of cos-push inflaion is increase in easy and non-funcional profis by oligopolisic and monopolis firms. This is he convenional monearis linkage from he creaion of reserve money o inflaion when Cenral Banks issues money a he rae ha exceeds he demand for cash balances a he exising price level and he increased demand in he goods marke pushes up he price level as he public ries o ge rid of is excess cash holdings.

3 however, occurs usually in developing counries which faces high budge deficis. The cenral governmen of any developing counry finances heir budge defici hrough moneizing process (borrowing from cenral bank). High moneizaion leads o higher inflaionary pressure o he economy. Thus borrowing from he cenral bank is considered as a leading indicaor of domesic inflaion. In line wih he above phenomenon, he main moivaion of his paper is o assess wheher volailiy in governmen borrowing has an impac of domesic inflaion in Pakisan. For his purpose Generalized Auo Regressive Condiional Heroskedasiciy (GARCH) model is used o esimae volailiy in governmen borrowing from cenral bank (GBCB) using monhly daa from July 199 o June 007. Our main hypohesis is ha GBCB has significan and posiive impac on domesic inflaion. I is also one of he leading indicaors of price insabiliy boh in shor and in he long run. The res of he paper is organized as follows: A review of previous empirical sudies is presened in secion. Secion 3 provides daa and mehodology. Empirical findings are discussed in secion 4 and he main conclusions are saed in secion 5.. BRIEF REVIEW OF EMPIRICAL LITERATURE There is an immense lieraure available on fiscal vis-a -vis moneary deerminans of inflaion. In his paper we also provide a brief review of some seleced domesic and inernaional sudies. This review provides us sylized facs and a baseline for our model consisency. Therefore, we inend o caegorize he lieraure for Pakisan ino wo ses including sudies which used governmen borrowing as a deerminan of inflaion and hose which have no incorporaed his deerminan in heir model seup. Appendix A summarizes almos all of he local empirical lieraure on inflaion since 198 o dae. In his sudy we also presen evidence of inernaional empirical lieraure relevan o his concep. In he case of Turkey, Akcay, Alper and Ozmucur (1996) invesigae deerminans of inflaion using annual daa from 1948 o 1994 vis-a -vis quarerly daa from 1987 o 95. Their analysis reveals ha a one uni increase in he defici GNP raio under money neuraliy will increase he long-run inflaion by 1.59 unis. Also a one uni increase in he defici GNP raio under money neuraliy will increase he long-run inflaion by 5.67 which is much higher han 1.59 for he whole sample indicaing greaer impac of defici on inflaion during pre-bond financing period. Mein (1998) provide a mulivariae coinegraion analysis of he deerminans of inflaion for Turkey using annual daa from 1950 o The major finding from he new equaion is ha budge deficis (as well as real income growh and deb moneizaion) significanly affec inflaion. For he condiional model, an increase in he scaled budge defici immediaely increases inflaion. Real income growh has a negaive immediae effec and posiive second-lag effec on inflaion. Moneizaion of he defici also affecs inflaion a a second lag. 4

4 Caao and Terrones (003) sudied he defici-inflaion relaionship in 107 counries over he period 1960 o 001. This sudy was disincive in wo respecs. Firsly, i used an ineremporal opimizaion model o show ha he equilibrium inflaion is direcly relaed o fiscal defici which is scaled by narrow money. This approach resuled in inroducing nonlineariy in he model which is beer han semi-logarihm specificaion used earlier3. Secondly, hey modeled he link beween fiscal defici and inflaion as inrinsically dynamic, explicily disinguishing beween he shor run and long run. This sudy specified an auoregressive disribued lag (ARDL) model for each counry and polled hem ogeher in a panel, and hen esed he cross-equaion resricion of a common long-run relaionship beween he wo variables using pooled mean group esimaor (PMG)4. As he difference beween he MG and PMG esimaes of long-run elasiciy parameer idenified sample heerogeneiy, herefore he auhors divided he panel ino groups on he basis of financial developmen and inflaion performance. Then esimaes of MG and PMG indicaed ha budge defici was significan driver of inflaion in mos groups excep he low inflaion economies and advanced economies. The resuls showed ha in case of developing counries, a reducion (increase) of one percen in raio of budge o GDP lowered (raised) inflaion by around 8.75 percenage poins. For emerging marke economies, a percenage poin change in he raio of budge balance o GDP is esimaed o change inflaion by.5 percenage poins. Similarly, changes in inflaion srongly impaced he high inflaion economies, and less srongly on moderae inflaion economies. This sudy concluded ha fiscal defici displayed a powerful effec on inflaion in developing counries, emerging markes and high-inflaion economies and a much smaller effec amongs moderae inflaion counries. Roher (004) examined he relaionship beween discreionary fiscal policies and inflaion volailiy for fifeen indusrialized counries for he period from 1967 o 001. Their resuls suggesed ha he volailiy in discreionary fiscal policies srongly conribued o inflaion volailiy. They found ha a one sandard deviaion increase in discreionary fiscal policy could raise inflaion volailiy o range of percenage poins. These resuls were obained using panel daa and performing regressions for differen measures of inflaion volailiy (condiional and uncondiional variabiliy of inflaion rae5) as a funcion of he volailiy of acivis fiscal policies6 and oher explanaory variables (like oupu gap, moneary and exchange raes). Moreover, he Generalized Leas Squares (GLS) was employed in order o accoun for he possibiliy of cross-secional Heroskedasiciy. Alavirad and Ahawale (005) invesigae deerminans of inflaion in Islamic Republic of Iran using annual daa from 1963 o They find ha budge deficis do have a significan impac on inflaion raes in he long run in he Islamic Republic of Iran. The ECM resuls show 3 This non-lineariy in he model resuled in capuring a sronger impac of fiscal defici in higher inflaion economies. 4 This mehodology is beer han earlier used saic fixed-effecs esimaor as counry-specific ARDL srucure is capable of accommodaing cross-counry heerogeneiy in inflaion ineria. 5 Uncondiional variabiliy in inflaion rae is defined as he sandard deviaion over a calendar year of monh-on-monh inflaion raes, hereby capuring he exen of shor-erm flucuaions in inflaion. Moreover, condiional inflaion variabiliy is measured by he sandard deviaion of one-sep-ahead forecas errors derived from ime-series based inflaion forecas model. 6 To measure he volailiy of discreionary fiscal policy, fiscal policy sance is defined as he year-on-year change in he cyclically adjused primary balance relaive o GDP. 5

5 ha he budge defici and liquidiy in he shor run, and relaed o he long run, have less of an effec on price levels. The coefficien of error correcion is esimaed a -0.. This value shows ha he adjusmen speeds is relaively slow. Caao and Terrones (005), using panel of 3 emerging marke counries for he period o invesigae deerminans of inflaion. They found ha a one percenage poin reducion in he raio of fiscal defici o GDP lowered long-run inflaion by 1.5 o 6 percenage poins. This sudy used an economeric specificaion derived from iner-emporal opimizaion model ha relaes o long-run inflaion o he permanen componen of fiscal defici. One of he mos disinguishing feaure of his sudy is ha i fiscal defici is scaled by he size of inflaion ax base which is measured by he raio of narrow money o GDP. This resuled in inroduced he desired non-lineariy in he relaionship beween fiscal defici and inflaion. Giannisarou and Sco (006) examined he means hrough which fiscal susainabiliy was achieved by six indusrialized counries (namely US, Japan, Germany, Ialy, UK and Canada) during he period They assessed he relaive conribuion of primary defici, inflaion and GDP growh as means o couner fiscal imbalances in he counries under sudy. Their findings suggesed ha fiscal balance was achieved mainly hrough variaions in primary deficis ( percen), whereas inflaion (0-10 percen) and GDP growh (0-0 percen) conribued minimally owards fiscal susainabiliy. The empirical resuls suggesed ha fiscal imbalances and weak forecaser for fuure inflaion in economies under sudy. More specifically, hey found ha he prediced rise in fiscal defici scenario in fuure could possibly impac in an insignifican manner owards increasing inflaion in he economy. The auhors furher observed ha heir resuls should be used wih much cauion as economerically evaluaing he iner-emporal budge consrain is vulnerable o non-saionariy and ime dependence problems. 3. Mehodology and Daa Descripion 3.1 Theoreical Framework To sudy he adverse impac of volailiy in governmen borrowing from cenral bank on domesic inflaion, i is necessary o observe is funcional channel (see, flow char 1). Theoreically speaking, budge defici (BD) weakly causes inflaionary pressures, bu raher impacs srongly on general price level hrough he impac on money aggregaes (say, M1 and M) and public expecaions, which in urn rigger volailiy in prices. Since, governmen borrows from differen sources o finance budge deficis, so i is necessary o observe is dynamics which generae volailiy in money growh. To do his, we adoped a heoreical model inroduced by Sachs and Larrain (1993). 6

6 Flow Char 1 - Funcional Channel of Governmen Borrowing and Money Growh Volailiy The budge consrain of he public secor governmen as inroduce by Sachs and Larrain (1993) can be expressed as follows: Where: g g g g g 1 ( ) 1 BDF = GD = GD GD = P G+ I T + igd (3.1) o o o o o g g GD GD 1, is he change in governmen deb beween he curren and previous periods, P is he price level, g G + I, is Governmen expendiures T is axes g GD, is he ineres paymens on previously issued deb. i 1 Governmen deb, in he form of eiher bonds or credis, can be held by he public (domesic and foreign) and by he cenral bank. Le s assume for he purposes of he presen repor ha he cenral bank s credi o banking sysem doesn aler over ime. Then he change in moneary base MB equals he change in he sock of governmen deb held by cenral bank g g * * ( GD GD 1) plus he change in foreign exchange reserves, E ( B c B ), where E sands c c for he nominal exchange rae, we obain: c 1 g g g * * p p 1 c c 1 GD = MB+ ( GD GD ) E ( B B ) (3.)

7 Equaion (3.) gives us informaion ha here are hree ways o cover a budge defici; [a]: by moneizaion of he defici (i.e. by increasing moneary base or by so called prining money); [b]: by increase in he public s (foreign and domesic) holdings of deb; and [c]: by running down foreign exchange reserves a he cenral bank. Since, our arge is o find he volailiy in governmen borrowing from cenral bank on domesic inflaion. So for simpliciy in our model, we assumed ha governmen only borrows from cenral bank 7. In his case, equaion (3.) becomes: Where; g GD = MB (3.3) g g c 1 ( GDc GD ) = 0 and * * c c 1 E ( B B ) = 0 Le: g GD = GB g and MB = Mg Where: o o GBg is growh in governmen borrowing; Mg is he money growh This ype of borrowing is called moneizing 8 he defici. Because his phenomenon always leads o he growh of moneary base (MB) and money supply, i is ofen defined as prining money. From equaion (3.3), we can observe ha an increase in he high-powered money is he source of financing budge defici. Lasly, from equaion (3) we can define general funcional form as: Or vol( Mg) = vol( GB g ) (3.4) Equaion (3.4) implies ha volailiy in governmen borrowing impacs direcly on money growh via moneizaion channel. Quaniy heory also idenify ha he volailiy in money growh is he key facor ha effec he changes in price level [Walsh (003) and Romer (006)]. So, we also have he following relaionship: π = vol( MB ) g (3.5) 7 Ouanes and Thakur (1997) argues ha here exis five differen ways of financing budge defici: (a) borrowing from he cenral bank (or moneizaion of he defici); (b) borrowing from he res of he banking sysem; (c) borrowing from he domesic nonbank secor; (d) borrowing from abroad, or running down foreign exchange reserves; and (e) accumulaion of arrears. 8 Moneizaion occurs (i) when he cenral bank direcly finances budge defici by lending funds needed o pay governmen bill s; or (ii) when he cenral bank purchases governmen deb a he ime of issuance or laer in he course of open marke operaions. 8

8 Where; π Domesic inflaion Hence, from relaionship (4) and (5) we can also esablish a direc relaionship ha volailiy in governmen borrowing have an impac on domesic inflaion as: π = vol( GB ) g In order o esimae he funcional relaionship (3.6), we use ARCH/GARCH model inroduced by Engle (198) and Bollerslev (1986), respecively. To apply his mehodology, i is necessary o search for appropriae ype of ARCH/GARCH specificaions o model he dynamics of GBCB volailiy. We apply LM es developed by Engle [198] o deermine ime varying volailiy behavior as well as searching for he asymmeric effecs of shocks on volailiy. Consider an informaion se model is given as: (3.6) abou GBCB. So, joinly esimaed sandard ARCH/GARCH GB = µ + ε (3.7) Where; and Using model specificaions (3.6) and (3.7), we have a final version of our complee economeric model. π = α + βvol( GB ) + ξ GB = µ + ε (3.8) Where; and ξ, 3. Daa Descripion This paper uses Auo Regressive Disribued Lag (ARDL) es wih bound esing echnique o invesigae he long run relaionship beween volailiy in GBCB 9 and domesic inflaion using Pakisan s ime series daa aken from he Pakisan Economic Survey and Annual Repors (various issues) and SBP monhly saisical bulleins (various issues). This daa series is on monhly basis from 199 o 007. In line wih our hypohesis, we also provide some sylized facs in Appendix B. (Figure 1 o Figure 3) shows a posiive correlaion beween governmen borrowing from cenral bank and domesic inflaion. Furhermore, he process of moneizaion 9 Generalized Auo Regressive Condiional Heroskedasiciy (GARCH) model is used o esimae volailiy in GBCB.

9 is also be observed from growh in moneary aggregaes which also leads domesic inflaion in Pakisan. The whole graphical represenaion clearly provide us a skech ha governmen finance is budge defici wih borrowing from cenral bank which lead pressure on moneary aggregaes and hence rises domesic inflaion in Pakisan. This also shows ha recen higher governmen borrowing from cenral bank leads higher domesic inflaion in Pakisan, since FY EMPIRICAL RESULTS AND DISCUSSION In line wih our sudy hypohesis, we esimae model (3.8) using monhly daa from July 199 o June 007. Esimaion resuls of model (3.8) are presened in Table 1. We use log difference form of consumer price index as a proxy of domesic inflaion for Pakisan. The resuls in Table 1 provide us imporan informaion ha he impac of volailiy in governmen borrowing from cenral bank on domesic inflaion is economically and saisically significan. The esimaed coefficien of governmen borrowing shows ha one sandard deviaion change in (volailiy) governmen borrowing from cenral bank leads 8.5% change (increase) in domesic inflaion Pakisan. Now in order o invesigae long run dynamics (coinegraion) beween domesic inflaion and volailiy in governmen borrowing, we use ARDL model as inroduce by Pesaran e al (1999). Deail mehodological descripion is also available in Appendix C. In line wih his mehodology we are going o inroduce coinegraion funcional form as: k π = α + απ + β vol( GB) 0 i i i i i= 1 i= 0 k k + γ π + δ vol( GB) k i i i i i= 1 i= 0 (3.9) Two furher aspecs of he regression equaion (3.9) need specifying in pracice. Firs we specify he lag order αk in he regression. We sared esing wih a maximum lag of 1 and used informaion crieria and sequenial F ess along wih ess for residual auocorrelaion o guide our lag choice. Since his is monhly daa and we wish o preserve as many degrees of freedom as possible, his seems a reasonable maximum lag order. The second decision regards he inclusion of deerminisic consan and rend erms. We repor here ess based on a model wih an unresriced consan, since we found no evidence of a significan deerminisic rend in he relaionship. We based our decision on lag order on he observaion of informaion crieria, F es of he reducion (from 1 lags o 1 lag) and he auocorrelaion es. Tess of he null hypohesis of no long run relaionship can hus be carried ou using an F es of he null ha β i= П i= 0. Resuls in Table sugges here is a srong long run relaionship beween domesic inflaion and volailiy in governmen borrowing from cenral bank. The value of F-saisic shows a 1

10 significance of he rejecion of null hypohesis of no coinegraion as suggesed in Pesaran, Shin and Smih (1999) 10. Finally, since he above resul appears o confirm he exisence of a long run relaionship, we use he esimaed regression o form an error correcion erm and esimae a simple dynamic ECM for domesic inflaion. The esimaed regression is reproduced below wih a sandard range of diagnosics. The resuls of ECM model are presened in Table 3. The error correcion erm is correcly signed and significan. The value of he coefficien on he ECM indicaes ha a change in volailiy in governmen borrowing from cenral bank brings abou a 77% change in domesic inflaion in Pakisan in he span of welve monhs. The ECM also passes a range of diagnosic ess. Table 1- ARCH/GARCH Model Esimaion Resuls Impac of volailiy in GBCB on Domesic inflaion Parameers Esimaed Coefficiens S.E raios π = vol( GB ) (7.3) (1.994) *Noe: Values in prenices shows -saisics Table - F es for he exisence of a long run relaionship Tes Saisic Value df Probabiliy F-saisic (4, 137) Chi-square * Noe: 95% criical bounds for he F es: Table 3- Error correcion model Resuls Variable Coefficien S.E -value Consan vol(gb) vol(gb) ECM R = 0.408, D.W =.0 10 This mehod is, once again, applicable irrespecive of wheher he regressors are I(0) or I(1). The long run esimaes and heir sandard errors were obained using EViews Criical bounds are from Table C1.iii of Pesaran e al., (1999). 0

11 5. CONCLUSION This sudy suppors he fiscal dominance hypohesis in deermining inflaion in he case of Pakisan economy. In connecion wih his hypohesis, he resuls depic imporan informaion ha he impac of volailiy in governmen borrowing from cenral bank on domesic inflaion is economically and saisically significan. Furher, he empirical evidence suggess ha here is a srong long run relaionship beween domesic inflaion and volailiy in governmen borrowing from cenral bank. The esimaed coefficien of governmen borrowing shows ha one sandard deviaion change in (volailiy) governmen borrowing from cenral bank leads 8.5% change (increase) in domesic inflaion. In paricular, i suggess incorporaing he rend effecs of governmen borrowing from moneary auhoriies in inflaion modeling. Finally hese findings may help in undersanding inflaion experience in differen developing economies like Pakisan. 00

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14 [39] Khan, Ashfaque H., (198b), The Demand for Money and he Variabiliy of he Rae of Inflaion - An Empirical Noe, in Economics Leers, Vol. 10, pp. 57é61. [40] Khan, A. H. (1994), Financial liberalizaion and he demand for money in Pakisan, in Pakisan Developmen Review, Vol. 33, No. 3, pp [41] Khan, A. H., and M. A. Qasim (1996), Inflaion in Pakisan Revisied, in The Pakisan Developmen Review, Vol. 35, No. 4, pp. 747é759. [4] Khan, Imran Naveed, (199), The Demand for Money in Pakisan & India, in Pakisan Economic and Social Review, Vol. 30, No., pp [43] Khan, M. S., and A. Schimmepfennig (006), Inflaion in Pakisan: Money or Whea?, IMF Working Paper, WP/06/60. [44] Mein, K. (1998), The Relaionship Beween Inflaion and Budge Defici in Turkey, in Journal of Business & Economic Saisics, Vol. 16, No.4, pp [45] Naqvi, Syed Nawab, A.R. Kemal, and Rashid Aziz, (198), The P.I.D.E. Economeric Model of Pakisan's Economy ( o ), Published by Pakisan Insiue of Developmen Economics, Islamabad, Pakisan. [46] Naqvi, S.N.H. and Khan, A.H. (1989), Recen Inflaionary Upsurge in Pakisan, in Pakisan Developmen Review, vol. 8, No. 4, pp [47] Naqvi, S. N. H., A. H. Khan, A. M. Ahmed, and R. Siddiqui (1994), Inflaion in Pakisan: Causes and Remedies, Research Repor, Pakisan Insiue of Developmen Economics, Islamabad. [48] Nasim, A. (1997), Deerminans of Inflaion in Pakisan, SBP Publicaion, Sae Bank of Pakisan Press, Karachi, Pakisan. [49] Nisar, Shaheena and Naheed Aslam, (1983), The Demand for Money and he Term Srucure of he Ineres Raes in Pakisan, in The Pakisan Developmen Review, Vol., No., pp [50] Ouanes, A., and Thakur, S. (1997), Macroeconomic Accouning and Analysis in Transiion Economies, Washingon, D.C.: Inernaional Moneary Fund. [51] Pesaran, M. H., and Y. Shin (1995), Long-run Srucural Modeling, DAE Working Paper No. 9419, Deparmen of Applied Economics, Universiy of Cambridge, Cambridge. [5] Pesaran, M. H., Shin, Y., and R. J. Smih (001), Bounds Tesing Approaches o he Analysis of Level Relaionships, in Journal of Applied Economerics, Vol. 16, pp. 89é36. [53] Pesaran, M. H., and B. Pesaran (1997), Working wih Microfi 4.0: An Ineracive Approach, Oxford: Oxford Universiy Press. [54] Price, S. and A. Nasim (1999), Modelling Inflaion and he Demand for Money in Pakisan; Coinegraion and he Causal Srucure. In Economic Modelling, Vol. 16, pp [55] Qayyum, A., and Bilquees, F. (005), P-Sar Model: A Leading Indicaor of Inflaion for Pakisan, in The Pakisan Developmen Review, Vol. 44, No., pp. 117é19. [56] Roher, P. C., (004), Fiscal Policy and Inflaion Volailiy, ECB Working Paper Series, WP No. 317/March/004. [57] Romer, D., (006), Advanced Macroeconomics. Third Ediion, New York: The McGraw-Hill Companies, Inc. [58] Sachs, J. D., and Larrain, F., (1993), Macroeconomics in he Global Economy, Englewood Cliffs, NJ: Prenice-Hall, Inc 05

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16 Appendix- A Table A1- Seleced Pakisan Empirical Sudies of Inflaion and Moneary Policy Secion (i): Pakisan Sudies which used Governmen Borrowing as a deerminan of Inflaion Dependen Auhors Empirical Approach Variable(s) Regressors Agha, Asif Johansen coinegraion consumer price consolidaed fiscal defici, oal bank Idrees and analysis, VECM index borrowing Khan, model Muhammad Saleem (006) Khan, A. Aleem, Bukhari, S. K. Hyder and Ahmed, Q. Masood (006) Chaudhary, M. Aslam and Anjum, S. Waseem (1996) Chaudhary, M. Aslam and Ahmed, Naved (1995) Ordinary leas square (OLS) mehod and verifying resuls hrough Breusch- Godfrey Serial Correlaion LM and Augmened Dickey- Fuller ess Susainable defici economeric model for Pakisan is esimaed. Simulaneous model and OLS i.e regressions of money supply equaion, real cash balance equaion, price equaion, oupu equaion and expor supply equaion. consumer price index Growh rae of GNP, inflaion rae, ineres rae of foreign deb ec. Consumer Price index, money supply, demand for real cash balances, expors Governmne secor borrowing (plus NFA and oher iems) as raio o real GNP, real demand relaive o real supply, nongovernmen secor borrowing (pluc borrowing of auonomous bodies) as raio of real GNP, price index of impors, exchange rae, governmen axes as a raio of manufacuring secor value added, lagged CPI and suppor price of whea. A number of assumpions regarding growh rae of GNP, inflaion rae and ineres rae on foreign deb (1) Money supply equaion- inernaional reserves, domesic financing of budge defici including banking and nonbanking sysem, commercial banks credi o privae secor () Demand for real cash balances- income, proxy for cos of holding real balances (3) Price equaionincome, money supply, impor price (4) Oupu equaion- governmne expendiures, commercial credi (5) Expor supply equaion- income, expor price Sample Period Findings 1973 o 003 The empirical resuls sugges ha in he long-run inflaion is no only relaed o fiscal imbalances bu also o he sources of financing fiscal defici. 197 o 005 The mos imporan deerminans of inflaion are adapive expecaions, privae secor credi and rising impor prices whereas fiscal policy's conribuion o inflaion was minimal. Specifically, if governmen secor borrowing as a raio o GNP chnaged by 10 percen, hen he resuling change in CPI will be around 1 percen. Three ime periods- 1980s, and , and Throughou he period under analysis, fiscal defic was no susainable. Domesic financing of budge defic, paricularly from he banking sysem is inflaionary in long run. Money supply is no exogenous, raher i depends on he posiion of inernaional reserves and fiscal defici and i has emerged as an endogenous variable. 0

17 Secion (ii): Pakisan Sudies which did no consider Governmen Borrowing as a deerminan of Inflaion Auhors Empirical Approach Dependen Variable(s) Regressors Sample Period Findings Hyder, Zulfiqar and Sardar Shah (004) VAR CPI inflaion, WPI inflaion, PR/USD, M, LSM index, oil 1988:1 o 003:9 Lile exchange rae pass hrough o domesic CPI inflaion. Choudhri, Ehsan U. and Mohsin S. Khan (00) Ahmad, Eazaz and Muhammad Munirs (000) Ahmad, Eazaz and Saima Ahmed Ali (1999a) Ahmad, Eazaz and Saima Ahmed Ali (1999b) Price, Simon and Anjum Nasim (1999) Single equaion and VAR in firs differences OLS, coinegraion analysis Single equaion, including Engle/Granger coinegraion es, -equaion model wih SLS -equaion model wih SLS Johansen (VECM), and SUR CPI and WPI prices U.S. dollar exchange rae, foreign price index M1, M Index of indusrial producion, inerbank call money rae, CPI inflaion CPI and exchange rae CPI and exchange rae CPI and exchange rae Exchange rae, impor prices, world prices, money supply, GDP, forex reserves Exchange rae, impor prices, world prices, money supply, GDP, forex reserves Broad money, world prices, GDP, deposi rae 198γ001 There is no exchange rae pass-hrough o domesic prices. 197:I o 1996:I Find ha inflaion is a beer measure of opporuniy cos han ineres rae, money demand adjuss sluggish, and here was a srucural break in he early 1990s. 198:II o 1996:IV 198:II o 1996:IV CPI reacs o changes in impor prices (due o change in world prices or exchange rae) and money supply. Exchange rae responds o domesic and world prices. CPI reacs o changes in impor prices (due o change in world prices or exchange rae) and money supply. Exchange rae responds o domesic and world prices o 1994 PPP and money demand relaion are idenified ha are conneced hrough coinegraing relaionships. Hsing, Yu (1998) Single equaion Real M Real GDP, deposi rae n.a. Real GDP elasiciy is close o uniy whereas ineres elasiciy is low. Shamsuddin, Abul F.M. and Richard A. Holmes (1997) Johansen procedure, VARMA, ARMA CPI Broad money, real oupu 197:II o 1993:IV Rejecs a coinegraing relaionship beween inflaion, broad money and GDP and concludes ha a univariae ARMA yields he bes forecass. Tariq, Syed Muhammed and Ken Mahews (1997) Chaudhary, M. Aslam and Naved Ahmad (1996) Johansen, single equaion ECM M, M1, divisia Real GDP, opporuniy coss OLS CPI inflaion Broad money, GDP growh, share of service secor, public deb, impor prices 1974:IV o 199:IV Idenifies a coinegraion vecor ha is inerpreed as a money demand funcion. Shor-run parameers of money demand equaion are sable. 197 o 199 Inflaion resuls from money growh and srucural facors such as growh, share of service secor, public deb, and impor prices. 08

18 Secion (ii): coninuedε Arize, A.C. (1994) OLS of ECM M1, M GDP, inflaion rae, call money rae, governmen bond yield, expeced rae of depreciaion (foreign ineres differenial) Hossain, Akhar (1994) Khan, Ashfaque H. (1994) Dhakal, Dharmendra and Magda Kandil (1993) Khan, Imran Naveed (199) Ahmad, Eazaz and Harim Ram (1991) Ahmad, Mushaq and Ashfaque H. Khan (1990) Burney, Nadeem A. and Mohammad Akmal (1990) Khan, Ashfaque H. and Bilquees Raza (1989) Engle/Granger - sage, Johansen Engle/Granger - sage OLS of disribued lag specificaion (AIC) M1, M GDP, yield on governmen bonds, marke call rae, CPI inflaion M1, M Real income, real ineres rae (shor-erm and medium-erm), nominal ineres rae (shor-erm and medium-erm), inflaion CPI inflaion M1, indusrial producion, ineres rae, foreign ineres rae, impor prices 1973:I o 1990:I 1951γ :III o 1993:III 1970:I o 1987:IV Finds ha money demand is a funcion of GDP, inflaion, ineres rae and exchange rae expecaions. Also, dummies for he oil shocks, and srucural free banking and floaing he rupee maer. accoun of inroducion of parial ineres- breaks in 1981 on Meaningful coinegraion relaionship (money demand funcion) for he pos- 197 period. Finds coinegraing relaionship beween M (or M1) and real income, real ineres rae and inflaion. Impor prices, indusrial producion, and U.K. ineres rae explain inflaion. M1 is insignifican. OLS M1, M GNP, call rae, CPI n.a. Money demand in Pakisan is a funcion of income and inflaion, bu no of ineres rae. OLS ML (Cooley/Presco 1976 varying parameer echnique) NLLS WPI, CPI, GNP deflaor, and absorpion deflaor inflaion Real GNP growh, growh rae of uni value of impors, growh rae of M1/M, lagged inflaion M1, M Income, iner-bank call rae, ime deposi rae Real money sock Income, CPI inflaion, CPI inflaion volailiy OLS M1, M Real GNP, ineres rae, expeced inflaion 1960 o 1988 Inflaion is deermined by real GNP growh, uni value of impor growh, nominal money growh, and lagged inflaion o 1987 Demand for real money was unsable a h ime of delinking he Pakisani rupee from he U.S. dollar and inroducion of ineres- free deposi accouns. n.a. 197:II o 1987:II Real money adjuss insananeously o he desired level of money demand which is driven by income, and expeced inflaion. Larger han uniy income elasiciies of money demand and he expeced influence of expeced inflaion and ineres raes. 0

19 Secion (ii): coninuedε Huq, M.D. Shamsul and Majumdar, Badiul A. (1986) Nisar, Shaheena and Naheed Aslam (1983) Khan, Ashfaque (198a) Khan, Ashfaque H. (198b) Naqvi, Syed Nawab, A.R. Kemal, and Rashid Aziz (198) OLS M1, M GNP, call money rae, governmen bond rae, CPI inflaion OLS M1, M GNP, erm srucure, GNP deflaor OLS M1, M GNP, ineres rae on ime deposis OLS M1, M GNP, expeced inflaion, inflaion variabiliy 53-equaion macro model 1955 o 1977 Srucural breaks in he demand for money in 1965 and o 1978 Term srucure maers for money demand besides income. 1959/60 o 1979/80 n.a. 1959/60 o 1978/79 Income elasiciy of 1.7 and ineres elasiciy of 0.5. Including he variabiliy of inflaion improves he esimae of he money demand funcion. Inflaion is no impored. Money demand is ineres-sensiive. The GNP elasiciy of money demand is fairly large. 01

20 Appendix- B Fig 1: Governmen Borrowing from SBP and Inflaion Governmen Borrowing from SBP Inflaion (YoY) rojecdc 0 FY98 FY99 FY00 FY01 FY0 FY03 FY04 FY05 FY06 FY07 FY08 Fig : Budge Defici Growh and Inflaion 60 Inflaion (YoY) Growh in Budge Deficis FY95 FY96 FY97 FY98 FY99 FY00 FY01 FY0 FY03 FY04 FY05 FY06 FY07 3

21 Noe: M0gr := Growh in Reserve Money; M1gr := Growh in M1 and Mgr := Growh in M 30

22 Appendix- C Auo Regressive Disribued Lag Model (ARDL MODEL) Following Pesaran, Shin and Smih (1999) coinegraion mehodology using Auo Regressive Disribued Lag model his paper ry o find long run relaionship beween inflaion and volailiy in governmen borrowing from cenral bank in Pakisan. This ess procedure is applicable irrespecive of wheher he regressors are I(0), I(1) or muually coinegraed. The es is based upon esimaion of he underlying VAR model, re-parameerised as an ECM(error correcion model) 1. The VAR(p) model p = b + c + Γ iz i Φ i= 1 z + (A.1) where z represens a vecor of variables. Under he assumpion ha he individual elemens of z are a he mos I(1), or do no have explosive roos, equaion (A.1) can be wrien as a simple Vecor ECM. p Ι i z i + i= 1 z = b + c + Πz Φ (A.) where p p k+ 1 Γ i ) and Ι i = j, i = 1,...p -1 i= 1 j= i+ 1 П = ( I Γ are he (k+1) (k+1) marices of he long run mulipliers and he shor run dynamic coefficiens. By making he assumpion ha here is only one long run relaionship amongs he variables, Pesaran e al focus on he firs equaion in (A.) and pariion z ino a dependan variable y and a se of forcing variables x. This is one of he key assumpions of heir paper. Under such condiions he marices b, c G and, mos imporanly, P, he long run muliplier marix can also be pariioned conformably wih he pariioning of z. 11 γ 1 П = π b b = 1 γ 1 П b c = c 1 c Ι i = Δ γ 11,i 1,i Δ Δ 1,i,i The key assumpion, ha x is long run forcing for y, hen implies ha he vecor Δ 1 =0, ha is ha here is no feedback from he level of y on x. As a resul he condiional model for y and x can be wrien as p 1 p 1 y = b1 + c1 + π 11 y 1 + π γ 11, y i i + Δ 1, i x i + ε1 i= 1 i= 0 x (A.3) x p 1 p 1 + c + Пx 1 + 1, i y i + Ι, i x i + Φ i= 1 i= 1 = b γ (A.4) Under sandard assumpions abou he error erms in (A.3) and (A.4) 13 Pesaran e al re-wrie (A.3) as 1 Mos of he following is based on Pesaran, Shin and Smih (1999) and follows heir original noaion. 13 Essenially ha hey are independenly normally disribued wih a posiive definie variance covariance marix. 33

23 y = a p 1 p 1 + a+ φ y + δx + υ y + ϕ + ϖ i i i i (A.5) i= 1 i= 0 x which hey erm an unresriced error correcion model. Noe ha in (A.5) a long run relaionship will exis amongs he levels variables if he wo parameers φ and δ are boh non zero in which case, for he long run soluion of (A.5) we obain y a = φ a φ δ φ 0 1 x (A.6) Pesaran e al choose o es he hypohesis of no long run relaionship beween y and x by esing he join hypohesis ha φ = δ = 0 in he conex of equaion (A.5). The es hey develop is a bounds ype es, wih a lower bound calculaed on he basis ha he variables in x are I(0) and an upper bound on he basis ha hey are I(1). Pesaran e al (1999) provide criical values for his bounds es from an exensive se of sochasic simulaions under differing assumpions regarding he appropriae inclusion of deerminisic variables in he ECM. If he calculaed es saisic (which is a sandard F es for esing he null ha he coefficiens on he lagged levels erms are joinly equal o zero) lies above he upper bound, he resul is conclusive and implies ha a long run relaionship does exis beween he variables. If he es saisic lies wihin he bounds, no conclusion can be drawn wihou knowledge of he ime series properies of he variables. In his case, sandard mehods of esing would have o be applied. If he es saisic lies below he lower bound, no long run relaionship exiss. 34