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Inflation & Money Supply Essay

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Inflation & Money Supply Econ 302 Fall Semester Salman Sharoon John 09-15103 Department Of Economics FORMAN CHRISTIAN COLLEGE (A Chartered University) Acknowledgements: I would like to thank Mr. Zahid Iqbal, Luqman Saeed & Keizer Xavier for the help and all the time needed in knowing and studying the variables and helping in this research paper. Introduction: Inflation is a burning issue in Pakistan. Pakistan has double digit inflation. The factor determine the inflation, first of all money supply are the major determinant of the inflation.

In case of Pakistan concluded that in the long run excess money supply is the main factor responsible for inflation. The data given below is from year (1998-2008). Data shows that how much percentage change was change every year. Controlling inflation is a high priority for policy-makers. But the instability of the economy it is not possible to control inflation. Every year the percentage of inflation will increase, some other determinants are discussed. Inflation is also determines on imports, so government increase the taxes on imports, if the imports will reduce and the exports will increase the rate of inflation must be decreased.

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The background disinflation policy in many countries is framed with the objective of constraining monetary growth to be in line with the expansion in nominal income. Hence, an increasing number of countries have granted their central banks autonomy in the hope that it will insulate them from having to accommodate imprudent fiscal policies. Money demand should depend on expectations about future inflation; a purely monetary effort at reducing inflation may not be successful. Theoretically, once account is taken of forward-looking expectations, multiple equilibrium paths for nflation can coexist. Under such circumstances, money supply alone may not be sufficient to pin down the time path of inflation. Against this background, attention has increasingly been given to the role of fiscal policy in determining inflation. In seminal paper by Sargent and Wallace (1981) is that the effectiveness of monetary policy in controlling inflation depends critically on its coordination with fiscal policy. In their model, tighter monetary policy could lead to higher inflation under certain circumstances, even when the traditional relation between money and the price level holds.

The rationale is that, with the demand for government bonds given and in the absence of changes in future fiscal policy, a part of government obligations has to be covered by seignorage at some point in the future. A similar line of reasoning lies behind the fiscal theory of the price level (FTPL). Apart from seignorage financing, traditional analysis of the fiscal impact on inflation focus mostly on Keynesian aggregate demand considerations, public wage spillovers to private sector wages, and taxes affecting marginal costs and private consumption Literature Review

Pakistan is facing a major downfall in the economy, the deficits and a high rate of inflation. Inflation in Pakistan has been gone to double digit that is a major problem[1]. Fiscal deficit was around 7. 4 percent of the GDP during the period of 1970-80, and 7. 6 percent during the 1980. The major problems that have been placed are double digit inflation that increased the poverty[2]. On the other hand the current account balance is disturbed. The major reasons for that were excess government spending and a major trade imbalance, in which the imports were greater than the exports.

The country’s huge budget deficit as well as high rates of growth of money did have a significant impact on the inflation rate. The article says that due to domestic borrowing to overcome the deficits increase inflation in the long run. There is a positive relation between the deficit and inflation, because due to borrowing from the foreign bank. To overcome the deficit the debt has to be paid in short run. The deficit if is borrowed from the foreign banks then it should be used on the places that caused deficit, and also can be used for development projects.

The government should decrease the government spending and put taxes on the imports. One the other hand the article suggests that the government should take major steps and install private business environment in order to overcome the deficit (M. Aslam Chaudhary and Naved Ahmed, 1995). More imported theories can be cost push or demand pull theories of inflation[3]. Secondly distinction between exogenous and endogenous money supply proper classification of inflation theories. According to Lenin is no surer, way of over turning a society to degrade its currency (John Maynard Keynes).

Inflation has its long lasting effect in last past eight centuries the world economy has experienced for major price revolutions. Who’s inflationary forces ultimately transformed economy. There are several types of inflation (i) High inflation (ii) Hyper inflation[4]. These both occur where the war is announced. The former theory emphasizes the role of wage and input increases its generating inflation. In analytical cut results from the facts there is clear empirical connection between monetary stocks and inflation measures.

This paper divided in few different sections. Historical records both related to long term trends i. e. price level or price revolutions, devasting the hyper inflation. The following two sections money and inflation and main counter points from a heterodox perspective. The wisdom among economist and monetarist used are the dominant interpretation of long term processes(Matias vernengo,2005). The “STATE BANK OF PAKISTAN” is fully capable of implementing its own independent monetary policy consistent with the needs of the domestic economy[5].

Maintaining price stability will ultimately be the best policy contribution to sustained growth that the SBP can make. While there may not be a trade-off between inflation and growth in the short run. While headline inflation is better understood by the public, it is often argued that monetary policy should be more concerned with core inflation. There is a positive relation between inflation, money supply, and interest rate between 1978 and 1991, inflation was 8 percent on average and real per capita growth averaged 3 percent.

Between 1992 and 1997, inflation increased on average to 11 percent, while real per capita growth fell substantially and averaged only 1 percent. Finally, between 1998 and 2003, inflation was reduced again to an average of 5 percent, and real per capita growth. There seems to be a fairly stable relationship between private sector credit growth and inflation 12 months from now. In addition, there is also a relationship between broad money growth and inflation 12 months from now. Therefore, the SBP should set monetary policy today with a view to meeting its inflation target around one year from now (Mohsin S.

Khan and Axel Schimmelpfenning,2006). There is a link between excess of money supply growth and inflation in Pakistan. The results indicate a positive association or link between money growth and inflation. The inflation adversely affects the overall growth the moderate levels of inflation damage real growth. The inflation decreases the real income and uncertainty. The money supply growth effects real Gross domestic product (GDP) and secondly it effects the inflation in Pakistan. The inflation in Pakistan can be cured by a sufficiently tight monetary policy.

In quantity theory it is assumed that the real income grows at the long-run rate and the velocity of money remains constant[6]. According to this situation inflation is determined by the change in money supply. The quantity theory indicates the money supply as the factor that effects the changes in the price level. The main determinates of real income growth are labor capital and technological change. These factors of growth are unrelated to the demand for money the real income growth is independent of quantity of money supply and price level[7].

There is a proportional relationship between the price level and the nominal quantity of money relative to real income. The result indicate that in the long run there is a one to one relationship between the rate of inflation and growth in real income and money supply and the rate of inflation is consistent with the other studies. The results also confirm the monetarists’ proposition that money supply is the main factor that contributes towards the inflation in Pakistan. (Abdul qayyum, 2006)

In this article Carlo Alta villa and Matteo Ciccarelli aim to investigate the role of inflation forecasting. Reflecting to the relative ability to sub sample period to increase forecasting. In that case estimate the effect of monetary shocks on unemployment associated with the estimated effects of policy decision . The important part of his article is to predict the inflation and the price level forecasting. They producing the relative ability of alternative models inflation forecasting which helpful of improving the monetary authorities to set the interest rate and also help to nderstand the monetary policy on unemployment alternative set of forecasting. Bayesian VAR shows the inflation forecast is one of the endogenous variables and parameters. In Taylor model[8] forecasting inflation might improve the ability of monetary authorities to set interest rates and the price stability. The combination accounts for the time-varying forecasting ability that a single forecasting model might only be optimal conditional on given realizations information set model under practical conditions. There is a positive relationship of gdp and inflation.

Our results indicate that combining inflation forecasts from many models not only yields more accurate forecasts model, but also seems to reduce the uncertainty allied with the estimated effects of policy decisions. (Carlo and matteo, 2007) Quantity theory of money does not hold in Pakistan money supply growth rate is 9 percent[9]. Then author examine the food price inflation and international commodity prices which determine the overall global and domestic inflation. According to the author there is a positive relation between money and inflation.

It is excessive money growth which is beating the prices up and not vice versa. Therefore, cause and effect should be better approved by taking recourse to knowledge outside our analytical approach (Riaz Riazuddin, 2008) Political instability weak form of fiscal theory of price level determination is leads to high inflation due to government[10]. The observed literature examining the inflation determinants in Pakistan does not consider a political instability as a possible determinant in their models. Studies tell us that inflation occurs due to monetary policies.

According to Safdar Ullah Khan there is a high correlation between money and inflation and there is a positive relationship. He also described two models in his article first is monetary which is crucially depends upon the political instability. And now second is non-monetary model explicitly establishing measure the instability in Pakistan. While both the theories of war of attrition and political instability these theories can nonetheless be applied to any other variable such as public investment. Absence of fiscal polices abovementioned political economy predictions the public investment bound through increase n government debt thus the leading to the inflation. More importantly, political instability undermines the effectiveness of government implementing policies and weakens the state’s hold on management of economy (Safdar ullah and omer farooq, 2008). Data and selection of variables The annual data of all the variables for the period 1973-2008 are obtained from the handbook of statistics of Pakistan, 2008 and from the economic survey 2007_08. Dependent Variable Gross domestic product (GDP) is taken as a dependent variable. Analyze and forecast the growth rate of gross domestic product (GDP), i. . of the value of all final goods and services produced in an economy. This is the most widely used measure of an economy’s success, and it is also for measuring the productivity of the labor. Independent Variables Economic Variables: Here we discuss some economic independent variables, which are using for the calculation of data. • Inflation It is a rise in the general level of prices of goods and services in an economy over a period of time According to Carlo Alta villa and Matteo Ciccarelli there is a positive relationship of gdp and inflation.

According to Safdar Ullah Khan there is a high correlation between money and inflation. According to Safdar Ullah Khan there is a positive relationship. According to the author Riaz Riazuddin there is a positive relation between money and inflation. • Gross Domestic Product (GDP) The gross domestic product (GDP) or gross domestic income (GDI) is a basic measure of a country’s overall economic output. It is the market value of all final goods and services made within the borders of a country in a year.

It is often positively correlated with the standard of living[11] • IMPORT Thus an import is any good (e. g. a commodity) or service brought in from one country to another country in a legitimate fashion, typically for use in trade. It is a good that is brought in from another country for sale. [12] • MONEY SUPPLY Money supply is the total amount of money available in an economy at a particular point in time. There is a positive relation with inflation. Relationship between dependent and independent variables Variables |Define variables |Expected signs | |GPD |Gross Domestic Product |+ | |INF |Inflation |+ | |M |Import |- | |I |Investment |+ | |M1 |Money supply |+ | ECONOMETRIC MODEL ^ ^ ^ ^ ^ GDP = ? + ? 1INF+ ? 2M+ ? 3I+ ? 4M1+ ui GDP = Gross Domestic Product INF = Inflation M = Import I = Investment M1 = Money supply Ui = Error term Methodology, Estimated results and their Interpretations: Dependent Variable: LOG(GDP) | | | |Method: Least Squares | | | |Date: 01/20/10 Time: 11:50 | | | |Sample: 1973 2008 | | | |Included observations: 36 | | | | | | | | | | | | | | | |Variable |Coefficient |Std. Error |t-Statistic |Prob. | | | | | | | | | | | | | |C |6. 643380 |0. 084801 |78. 34058 |0. 0000 | |LOG(I) |0. 029076 |0. 014417 |2. 016754 |0. 0525 | |LOG(M) |0. 13925 |0. 013217 |1. 053538 |0. 3002 | |LOG(M1) |0. 367727 |0. 010616 |34. 63854 |0. 0000 | |INF |0. 003192 |0. 001334 |2. 393610 |0. 0229 | | | | | | | | | | | | | |R-squared |0. 995124 |    Mean dependent var |11. 41504 | Adjusted R-squared |0. 994494 |    S. D. dependent var |0. 537180 | |S. E. of regression |0. 039858 |    Akaike info criterion |-3. 478728 | |Sum squared resid |0. 049249 |    Schwarz criterion |-3. 258794 | |Log likelihood |67. 61710 |    Hannan-Quinn criter. |-3. 401965 | |F-statistic |1581. 568 |    Durbin-Watson stat |1. 015038 | |Prob(F-statistic) |0. 000000 | | | |

In order to find out the relationship between gdp and the concerned independent variable, technique of OLS was applied. The results show that investment does have significant affect upon dependant variable moreover its p value is also quite high. Money supply is also found to be significant. The most significant of all variable is found to be M1 with the lowest of p value. Inflation also has significant results. Moreover their negative auto in the data. 99% variation is explained by the independents variables. The methodology will be to construct the econometric model that manipulates different components of current account deficits separately along with their econometric determinants. The model is designed for time-series data of Pakistan from 1973-2008.

We work with time series data, which will allows us to look at the effect of different variable with in the country at a particular time period. Here our focus will be to calculate the response of the determinants on the inflation. We will use an OLS model which is designed for time series data. Regression on this model uses the Ordinary Least Square estimation. Interpretation of independent variables: Investment: 0. 02% change GDP is due to the 1% increase in the investment variable. As the expected sign proposed in the paper was positive, and sign is also come positive. As the investment increased, people invest more and which caused increased in GDP Imports: 1 % change in imports resulted, 0. 013% increased in the GDP. Expected sign was negative and which come as it was proposed.

As imported goods come in a country, it will increased the prices of local goods, and competition in market increased but as in Pakistan local companies can’t compete with the foreign companies, which caused lower economic growth. Money supply: This is the most significant variable. 1% increased in the money supply, resulted in 0. 36% change in GDP. Sign is also positive which shows the positive relation between the money supply and GDP. As the money supply increased, people hold more money; they demand more goods resulted in increased in prices which increased the inflation as the which increases the profit of producer. And ultimately increased the GDP Inflation: 1% increased in the inflation caused 0. 003% increased in the GDP. There is positive relation between the inflation and the GDP.

This relationship is explained by the Phillips curve. as the inflation increased it decreases the unemployment. Unemployment decreases only when the investment increased and new employment opportunities generated. Which results in increased the GDP. Conclusion ; Policy Recommendation: In case of Pakistan concluded that in the long run excess money supply is the main factor responsible for inflation. Controlling inflation is a high priority for policy-makers. But the instability of the economy it is not possible to control inflation. . Money demand should depend on expectations about future inflation; a purely monetary effort at reducing inflation may not be successful.

We will use an OLS model which is designed for time series data. Regression on this model uses the Ordinary Least Square estimation. Theoretically, once account is taken of forward-looking expectations, multiple equilibrium paths for inflation can coexist. 0. 02% change GDP is due to the 1% increase in the investment variable. 1 % change in imports resulted, 0. 013% increased in the GDP. Under such circumstances, money supply alone may not be sufficient to pin down the time path of inflation. 1% increased in the inflation caused 0. 003% increased in the GDP. There is positive relation between the inflation and the GDP. This relationship is explained by the Phillips curve.

As the inflation increased it decreases the unemployment, there is a positive relation between the deficit and inflation, because due to borrowing from the foreign bank. Inflation also has significant results. The most significant of all variable is found to be M1 with the lowest of p value. Inflation also has significant results. Moreover their negative auto in the data. 99% variation is explained by the independents variables. The methodology will be to construct the econometric model that manipulates different components of current account deficits separately along with their econometric determinants. Controlling inflation is a high priority for policy-makers.

But the instability of the economy it is not possible to control inflation Reference: 1. Carlo Altavilla and Matteo Ciccareli (2007) Inflation Forcasts, Monetary Policy and Unemployement Dynamics: Evidence from the Us and the Euro Area. 2. Abdul Qayyum (2006) * Money, Inflation, and Growth in Pakistan The Pakistan Development Review 45: 2 pp. 203–212. 3. Mohsin S. Khan ; Axel Schimmelpfennig (Summer 2006) Inflation in Pakistan The Pakistan Development Review 45 : 2 pp. 185–202 4. Khan, Safdar Ullah and Saqib, Omar Farooq (November 2008) Instability and Inflation in Pakistan State Bank of Pakistan, Bond University, Australia. 5. Matias Vernengo (2007) Money and Inflation: A Taxonomy Working Paper No: 2005-14 6.

Mohammad Aslam Chaudhary ; Naveed Ahmad (Winter 1995) Money Supply, Deficit, and Inflation in Pakistan The Pakistan Development Review34 : 4 Part IIIpp. 945—956 7. Riaz Riazuddin (September 2008), An Exploratory Analysis of Inflation Episodes in Pakistan. 8. Pakistan, Government of ( 2008) Economic Survey of Pakistan 2008-09, Islamabad: Ministry of Finance 9. UN, The UN Government Finance Statistics, New York, UN (various years). 10. Economic Survey (2007-08). 11. State Bank of Pakistan: Annual Reports (various years). 12. Pakistan Bureau of statistics ( 2008) ———————– [1] (MOHAMMAD ASLAM CHAUDHARY and NAVED AHMAD,1995) [2] (Economic survey of Pakistan, 2000) [3] Macro economics by john Phillips 4] hyperinflation is inflation that is very high or “out of control”, a condition in which prices increase rapidly as a currency loses its value. [5] http//:www. state bank of Pakistan. com [6] Monetary Theory by J. S Smith . [7] Monetary Theory by J. S Smith [8] (Taylor model, 2004) [9] Issues in Pakistan’s economy. [10] (Safdar ullah and omer farooq, 2008) [11] Sullivan, Arthur; Steven M. Sheffrin (1996). Economics: Principles in action. Upper Saddle River, New Jersey 074589: Pearson Prentice Hall. pp. 57, 305. ISBN 0-13-063085-3. [12] Sullivan, Arthur; Steven M. Sheffrin (2003). Economics: Principles in action. Upper Saddle River, New Jersey

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