The Pakistan Development Review

44 : 4 Part II (Winter 2005) pp. 961–974

Economic Growth, Inflation, and Monetary Policy in

Pakistan: Preliminary Empirical Estimates
AHMED M. KHALID*

I. INTRODUCTION
The recent increase in financial market volatility and the increased surge
within developing world to become part of the global market have posed several
challenges for policy-makers in the emerging markets to decide on a policy regime—
monetary or exchange rate—that suits their needs and could also provide stability to
the financial system. In view of the macroeconomic characteristics of these
emerging economies, the choice of an appropriate policy becomes important to
achieve certain targets such as sizeable domestic and foreign investment, reduced
reliance on external borrowings, fiscal discipline, etc. These would require both
price and exchange rate stability and country’s ability to deal with external shocks to
maintain and achieve sustainable economic growth. Pakistan is no different and until
recently had a history of macroeconomic imbalances with extremely high foreign (as
well as domestic) debt, high budget and current account deficits, extremely low
international reserves, high inflation, high nominal interest rates and low economic
growth. The average economic growth over 40 years is around 4 percent. The main
focus of any policy has been to achieve a sustainable growth pattern. However, due
to a number of macroeconomic imbalances such as high budget deficits, extremely
high indebtedness, low savings and investment rates, lack of fiscal discipline,
undeveloped financial markets, unstable exchange rates along with high population
growth and huge defence expenditure made this task almost impossible. Some of
these macroeconomic imbalances contributed to episodes of high inflation and
unemployment that the country experienced during most of the period since
independence.
Some important steps to reform the economy were initiated in early 1990s and
further efforts were made in early 2000. One of the main focuses of the later reforms
was to achieve price stability through monetary policy. Highlights of these reforms

Ahmed M. Khalid is based at Bond University, Gold Coast, Qld., Australia.

Author’s Note: An earlier version of this paper was presented at the PSDE Conference: 19-21
December 2005.
962 Ahmed M. Khalid

were providing autonomy to its central bank (State Bank of Pakistan; SBP),
privatisation of commercial banks, establishing a domestic bond market and
launching Pakistan bonds in the international market and maintaining high foreign
exchange reserves. Autonomy to the SBP was needed to enable the central bank for
the design and implementation of an independent monetary policy. This is an
essential to achieve sustainable growth through price stability, among other
measures. As a result of these measures, the SBP has been able to bring inflation
down to single digits at a time when the economy has performed strongly. However,
high domestic and international debt and consistently high budget deficits remain
central issues in Pakistan’s monetary policy. The current surge in fuel prices has
further aggravated the problem. Given that the SBP is enjoying a relatively more
autonomous environment and the country has been able to achieve remarkable
growth performance since 2003, this is probably the best time to decide on the future
choice of a policy regime to pursue and achieve long-term and sustainable economic
growth.
Recently, some emerging economies decided to switch to an inflation
targeting regime. The successful experience of these emerging economies may help
to draw important lessons for Pakistan.12 Any policy shift towards inflation targeting
will, however, require an identification of a causal relationship between inflation and
other important macroeconomic variables. This will also need a correct specification
of inflation model for Pakistan for forecasting purposes. The focus of this paper,
therefore, is to empirically analyse the above two objectives. The paper is organised
in the following manner. The introduction is followed by a discussion on inflation
targeting in the context of some emerging economies. An empirical model for
inflation is specified and estimated in Section III. Finally, some conclusions are
drawn in Section IV.

II. PRICE STABILITY AND INFLATION TARGETING:

EMERGING ECONOMIES, EXPERIENCE
The debate on the effectiveness of monetary policy places significant
importance of the information mechanism in the economy. An efficient information
mechanism leads to price stability which is important instrument to achieve a
sustainable economic growth. It is for this very reason that many emerging
economies with a history of high and volatile inflation considered inflation targeting
as a choice of monetary policy. Inflation Targeting (IT) can be defined as a
monetary policy strategy with an explicit objective of achieving and main-
taining price stability. This objective is achieved through an easily understandable
1
New Zealand was the first country to adopt an inflation-targeting regime in 1990. Since then,
many countries have joined the club including both industrialised countries (such as Australia, Sweden,
Switzerland, and the United Kingdom) and emerging economies (such as Brazil, Chile, Columbia, Czech
Republic, Iceland, Israel, Mexico, Peru, the Philippines, Poland and South Africa).
 Table 1
Pakistan—Basic Macroeconomic Indicators (1960-2005)
1996–
1961–70 1971–80 1981–90 1991–95 2000 2000 2001 2002 2003 2004 2005
National Accounts
GDP Growth (%) 3.35 4.81 6.19 4.85 3.07 4.26 2.72 4.41 5.1 6.4 8.4
Per Capita GDP (US$) 138.86 180.18 327.06 404.85 438.82 426.64 380.54 439.00 455 470 491
Financial Indicators (%)
GDS/GDP – 13.81 13.83 14.81 13.29 14.40 14.60 13.60 17.6 16.4 13.7
GFCF/GDP 15.37 15.38 16.96 18.07 15.41 14.37 14.29 12.33 16.9 17.3 16.8
Inflation (per Annum) 3.51 12.42 6.98 11.20 7.30 4.37 3.15 3.29 3.1 4.6 9.3
M2/GDP 36.14 41.76 41.25 43.39 46.63 46.92 48.30 51.74 56.40 – –
M3/GDP 40.26 46.78 49.62 50.38 49.69 50.19 50.85 55.54 – – –
DC/GDP) 38.44 45.49 51.18 52.70 50.63 49.57 45.47 42.34 42.69
Fiscal Balance/GDP –5.17 –7.41 –6.74 –7.67 –6.91 –5.47 –4.71 –4.62 –3.7 –3.0 –.30
Domestic Borrowing/GDP 1.84 3.42 5.29 5.60 4.89 4.56 2.51 3.35 2.32 – –
Foreign Borrowing/GDP 3.34 3.74 1.45 2.06 2.03 0.91 2.20 1.27 1.18 – –
Debt/Exports 403.90 606.09 509.28 – – 550.66 – – – – –
Debt/GDP 33.91 61.96 64.15 – – 90.00 – – – – –
Foreign Reserves/Imports 21.27 17.98 11.52 14.24 10.56 14.23 34.05 71.86 – – –
Source: Ariff and Khalid (2005).
Notes: M2 = Currency + quasi money; M3 = M2 + Other Deposits; GDS: Gross domestic saving; GFCF = Gross fixed capital formation; DC: Domestic credit.
964 Ahmed M. Khalid

numerical target value of inflation. This requires a country’s central bank to

have some flexibility in choosing monetary policy instruments most appropriate
to achieve the target (inflation target). Price stability does not strictly mean a
‘constant price level or zero inflation’ but a stable price level that helps to
achieve a target inflation with some tolerance band over a specified time
horizon. Inflation targeting is a forward-looking policy regime which relies
strongly on rational expectations of monetary policy transmission. The way IT is
implemented in emerging economies suggests the central banks in inflation
targeting countries enjoyed some discretionary power to make adjustment in
monetary instruments as and when needed.
Since the early 1990s, many emerging economies switched to inflation
targeting as their monetary policy regime. These countries had different economic
environments and hence decided to follow a policy suitable to a specific economic
environment. We can split these countries into three groups.23 First, countries with
relatively strong financial market fundamentals, a stable macroeconomic
environment and independent central bank moved to inflation targeting with flexible
exchange rates with specific inflation targets to be achieved over a specified period.
The second group of countries did not have the same environment and switched to
inflation targeting with tolerance bands. The third group of countries had difficulty
in maintaining a specific target due to a less credible central bank and adopted a
policy of ‘inflation targeting lite’.34
New Zealand was the first country to adopt an inflation targeting regime.
Since then many emerging economies in Asia, Latin America and Europe have
switched to inflation targeting as their monetary policy objective.45 For instance, the
Latin American region experienced the highest inflation in the world in the 1980s.
At regional level, inflation averaged 145 percent annually. As such price stability
became the most important argument of the monetary policy. Chile (1990), Peru
(1994) and Mexico (1999) used a gradual approach to adopt an inflation targeting
regime while Brazil (1999) used a big-bang approach to do the same. Among these
countries, Chile followed a ‘gradual convergence towards full-fledged inflation
targeting (1990-99) when the Central Bank of Chile adopted a legal, operation and
goal independence. The Bank of Chile also pursued an exchange rate target from
1984-1999. The Central Bank of Chile used the period 1990-99 to provide price
stability and announced inflation targets (or a range) on an annual basis before it
decided to move to full-fledged inflation targeting and set an indefinite target range
2
Some of the Latin American countries moved to inflation targeting along with dollarisation, thus
completely giving up their monetary policy and national currencies. This could be considered as the
fourth group. There is also another small group that may adopt inflation targeting along with currency
boards.
3
ITL is a transitional regime until the country is ready to move to a full-fledged IT regime.
4
The experience of some of these countries is summarised in Table 1.
 Growth, Inflation, and Monetary Policy 965

of 2-4 percent in 2001.56 Mexico used a somewhat similar approach (1995-2001) but
started with a monetary growth target in 1995 and at the same time used this
monetary growth target to bring down inflation from 52 percent in 1995 to 16
percent in 1997. Eventually, the Central Bank of Mexico moved towards a gradual
transition to full-fledged inflation targeting in 1998. Contrary to the example of
Chile and Mexico, the Central bank of Brazil used a Big-bang approach (1999-2001)
to move to a full-fledged inflation targeting regime in July 1999, with a 2 percent
tolerance band.
Among the Central European transitional economies, Czech Republic and
Poland are the only two countries which have adopted an IT regime. The Czech
Republic adopted an IT regime in January 1998 after abandoning the currency peg in
May 1997. The Czech central bank adopted a strict version of IT with a strong
commitment to price stability. The Polish IT regime was introduced at time when
Poland was experiencing relatively high inflation. The Polish central bank decided
to target CPI inflation after moving to a fully floating exchange rate regime.
Columbia presents an example of inflation targeting with small-scale foreign
exchange intervention. Although Columbia implemented several elements of IT
starting as early as 1992, the full-fledged IT regime was only implemented in
1999Q3. In this way, Columbia experimented with inflation targeting with exchange
rate bands. The absence of pre-conditions and macroeconomic mismanagement lead
to the deepest and longest recession in this country. Columbia experienced 22
percent peso depreciation between January 1998 and December 1999, just about the
time that Columbia adopted inflation targeting. The central bank lost about 18
percent of its international reserves during the same period in an effort to defend the
peso. As evident from Table 2, the country was also going through severe recession
with economic growth at –4.2 percent at the time of adoption to IT. Eventually,
Columbia switched to a floating regime and a full-fledged IT regime in late 1999.
As regards to exchange rate policy, the Central Bank of Columbia followed a ruled-
based foreign exchange market intervention to reduce volatility in international
reserves. However, due to certain internal and external factors which led to a sharp
depreciation of the peso, the Central Bank of Columbia engaged in large foreign
exchange market intervention in 2003 and again in 2004.67
In view of the above discussion and the successful experience of emerging
economies in controlling inflation through a policy of inflation targeting, it would be
interesting to see if Pakistan should pursue the same policy to achieve a sustainable
growth target. Khalid (2006) provides a comparison of Pakistan’s current
state of the economy with other emerging economies (stated above) and argues that

5
de Gregorio, Tokman and Valdes (2005) discuss in detail the Chilean experience of inflation
targeting with flexible exchange rate regime.
6
See Vargas (2005) for a detailed discussion on Columbian experience of exchange rate policy
and inflation targeting.
966 Ahmed M. Khalid

Table 2
Macroeconomic Performance of Emerging Market ITters at the
Time of Adoption to Inflation Targeting
Real GDP
Growth (%)— Fiscal Balance
(One Year (% of GDP)—
IT Adoption before (in the Year of Seigniorage
Countries Date Adoption) Adoption) (1992-95)
Chile 1999Q3 –0.98 – 1.53
Peru 2002Q1 0.2 – –
Mexico 2002Q1 6.64 – 0.69
Brazil 1999Q2 0.79 –6.89 7.46
Columbia 1999Q3 –4.2 – 1.97
Czech Republic 1998Q1 –0.76 –1.63 –
Poland 1999Q1 4.84 –4.98 2.23
Hungary 2001Q3 5.19 – 4.12
Israel 1997Q2 4.51 – 0.53
South Africa 2000Q1 2.12 –2.65 0.37
South Korea 1998Q2 5.01 – 1.12
Thailand 2000Q2 4.43 –2.24 1.39
The Philippines 2002Q1 3.4 – 1.39
Sources: Kuttner (2004), Amato and Gerlach (2002), Khalid (2006).

Pakistan’s economy is in a much better shape that some of the Latin American or
Central European countries at the time of adoption of an IT regime. Given this, one
can assert that this is probably a good time to assess the feasibility of inflation targeting
in Pakistan. However, any policy shift towards IT would require the State Bank of
Pakistan to fully understand the path and mechanism under which inflation is
determined in Pakistan. This is needed to achieve two purposes. First, the policy
makers need to have a clear understanding of the movement of policy variables that
may influence prices. Any movement in these variables would signal the direction and
magnitude of movement in prices level and would require certain policy measures to
keep prices stable. Second, factors that determine inflation would be needed to
develop inflation forecasting model for a credible monetary policy. Both of these
require some empirical estimation. These questions are discussed in the nest section.

III. INFLATION MODEL FOR PAKISTAN:

SOME PRELIMINARY ESTIMATES
There are two main issues to be investigated here. First, what are the leading
indicators of inflation in Pakistan? These leading indicators would help policy
 Growth, Inflation, and Monetary Policy 967

makers to predict future path of inflation and to devise policies to restrict inflation
within a target band. Granger causality tests are performed to identify leading
indicators of inflation in Pakistan. Second, what are the determinants of inflation in
Pakistan? A well-specified inflation equation can be used as a forecasting model for
inflation which is an important part of IT policy. The estimation of inflation
equation is performed using a general-to-specific method.
For determining leading indicators of inflation for Pakistan, we modify
Debelle and Lim (1998) to estimate a bivariate VAR suitable for Pakistan’s
economic environment. The model estimated is of the following form.
∆CPIt = α(L)∆CPIt–1 + β(L) ∆Yt–1 + et
∆Yt = α(L)∆Yt–1 + β(L) ∆CPIt–1 + ut … … … (1)
Where;
CPI = price index
Y = set of indicators
Output gap (YGap); budget deficit-GDP ratio (DefGDP); US inflation
(USINF); seigniorage (DM1GDP); log of domestic credit (LDC); the share price
index (SP); the Call Money Rate (CMR); real GDP (RGDP); openness (TTGDP);
exchange rate depreciation against Us dollar (∆ER); money depth (M2GDP); and
domestic borrowing (DBOR).
It is important to determine the order of integration before estimating a VAR
or identifying any causal relationship among this set of variables. Standard
Augmented Dickey-Fuller (ADF) method is used to determine the order of
integration. Results of unit root tests are reported in Table 3. These results suggest

Table 3
Unit Root Tests Result
Variable ADF(Levels) ADF(First Difference)
∆CPIt–1 –3.429210** –5.748879*
USINF –3.003700** –6.570895*
RGDP –.0266240 –3.500059*
YGap 0.575690 –5.417021*
DefGDP –3.849298*
∆M1GDP –5.37479*
LDC 2.725933 –4.817433*
SP –0.749881 –4.082395*
CMRate –2.146065 –7.323656*
ER 2.842852 –3.673984*
M1GDP –4.326640* –
M2GDP –2.502640 –5.926836*
DBOR 0.064564 –12.40113*
TTGDP –1.815292 –4.200009*
Note: *, ** and *** Indicate the rejection of null at 10 percent, 5 percent and 1 percent respectively.
968 Ahmed M. Khalid

that CPI, USINF, Def/GDP, ∆M1GDP, M1/GDP are stationary in levels. However,
real GDP (RGDP), output gap (Ygap), domestic credit (LDC), stock price index (SP),
CMRate, exchange rate (ER), M2/GDP, domestic borrowing (DBOR) and openness
(TT/GDP) are stationary in first difference; I(1). We, therefore, use these variables
in first-difference in the VAR model.
We perform two different types of Granger causality tests to identify a causal
relationship and its directions. First we, use pair-wise Granger causality tests to
focus on each indicator and its causal relationship with inflation. In this way, we
isolate feedback through other variables. We allow up to four lags. The results are
reported in Table 4. The data suggests that US inflation (USINF), seigniorage
(∆M1GDP) and openness (TTGDP) do cause inflation. The results, however,
suggest that inflation causes changes in the budget deficits (DefGDP), domestic

Table 4
Granger Causality Test Results for Leading Indicators of Inflation
Null Hypothesis Lags F-Statistic Probability
YGap does not Granger Cause ∆CPI 1 3.71008*** 0.0616
∆CPI does not Granger Cause YGap 47.9989* 0.0000
DefGDP does not Granger Cause ∆CPI 1 1.5518 0.2205
∆CPI does not Granger Cause DefGDP 5.1110** 0.0296
USINF does not Granger Cause ∆CPI 3 2.9171** 0.0192
∆CPI does not Granger Cause USINF 0.4597 0.7123
∆M1GDP does not Granger Cause ∆CPI 1 5.5545** 0.0237
∆CPI does not Granger Cause ∆M1GDP 0.4424 0.5099
∆LDC does not Granger Cause ∆CPI 3 0.8989 0.4525
∆CPI does not Granger Cause ∆LDC 3.1107** 0.0399
∆SP does not Granger Cause ∆CPI 4 0.4742 0.7543
∆CPI does not Granger Cause ∆SP 0.4861 0.7458
∆CMRate does not Granger Cause ∆CPI 1 0.1918 0.6640
∆CPI does not Granger Cause ∆CMRate 6.8033** 0.0129
∆RGDP does not Granger Cause ∆CPI 4 0.3955 0.8102
∆CPI does not Granger Cause ∆RGDP 0.4297 0.7860
∆ER does not Granger Cause ∆CPI 2 1.1035 0.3429
∆CPI does not Granger Cause ∆ER 0.3123 0.7338
∆M2GDP does not Granger Cause ∆CPI 1 1.7768 0.1905
∆CPI does not Granger Cause ∆M2GDP 4.0744** 0.0506
∆DBOR does not Granger Cause ∆CPI 4 0.0548 0.9941
∆CPI does not Granger Cause ∆DBOR 0.2315 0.9184
∆TTGDP does not Granger Cause ∆CPI 2 23.003* 0.0000
∆CPI does not Granger Cause ∆TTGDP 2.5963 0.1154
Note: *, **, *** Denotes rejection of Granger non-causality in mean at 10 percent, 5 percent and 1
percent levels of significant.
 Growth, Inflation, and Monetary Policy 969

credit (LDC), domestic interest rates (CMRate) and financial depth (M2/GDP). We
also found evidence of a bi-directional causality between outputgap (YGap) and
Inflation. These results indicate that inflation in Pakistan is not influenced by
indigenous factors only. Due to influence of US dollar in domestic currency
valuation, US inflation does affect domestic prices. The inflationary pressure
through the use of seigniorage is not surprising and is consistent with theoretical
prediction. Openness causes inflation due to negative trade balance and captures the
effect of rising import prices. It is a bit surprising to see a reverse causality
between inflation and budget deficits. However, one possible reason could be
the factors such as; the high level of external debt, debt servicing and sizeable
defence expenditure as well as higher price level puts pressure on budget
deficits. Higher inflation means a lower real cost of borrowing and thus may
lead to increased demand for credit. Higher inflation also puts upward pressure
on domestic interest rates. Bi-directional causality between inflation and output
gap shows central bank’s effort to exert monetary pressure to achieve a higher
growth which they may not achieve due to higher and increasing inflation
(consistent with historical trends in Pakistan till 2002). This may also suggest
some indication of higher sacrifice ratio.
Next, we use a VAR as specified in Equation (1) to identify the leading
indictors allowing some feedback effects as well. The results are reported in Table
5. These results indicate that output gap(YGDP) gap and share price index (SP) have
a high degree of predictive content on inflation. Narrow money also has some
predictive content. However, both narrow money and share prices cause inflation

Table 5
Leading Indicators of Inflation (VAR Estimation)
Causality from CPI to Causality from Other
Other Variables Variables to CPI
F-stat Lags F-stat Lags
GDP 3.11 1 GDP 5.6* 1
CMRate 0.06 1 CMRate 0.000 1
DC 27.04* 1 DC 1.17 1
ER 10.4* 1 ER 0.38 1
G.Bond 4.85** 1 G.Bond 0.57 1
M1 1.51 3 M1 4.38** 3
M2 0.76 1 M2 0.09 1
M4 0.004 1 M4 0.10 1
SP 2.38 3 SP 18.2* 3
Note: *, **, *** Denotes rejection of Granger non-causality in mean at 10 percent, 5 percent and 1
percent levels of significant.
970 Ahmed M. Khalid

with a lag of three years. On a reverse causality, inflation causes changes in

domestic credit, exchange rates and government bond yields. One has to look at
these results with caution. As quarterly data on GDP is not available in Pakistan, in
this preliminary analysis we estimate the model using annual data. In order to
analyse the predictive performance of an inflation forecasting model, one has to use
quarterly data.78 The results, however, highlight an important point. As it is evident
from Table 5 that exchange rate is influenced by changes in CPI, a monetary policy
objective of price stability would help to stabilise exchange rates as well as making
central bank intervention in currency markets a less likely event.
Finally, we estimate an equation for inflation. Again we modify Debelle and
Lim (1998) to specify an equation for inflation of the following form.
∆CPIt = β0 + β1 ∆CPIt–i + β2 YGapt–i + β3 ∆ERt–i + β4 USINFt–1 +
β5 DefGDPt–i + β6 ∆M1GDPt–i + β7 M2GDPt–i + β8 CMRatet–i + et … (2)
Where;
∆CPI: inflation rate
YGap: output gap
∆ER: exchange rate depreciation
USINF: US inflation rate (based on CPI)
DefGDP: budget deficit to GDP ratio
∆M1GDP: change in M1 to GDP ratio (measure of seigniorage)
M2GDP: M2 to GDP ratio (measure of financial depth)
CMRate: call money rate (proxy for interest rate).
We estimate two different specifications of Equation (2). The results are
reported in Table 6. Column 2 of Table 6 reports the results of Model 1 (first
specification). These results indicate that first lag of inflation have positive and
statistically significant influence on current inflation and thus may help to predict
inflation. A positive estimate for the parameter of Output Gap suggests the use of
expansionary monetary policy to expand the economy could lead to higher inflation.
A negative and statistically significant coefficient for ∆ER could be result of a
reduced trade gap through higher exports (through exchange rate depreciation) and
hence resulting in lower inflation. The results also indicate strong evidence of
imported inflation in Pakistan as USINF is positive and statistically significant.
Consistent with theoretical predictions, higher deficits lead to inflationary pressure.
The results suggest that increases in public sector spending which result in higher
budget deficits could also be a source of higher inflation in Pakistan. Further,
financing these budget deficits through seigniorage leads to monetary expansion and
7
We plan to use some statistical methods to form a series of quarterly GDP and replicate this
analysis. This stresses the need for more frequent statistical reporting especially on important
macroeconomic variables such as GDP.
 Growth, Inflation, and Monetary Policy 971

Table 6
Inflation Forecasting Equation: Dependent Variable: ∆CPIt
Variable Model 1 Model 2
*
Constant –0.5209 –0.4026*
(–6.0234) (–4.8345)
*
∆CPIt–1 0.4714 0.7093*
(3.5564) (6.4157)
YGapt–3 0.2578** 0.1335
(2.2603) (1.1654)
YGapt–4 0.2060*** 0.2287***
(1.8187) (1.8296)
∆ERt–2 –0.0149* –0.0142*
(–4.4032) (–3.7841)
USINFt–1 0.0118* 0.0114*
(4.4021) (3.8684)
*
USINFt–2 –0.0149 –0.0167*
(–4.2730) (–4.4266)
**
USINFt–3 0.0056 0.0078*
(2.2281) (2.9917)
*
DefGDPt–1 0.0103 0.0094*
(4.2287) (3.5356)
∆M1GDPt–2 0.0054***
(1.9933)
∆M1GDPt–3 0.0074**
(2.6402)
M2GDPt–1 0.0085* 0.0083*
(6.6090) (5.9690)
M2GDPt–4 0.0075* 0.0048*
(4.4726) (3.1743)
*
CMRatet–1 –0.0169
(–4.7672)
CMRatet–4 –0.0126*
(–3.5697)
2
Adj-R 0.8275 0.7887
D-h –3.0947 –1.5970
F-Statistics 14.6532 13.5553
Note: *, **, and *** Denote the significance level at 1 percent, 5 percent, and 10 percent respectively.
972 Ahmed M. Khalid

thus to higher inflation. We also found the financial depth (M2/GDP) leads to
higher inflation. This result is consistent with the experience of many emerging
economies at the early stage of liberalisation. Increase in nominal short-term
interest rate serves as an announcement effect of the future monetary policy and
thus could lead to lower inflationary expectation. Model 2 (second specification)
excludes the seigniorage from the equation. The results are reported in Column 3
of Table 6. These results, in general, are consistent with the results of Model 1.
This could be due to the fact that Model 2 still has M2/GDP in the equation and
effect of M1 is imbedded in M2.

IV. CONCLUSIONS
Like many central banks in the emerging markets, the State Bank of Pakistan
is also under pressure to discuss and design a policy that could provide a stable and
sustainable economic growth as well as address the necessary conditions to be part of
the global economy. The main issue to be resolved is what type of monetary policy
should be pursued to achieve certain goals over a medium to long-term. Inflation
targeting has been experimented in some emerging economies in Latin America and
East Asia. However, a switch towards inflation targeting as part of the monetary
policy is subject to certain pre-requisites including an understanding of the
determinants of inflation and a reasonable forecasting mechanism. This is the main
objective of this paper.
Pakistan has made significant progress in implementing economic and
institutional reforms since 2000. Some of these developments have been well
recognised. Pakistan achieved the most rapid privatisation of the banking system
during this period. The State Bank of Pakistan has been identified as the most
efficient central bank in emerging economies in 2004. Inflation was been brought
to single digits and economic growth reached a record high level during 2004.
Although debt is still a major issue to be resolved, a sizeable foreign reserve has
reduced the risk of default. Given these characteristics of the economy, it is
probably the time to seriously consider an appropriate choice of monetary policy
for the central bank. Inflation targeting is one of such alternative.
The paper focuses on inflation targeting (IT) as a choice of monetary
policy and to achieve economic stability. The paper provides a detailed
illustration of the experience of some emerging economies that opted inflation
targeting with a comparison to Pakistan’s current economic performance. The
examples of the Latin American and some Central European countries suggest
the feasibility of inflation targeting in emerging economies even if these
countries had complicated political and economic environments and did not
satisfy all the pre-conditions suggested in the literature.89 These examples also

8
See Khalid (2006).
 Growth, Inflation, and Monetary Policy 973

suggest that inflation targeting benefited these countries in providing price and
macroeconomic stability. However, this success requires measures to ensure
central bank transparency and committed policies to develop strong fiscal,
financial and monetary institutions.
Any decision to adopt inflation targeting requires a good theoretical model
and some empirical estimates to understand the pricing mechanism in Pakistan.
This paper attempts to develop and estimate a model for Pakistan and provides
estimate for leading indicators of inflations as well estimating the determinants
of inflation for Pakistan. Our results suggest that imported inflation, seigniorage
and openness cause inflation in Pakistan. The results also indicate that imported
inflation, deficit-GDP ratio, seigniorage, money depth, exchange rate
depreciation and domestic credit may be important determinants of inflation in
Pakistan. A mechanism to predict the movements of these variables would help
the State Bank of Pakistan to curtail inflation within its target bands. This
preliminary analysis could be used as a step forward to develop a more
comprehensive model and econometric methodology to address these issues in
further details. It would be ideal to use, at least, quarterly data for inflation
forecasts. It is also important to decide which definition of inflation is
appropriate for Pakistan’s case. An analysis of policy alternatives would help to
understand which policy suits the best for Pakistan’s economic environment.
These are possible extension being pursued in a separate paper. Nevertheless,
this paper serves to initiate the discussion on this important issue and attempts to
answer some important empirical questions in the context of Pakistan economy.

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