Role Of Money Supply In Determinants Of Inflation Economics Essay

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Inflation is the increase in the prices of goods and services in an economy over a period of time. When the general price level rises, every unit of the currency buys smaller quantity of goods and services; so, inflation is a decline in the real value of money. Inflation is an important indicator of a country and of the economy. A stable inflation gives a fostering environment for economic growth, and also uplifts the poor and fixed income citizens.  

It has always been a high priority of the policy makers to control inflation. Large and persistent inflation adversely impacts the poor and economic development. Consequently the poor have little options to protect themselves against inflation. This group is most vulnerable to inflation as it erodes the savings of the poor.

Furthermore high and volatile inflation has been found to be damaging to growth.

The research problem identified is to identify the determinants of inflation and to focus on the role of money supply and monetary policy in it. The problem to be investigated is that what are the several factors in the economy of Pakistan which are contributing to the huge inflation going nowadays. Moreover the task will be to focus on the monetary theories and to study the effects of macroeconomic policies on the inflation of the country.

The study will be helpful in deciding the best methods to erode inflation from the economy of the country. The research will be different from other works as it will focus on the different approaches to look at inflation. One aspect could be to focus on the linkage between the money supply and the resulting inflation in the economy. Furthermore it will be observed that the increase in money supply may affect inflation in a differentiated manner depending upon the structure of the money supply and this experience varies from country to country. Moreover the econometric models will be seen to study the variables controlling the inflation in the economy. This will incorporate into the analysis the different schools of thoughts about the inflation and money supply into the economy.

The research provides a huge academic and managerial value. The study will provide the solution to overcome the problem of inflation into the economy. Furthermore the benefits to the general public will be attained if the problem of inflation will get solved. In addition the theories to be studied will provide a grip on the courses studied in economics. Inflation is a major problem of the economy of Pakistan and steps must be taken to resolve this problem. Otherwise the nation will suffer from a very bad condition and large turmoil.

The scope and orientation of the study is looked upon as how the inflation is affected largely by the money supply, inflationary expectations, government decisions to borrow money in budget deficits and especially by taxes.

Table of Contents

Chapter 1: Introduction

1.1 Overview of the Inflation

1.2 Relevance of the Topic and Research Title

1.3 Background Information and Evolution

1.4 Managerial concerns pertaining to Research

1.5 Academic concerns pertaining to Research

1.6 Keywords and Definitions

1.7 Study Objectives

End notes

€ Chapter 2: Literature Review

€ Chapter 3: Methodology & Analytical Choices

3.1 Framework of Analysis

3.2 Statement of Research Hypotheses

3.3 Elements of Research Design

3.4 Data Collection Preferences

3.5 Data Collection and Related Procedures

3.6 Statement of Analytical Approach and Methodology

End notes

Chapter 1


Overview of Inflation in Pakistan

The effects of inflation on economy can take the form of redistribution of income. It basically hurts savers as price rises, and real value or purchasing

power of savings declines. Saving account,

insurance policies, annuities and other fixed value

paper assets deteriorate in real value during


On the other hand unanticipated inflation benefits debtors at the expense of creditors. For the macroeconomic management, low rates of inflation are always required, especially in developing countries.

Inflation can have a number of adverse consequences for the economy. Firstly, inflation almost erodes the purchasing power of the people and hence,

leads to a reduction in economic growth. It

adds to macroeconomic instability as an inflationary environment creates many uncertainties.

Secondly, inflation has adverse consequences on the poverty profile of a country. The increase in overall prices hurts the poor in a more forceful manner since their consumption basket becomes significantly reduced with every inflationary increase. Thirdly, inflation can damage a country’s competitiveness by leading to an appreciation of the local currency and a resulting overvalued exchange rate, which have a negative effect on exports.

In case of Pakistan the mid-1970’s was a very inflationary time, with inflation rates averaging more than 15 percent annually. Many supply side and demand side factors could be responsible for this course of inflation. Inflation can also be due to the shocks to the supply of certain food items and to world oil markets. Growing oil prices can also pose risk of rise in prices of almost all other commodities of consumer basket. These supply-side shocks are very volatile and can cause large fluctuations in food and oil prices, the effects of which on overall inflation at times can be so extreme that these cannot be countered through demand management, including monetary policy.

1.2 Relevance of the Topic and Research Title

At this time in Pakistan’s history, double digit inflation has become a norm. The official price statistics, including GDP deflator, wholesale price index and consumer price index, showed an average annual rate of inflation of more than 15 per cent in the last four years but we all know from experience that prices are rising at a much faster rate than what the official statistics tell us. Inflationary expectations seem to have taken root creating a momentum for price increases. The country has thus entered a vicious circle in which actual price pressures and inflationary expectations have begun to feed each other. The ravages of high inflation are well known and those include deeper income inequality and poverty, falling saving and rising consumption, widespread speculation, hoarding and black marketing, balance of payment vulnerability, social tensions and political instability.

1.3 Background Information and Evolution

It has generally been said by the economists that high rates of inflation are the result of an extreme growth in the supply of money. Nowadays, most economists are in favor of a low steady rate of inflation. Low inflation reduces the severity of economic recessions by making the labor market to adjust more quickly in a downturn. It is the duty of monetary authorities to keep the rate of inflation low. The monetary authorities are mostly the central banks which control the size of the money supply by the setting of interest rates, by open market operations, and by the setting of banking reserve requirements.

There is huge information about the monetary policy, inflation and other theories of money supply. Great literature is devoted to the field of inflation and there are ample evidences on this aspect of macroeconomics. The most important theory is the monetary transmission mechanism. The monetary transmission mechanism shows how policy-induced changes in the nominal money stock or the short-term nominal interest rate impact on real variables such as aggregate output and employment.

Furthermore there are constant reports of state bank of Pakistan which discusses the monetary policy of the economy. It shows the recent trends of money supply and inflation in the economy. Apart from that there has been a lot of research conducted on the topic of inflation and its variables. The causes of inflation and its types are very well explained in the literature of all types. In addition there are lot of econometric models that tells about the components and factors affecting inflation.

1.4 Managerial and academic concerns pertaining to Research

The research provides a huge academic and managerial value. The study will provide the solution to overcome the problem of inflation into the economy. Furthermore the benefits to the general public will be attained if the problem of inflation will get solved. In addition the theories to be studied will provide a grip on the courses studied in economics.

1.6 Keywords and Definitions


Inflation is a rise in the general level of prices of goods and services over time. “Inflation” is also sometimes used to refer to a rise in the prices of some specific set of goods or services, as in “commodities inflation” or “core inflation”. It is measured as the percentage rate of change of a price index. (Haq, 2008)


Inflation caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favorable market conditions will stimulate investment and expansion. (Haq, 2008)


It is also called “supply shock inflation,” caused by drops in aggregate supply due to increased prices of inputs, for example. Take for instance a sudden decrease in the supply of oil, which would increase oil prices. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. (Haq, 2008)


It is induced by adaptive expectations, often linked to the “price/wage spiral” because it involves workers trying to keep their wages up (gross wages have to increase above the CPI rate to net to CPI after-tax) with prices and then employers passing higher costs on to consumers as higher prices as part of a “vicious circle.” Built-in inflation reflects events in the past, and so might be seen as hangover inflation. (Haq, 2008)


Inflationary expectations results when people tend to believe that there will be inflation occurring into the economy due to any factor.


The stock of money in an economy at a particular period of time is called the money supply in an economy at that time period.


The variable represents government sector borrowing and also includes net foreign assets and other items. (Khan, Bukhari and Ahmed, 2007)


Private sector includes borrowings by the private sector and also includes borrowing of autonomous bodies. (Khan, Bukhari and Ahmed, 2007)


It is the price for which one country’s currency can be exchanged with another country’s currency.


It is the demand relative to supply pressures, and it represents the output gap. (Khan, Bukhari and Ahmed, 2007)


These are the taxes imposed by the government on producers and consumers.


This includes the increase in prices of major products which are wheat, oil and imports.

1.7 Study Objectives

The aim of the study is to identify the key variables affecting inflation so that measures could be suggested to improve the condition of the economy by lowering the inflation rate as much as possible.

The expansionary economic policies of the government and the SBP over the last few years have remained successful in increasing the various macroeconomic indicators including Gross Domestic Product (GDP) growth. It remained above 6 percent during 2004-06. But on the other hand this impressive performance of the economy had caused some troublesome factors. The most significant of them is inflation, which remained above 8 percent during the last two years. It has been reported that in 2004-05, average CPI inflation was 9.3 percent. While on the basis of 12 month changes, inflation was recorded at 11 percent in April 2005.

The immediate effects of inflation are the decreased purchasing power of the rupee and its depreciation. Therefore it is not a good sign to have inflation in the economy. Furthermore it also hurts the economic development of the country.

Chapter 2: Literature Review

2.1 Inflation and its types

According to the literature inflation is the rise in the prices of goods and services in an economy over a period of time. Another finding says that when the general price level raises each unit of the functional currency buys fewer goods and services which will result in the decline of real value of money. It creates a loss of purchasing power in the internal medium of exchange, which is also the monetary unit of account in an economy. Inflation is a very important indicator of a country and it provides important insight on the state of the economy and the sound macroeconomic policies that govern it. A stable inflation rate does not only gives a fostering environment for economic growth, but it also uplifts the poor and fixed income citizens who are the most vulnerable in society. (Zaiby, 2009)

 There are two kinds of inflation; cost push and demand pull. Cost push inflation is caused by the increase in per unit production cost. The demand pull inflation is caused by an increase in the overall demand of the economy. The general measure to measure inflation is CPI. CPI is the consumer price index. Consumer price index is a measure that takes into account the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. It is being calculated by taking price changes for each item in the fixed basket of goods and averaging them. The goods are weighted according to their importance. 

The role of money supply in determining inflation

The relationship between money supply and inflation

The money supply and inflation are positively related with each other. The increase in money supply will lead to inflation and the decrease in it will result in the reduction on inflation. The money supply is determined by money multiplier. The money multiplier is again determined by required reserve ratio, currency ratio and the excess reserve ratio. Furthermore other determinants of inflation includes inflationary expectations, government sector borrowings, real demand, cost shocks, private sector borrowings, import prices, government taxes, exchange rates and wages.

Studies concluded that inflation is a monetary phenomenon in Pakistan, while some showed that structural factors explained the inflationary process in Pakistan. It is widely disagreed whether money supply is exogenous or endogenous. Vogel (1974), criticising the monetarist approach, said that further research is needed on the determination of money supply. Haan and Zelhorst (1990) also analysed the relationship between government budget deficit and money growth in the developing countries. The overall conclusion of this study did not provide much support that government budget deficit influences monetary expansion and, therefore, create inflation. Moreover Chaudhary and Parai (1991) have used a rational-expectations macro model of inflation to find out the effect of the anticipated budget deficit on inflation rates for Peruvian economy. They concluded that high rates of growth of money did have a significant impact on the inflation rate. Likewise, there is much literature of disagreement on whether money supply is exogenous or endogenous.

On the other hand Khan, Bukhari and Ahmed (2006) concluded that expansionary economic policies of the government and the central bank, which on one side resulted in impressive economic performance but on the other side encouraged the rise in consumer price index. The expansionary monetary policy through high growth in money supply and loose credit policy was believed to be contributing to high inflation. Khan and Axel (2006), who used monthly data from January 1998 to June 2005, concluded that the lagged growth of private sector credit and money supply (M2) lagged growth are the two significant causes of inflation in Pakistan in recent years.

This can be safely stated that the expansionary monetary policy though did contribute in promising GDP growth; it also led to the rise in consumer prices. Mainly the phenomenal growth in the flow of ‘loose credit’ to the private sector had a major role to play in disturbing the price mechanism. Moreover availability of money at virtually no cost encouraged speculators and hoarders. Then the role of adaptive expectations then became prominent when people started expecting higher prices in future as the land prices, house rents and food prices were seemed to have no limits.

Theories of money supply with regards to inflation

The most important theory of inflation is the Quantity Theory of Money. The equation for this theory is MV = PT where M is Money Supply, V is Velocity of Circulation, P is Price level and T is Transactions or Output. In this equation monetarists assume that V and T are fixed, in the long run, by real variables, such as the productive capacity of the economy, there is a direct relationship between the growth of the money supply and inflation.

The mechanisms by which excess money might be translated into inflation are examined. It is concluded that individuals can spend their excess money balances directly on goods and services. Consequently this has a direct impact on inflation by raising aggregate demand. Furthermore the increase in the demand for labour resulting from higher demands for goods and services will cause a rise in money wages and unit labour costs. Conclusively the more inelastic is aggregate supply in the economy, the greater the impact on inflation.

On the other hand the increase in demand for goods and services may cause a rise in imports. Resultantly this leakage from the domestic economy reduces the money supply; it also increases the supply of money on the foreign exchange market thus applying downward pressure on the exchange rate. This can cause imported inflation.

There is another theory regarding the Austrian view with which not much people are familiar with. It says that inflation is always and everywhere simply an increase of the money supply (i.e. units of currency or means of exchange), which in turn leads to a higher nominal price level, as the real value of each monetary unit is eroded, loses purchasing power and thus buys fewer assets and goods and services.

It is being considered in this theory that all major economies currently have a central bank supporting the private banking system, money can be supplied into these economies by means of bank-created credit (or debt). The Austrian economists believe that this bank-created credit growth which forms the bulk of the money supply sets off and creates volatile business cycles and maintain that this “wave-like” or “boomerang” effect on economic activity is one of the most damaging effects of monetary inflation. Furthermore the Austrian theory of the business cycle vary notably from the theories of Gordon Tullock,Bryan Caplan, and Nobel laureates Milton Friedman and Paul Krugman having said that they regard the theory as incorrect.

2.2.3 Monetary transmission mechanism

In a report of State Bank of Pakistan, the then governor of State Bank Ms. Shamshad Akhter talked in detail about the monetary transmission mechanism in general and with reference to Pakistan. She said that the monetary transmission mechanism refers to a process through which monetary policy decisions affect the level of economic activity in the economy and the inflation rate. She further explained that understanding the transmission mechanism of monetary policy is crucial for proper design and efficient conduct of monetary policy. She also added that as monetary policy actions affect policy variables with a considerable lag and with high degree of variability and uncertainty, it is important to predict the possible impact and extent of monetary policy actions on the real variables. So by its very nature, monetary policy tends to be forward-looking.

Furthermore it is also important to know which transmission channels are more effective in terms of transmitting changes in monetary policy actions to ultimate policy goals. Various financial sector developments particularly regarding introduction of new financial products, technological changes, institutional strengthening, and expectations about future policy can potentially change economic effects of the monetary policy measures.

Thus there is a need to regularly update, empirically test and reinterpret monetary policy transmission channels.

According to the report the impact of monetary policy is professed to transmit in to the real economic activity through five channels. The first channel and most widely studied and understood channel of monetary policy transmission relies on the link between changes in the short-term nominal interest rate (induced by changes in the policy rate) and the long-term real interest rate that ultimately affect components of aggregate demand such as consumption and investment in an economy. The second channel, known as the credit channel, involves changes in monetary policy that not only affects the ability of firms to borrow money (by affecting their net worth) but also affects the ability of banks to lend money. The strength of this channel depends on the degree to which the central bank has allowed banks to extend loans and the dependence of borrowers on bank loans. These factors are clearly influenced by the structure of the financial system and its regulation. The third channel of monetary policy transmission focuses on asset prices (other than the interest rate) such as the market value of securities (bonds and equities) and prices of real estate. A policy-induced change in the nominal interest rate affects the price of bonds and stocks that may change the market value of firms relative to the replacement cost of capital, affecting investment. Moreover, a change in the prices of securities entails a change in wealth which can affect the consumption of households. Fourth, a policy-induced change in the domestic interest rate also affects the exchange rate that in turn affects the foreign financial flows, net exports and thus aggregate demand. The strength of the exchange rate channel depends on the responsiveness of the exchange rate to monetary shocks, the degree of openness of the economy, sensitivity of foreign private inflows and net exports to exchange rate variations, and the net worth of firms and thus their borrowing capacity if they have taken exposure to foreign currency. Moreover, exchange rate changes lead to changes in the domestic price of imported consumption goods and imported production inputs affecting inflation directly. Since expectations influence the inflation dynamics, there is a fifth channel that is based on the economic agents’ expectations of the future prospects of the economy and likely stance of the monetary policy. According to this “expectations channel”, most economic variables are determined in a forward-looking manner and are affected by the expected monetary policy actions. Thus, a consistent, credible, and transparent monetary policy can potentially affect the likely path of the economy by simply affecting expectations.

The impact of independent variables on inflation

Relationship of the variables with inflation

The impact of money supply with inflation is already discussed above. Now the relationship of inflation with other variables is taken into account. First of all a very important variable is inflationary expectations. The inflationary expectations tend to increase the inflation. When people expect that inflation will increase in the coming year they purchase more goods so that they would not be able to buy the goods at a higher prices in the future. This will lead to an increase in the demand and the shortage of supply. Resultantly the price will increase because now too much currency is chasing too few goods.

Now coming to government sector borrowings which also increase the inflation. A measure of it can be budget deficit. The fiscal deficit in Pakistan has been startling during the last two decades. The fiscal deficit in Pakistan was almost 7.4 percent of the GDP during the period of 1970-80. And it was 7.6 percent during the 1980s. In 1987.88 it was 8.5 percent and around 7.9 percent in 1992. Thus inflation is considered to be an outcome of this fiscal deficit.

Furthermore coming to infrastructure which is another determinant on inflation though not very significant and direct variable. Heintz, Pollin and Peltier(2009) concluded that infrastructure is very important in increasing the growth rate of a country as well as job creation. It is highly significant in leading to a very productive environment which paces economic growth. On the other hand Looney (1990) concluded that the infrastructure has a potential role in reducing inflationary pressures in the economy. The link is being made between the infrastructure and the cost of production. As the cost of production is a prime factor in determining the prices of the goods, therefore the lower it is the minimum the inflation will be. As a general idea, the better the infrastructure, the easier it will be to transport the raw materials. It will further lead to a lower cost of production and therefore a decrease in inflation.

Moving on to another very significant variable which is government taxes and it play a significant role in determining inflation. As a general idea the taxes always lead to inflation. They can be either on producer or consumer. In both ways they lead to an increase in inflation. Khan, Bukhari and Ahmed (2007) concluded about the government taxes that in order to increase its revenue government increases the taxes which will put inflationary pressures on the economy.

Moreover import price is another determinant of inflation. In a country like Pakistan, there are thousands of commodities and necessities of life which are imported. Therefore the import prices are very important in determining Pakistan’s inflation rate. Like the prices of any other local commodity the increase in the import prices will lead to inflation. According to the studies the import prices must be kept at the level that inflation will not be the consequence. In addition to it the increase in food imports are also the cause of food inflation in Pakistan. The raw materials for food and the import of wheat at higher prices are making a poor man to be deprived of a basic necessity of food.

The official exchange rate is another determinant of inflation. Though not very significant according to the studies but still it does play a role in setting up the inflation of an economy. Exchange rate if expressed as rupees per dollar, which means that a depreciation of Pakistani Rupee would mean more rupees for a dollar and hence increase in the number. Then more rupees for a dollar would mean increasing cost of imports. This variable is assumed to have a direct impact according to the studies, which indicates that the depreciation of Pak Rupee would have inflationary effect on prices.

Another determinant of inflation is private sector borrowing. The studies showed private sector borrowing was the second most important factor for inflation in Pakistan. During 2004 and 2005 the growth in private sector borrowing has been above 30 percent and it was 23 percent in 2006. This growth is reflected in the contribution of private borrowings in inflation, which is 38 percent in 2004-05 and 35 percent in 2005-06. If seen in terms of percentage points it contributed 3.5 percentage points in total inflation of 9.3 percent in 2004-05 and 2.8 percentage points in total inflation of 8 percent in 2005-06.

Number of middlemen in agriculture marketing system did not appear in the studies significantly. It can be supposed that increase in the number of middlemen in agriculture sector will lead to a higher price of the final or the end product. Thus the food inflation will be the result.

2.4 Trends of inflation in Pakistan

According to a report of State Bank of Pakistan the expansionary economic policies of the government and the SBP over the last few years have remained successful in increasing the various macroeconomic indicators including Gross Domestic Product (GDP) growth. It remained above 6 percent during 2004-06. But on the other hand this impressive performance of the economy had caused some troublesome factors. The most significant of them is inflation, which remained above 8 percent during the last two years. It has been reported that in 2004-05, average CPI inflation was 9.3 percent. While on the basis of 12 month changes, inflation was recorded at 11 percent in April 2005.

The immediate effects of inflation are the decreased purchasing power of the rupee and its depreciation. Therefore it is not a good sign to have inflation in the economy. Furthermore it also hurts the economic development of the country.

2.5 Is Inflation always a bad phenomenon?

Khan, Ahmed and Bukhari (2007) concluded that inflation is not bad for the economy always. Thus a reasonable rate of inflation, around 3 to 6 percent for Pakistan is often viewed to have positive effects on the economy, as it leads to investment and production and therefore allows growth in wages.

On the other hand, when inflation goes beyond reasonable limits, it produces negative results. It also reduces the value of money, which is the medium of exchange. Consequently the uncertainty of the value of gains and losses of borrowers and lenders as well as buyers and sellers. Resultantly it discourages savings and investment. Savings go down as inflation reduces the real rate of return on financial assets. This in turn will lead to lower investment and lower economic growth. It does not only lead to lower growth but on the other hand it also leaves the poor worse off and increases the divide between the rich and the poor. When much of the inflation comes from increase in food prices, it mainly hurts the poor more since more than half of the budget of low wage earners goes towards food. And it redistributes income from fixed income earners (like pensioners) to owners of assets and earners of large and variable income, such as profits.

In Pakistan, annual inflation was above 11 percent in 11 of the past 32 years. The average real per capita income growth was 2.8 percent in years having less than 11 percent inflation, as compared to the years of high inflation which recorded an average of 1.5 percent growth in real per capita income.

Thus for Pakistan’s economy, inflation can be bad if it crosses

6 percent, and can be extremely harmful if it crosses the double digit level.

2.6 The importance of State Bank of Pakistan in the role of controlling inflation

According to a report of State Bank of Pakistan, the policies of the bank place more weight and demonstrate increased willingness on controlling inflation relative to output growth, and financial and exchange rate stability. It is important to accept, however, that in practical policy making, restricting to revealed preferences is rather difficult. The reason for that is central banks do not operate in a vacuum and require coordination with other policy making institutions, in particular the fiscal authority. Moreover, the social

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