Impact of Financial Development on Inflation: Evidence from Pakistan (1974-2007)

The relationship between financial development, growth and inflation has been analyzed by a number of recent empirical studies in Pakistan. Sizeable research finds that money supply growth at beginning affects real GDP growth and further it affects inflation in Pakistan. These two step process doesn’t fulfill the specification of the consequences. Therefore, this study looks at the association and causality of Financial Development Indicators towards Inflationary trend in Pakistan expressly for the period of 1974-2007 for Pakistan. The study investigates whether inflation and financial development are cointegrated? Using the Johansen approach and F-bound cointegration test. Finally, a VAR is constructed and impulse response function (IRFs) are employed to investigate the effects of macroeconomic shocks. The result suggests that inflation and financial development indicators are cointegrated. There is unidirectional relationship, running from inflation to financial development indicators, both in the long-run and short-run.