Determinants of Inflation and Feasibility of Inflation Targeting in a Small Emerging Market Economy: The Case of Pakistan By

This paper has been prepared as a background paper for the conference on " Monetary Cum Exchange Rate: What works best for emerging market economies? " to be held under the auspices Abstract The successes of inflation targeting monetary policies in established market economies have generated an interest among policy makers in some emerging market economies to explore the feasibility of adopting the same in order to overcome the recent inflationary trends. Using the data for Pakistan, this study investigates some important issues that the monetary authorities must consider before adopting a policy of targeting the inflation rate. In doing so, Pakistan's record of economic policy and performance during the period 1973-2005 is reviewed in relation to changes in economic policy and political regimes. The time series data on money supply (as an indicator of monetary policy), and budget deficits (as an indicator of fiscal policy) reflect significant changes that have taken place in the recent past. These changes include several market-based financial sector reforms that have taken place in Pakistan since the mid-1990s. As a part of these reforms, greater transparency has also been introduced in the operations of the central bank, the State Bank of Pakistan (SBP). The decline in fiscal deficit has also increased the independence of SBP in the conduct of monetary policy. The changes of government and the central bank's governor in 1999, and a move towards greater flexibility of foreign exchange rate may also have caused the changes reflected in the time series data. In order to assess the feasibility of adopting an inflation targeting monetary policy in Pakistan, the determinants of inflation and output cost of inflation targeting are analyzed using econometric models. A model of general price level that incorporates lag adjustments is developed and estimated using quarterly data for the period 1982-2004. Two versions of the model are estimated using CPI and WPI as measures of general price level. The results indicate that the foreign price level of imports, money supply, and domestic output level are statistically significant determinants of the general price level. The exchange rate is not statistically significant as a determinant. The effect of money supply on wholesale prices increased in 2000 while the impact on consumer prices remained the same throughout the period. However, the elasticity of the general price level with respect to money supply is relatively smaller than the elasticity with respect to foreign prices …