The paper finds that an increase in money supply over the long-run results in a higher rate of inflation and thus provides support for the quantity theory of money. It establishes that inflation is essentially a monetary phenomenon. However, the money supply does not instantly influence the price levels; the impact of money supply on inflation has a considerable lag of about 9 months. While the study shows that the money supply works through the system in less than a year, it also points out that the system takes rather long to converge to equilibrium if shocks appear in any of the three variables, viz., GDP, money supply, and prices.Growth, Inflation, Money Supply, QTM

M. Ali Kemal

English

Research Papers in Economics

The Pakistan Development Review 
45 : 2 (Summer 2006) pp. 213–220 
 
 
 
 
 
 
Is Inflation in Pakistan a Monetary Phenomenon? 
 
M.  ALI  KEMAL
* 
 
The paper finds that an increase in money supply over the long-run results in a higher 
rate of inflation and thus provides support for the quantity theory of money. It establishes that 
inflation is essentially a monetary phenomenon. However, the money supply does not instantly 
influence the price levels; the impact of money supply on inflation has a considerable lag of 
about 9 months. While the study shows that the money supply works through the system in less 
than a year, it also points out that the system takes rather long to converge to equilibrium if 
shocks appear in any of the three variables, viz., GDP, money supply, and prices. 
 
JEL classification: N15, E31, E51 
Keywords: Growth, Inflation, Money Supply, QTM  
 
1.  INTRODUCTION 
Inflation is one of the most researched topics in economics because it has serious 
implications for growth and income distribution. What factors determine the inflation 
rates has also been widely debated all over the world. Whereas on the one hand the 
structuralists believe that the inflation in developing countries has more to do with the 
rigid structures of the developing economies, the monetarists believe that it is essentially 
a monetary phenomenon and that the developing economies are no exception to that rule. 
It may be noted that quite often prices increase in the short run due to shortage of 
certain products but fall as soon as the supply situation improves. These movements of 
prices in the short run, may not affect the long run inflation. Supply shocks generally 
cause inflation in the short run which can be accommodated by contractionary monetary 
policy. However, most of the economists view inflation as monetary phenomenon when 
analysed over a longer period of time [Grauwe and Polan (2005)]. In case of Pakistan 
Khan and Schimmelpfennig (2006) concluded that in the long run excess money supply 
is the main factor responsible for inflation, however at the same time they also point out 
that other factors, including structural problems also influence the rate of inflation. 
This paper undertakes to examine; (a) the hypothesis whether the inflation is 
essentially a monetary phenomenon in Pakistan, as well as its impact on the economy in 
the short and the long run; (b) to examine the lag length over which the money supply 
may impact the inflation rate; and (c) to examine the joint relationship of growth of 
money supply, growth rate of output, and the rate of inflation in Pakistan. 
 
M. Ali Kemal <m_alikemal@yahoo.com> is Research Economist at the Pakistan Institute of 
Development Economics, Islamabad.  
Author’s Note:  The author is thankful to Dr Nadeem Ul Haque, Vice-Chancellor PIDE, Dr Faiz 
Bilquees and others for their suggestions and comments on the earlier version of the paper. M. Ali Kemal 
 
214
The paper is organised as follows: the theory behind the relationship between 
money supply and inflation rate is presented in Section II. In Section III, data issues and 
the methodology adopted in the study to establish the empirical relationship between 
money supply, GDP, and prices is presented. The results of the study are presented in 
Section IV and major conclusions and policy implications are given in the concluding 
section of the paper. 
 
2.  MONEY AND INFLATION 
The view that inflation is a monetary phenomenon is based on the traditional 
Quantity Theory of Money (QTM): 
  MV = PY 
Where 
M : Money supply  
V  : Velocity of money  
P  : Prices and 
Y  : Output 
The theory states that increase in money growth leads to equal changes in inflation 
rate through the Fischer Effect. It assumes that velocity and output in the long run remain 
the same. Grauwe and Polan (2005) discuss two aspects of the QTM, viz., permanent 
increase in money growth leads to equal increase in inflation
1 and does not affect the 
output and velocity in the long run (money is neutral); and in the short run, money 
growth might have a positive impact on output growth. Unexpected increase in money 
supply, in the short run, is beneficial to output growth. In the long run, however, 
individuals as well as firms can anticipate the increases in money supply and therefore 
increase prices of their products and wage rates accordingly. Therefore, eventually, an 
increase in money supply results in an increase in inflation, while real output remains at 
the same level. The short-run gains of output are at the cost of an increase in the 
variability of inflation, which leads to uncertainty about the future profitability of 
investment. Unexpected inflation distorts lending and borrowing decisions which 
eventually leads to low level of investment. Moreover, increase in prices, especially 
relative to its trading partners
2, reduces the international competitiveness thus adversely 
affecting the balance of payments. Increase in inflation also leads to decrease in 
purchasing power of people hence decline in the welfare of the people especially because 
the increase in wages occurs with a lag. 
Numerous studies have been carried out to check whether inflation in Pakistan is a 
monetary phenomenon or there are other factors that give rise to inflation. Khan and 
Qasim (1996), Nasim (1995), and Hossain (1990) show that inflation is a monetary 
phenomena. However, other studies such as Hossain (1986, 1990), Bilquees (1988), 
Naqvi, et al. (1994), Hasan, et al. (1995) and ABN AMRO Bank (1995, 1996) relate 
inflation to supply-side bottlenecks, adjustment in government-administered prices, 
 
1We can check it by using statistical inference tests, i.e., coefficient money = I or not. 
2Increase in prices of home country more than the increase in prices of trading partners would lead to 
either exchange rate depreciation or overvaluation of exchange rate if it is not changed. Is Inflation in Pakistan a Monetary Phenomenon? 
 
215 
exchange rate adjustments, escalation in indirect taxes, and inflationary expectations as 
well. Naqvi and Khan (1989) using the macro-econometric model
3 conclude that inflation 
is either explained by one year’s lag money supply or its own lags. Khan and 
Schimmelpfennig (2006) also conclude that in the long run, money is the main factor 
which creates inflation in Pakistan. Ahmad, et al. (2005) show that the monetary 
tightening leads first to a fall in domestic demand, financed by bank lending, which 
translates into a gradual reduction in price pressures that eventually reduces the overall 
price level with a lag. This implies that in the short run inflation does not respond to 
money supply spontaneously but with some lag. Husain and Rashid (2006) obtained 
univariate causality from money to prices in the long run. In the short run they conclude 
that money affects price level with two years lag. 
Graph 1 shows a significant long run relationship between money growth and 
inflation rate over the period 1975-2005. This is also confirmed by the correlation 
between the two, i.e., one year lagged-level correlation between money growth and 
inflation rate is higher than the level-level correlation
4. This implies that there may exist 
significant positive relationship between the two variables in the long run and lagged 
impact of money supply change on inflation rate in the short run
5. It is also observed that 
increase in variability in money supply leads to increase in the variability in inflation and 
variability in GDP growth.
6 
 
Graph 1.  Money and Inflation 
0
5
10
15
20
25
30
1
9
7
5
1
9
7
7
1
9
7
9
1
9
8
1
1
9
8
3
1
9
8
5
1
9
8
7
1
9
8
9
1
9
9
1
1
9
9
3
1
9
9
5
1
9
9
7
1
9
9
9
2
0
0
1
2
0
0
3
2
0
0
5
Money Growth Inflation Rate
  
 
3There are certain problems in macro econometric model specification. Moreover the estimation 
technique and appearance of variables may show spurious regression problems. 
4Level-level correlation between money and prices is 95 percent while one year lagged-level 
correlation between the two is 96 percent. 
5These estimates are based on annual data. Correlation between money and prices is 99.6 percent on 
quarterly data. 
6The argument is based on the calculation of coefficient of variation of the three variables over different 
time periods. For rigorous analysis one needs to do certain tests, such as co integration etc. M. Ali Kemal 
 
216
3.  METHODOLOGY AND DATA PROBLEMS 
Our primary objective is to check the long-run relationship and short-run dynamics 
between the money and inflation. Cointegration technique is used to check the long run 
relationship
7 and vector error correction mechanism is used for short run dynamics. 
Order of integration of the variables can be checked by using various stationarity 
tests of which ADF and PP tests are most popular amongst them.
8 The two most popular 
approaches used for the co integration analysis are the Engle-Granger approach and the 
Johansen co integration technique. Due to some shortcomings of the Engle-Granger 
approach
9 we use Johansen approach of cointegration.
10 Impulse response function (IRF) 
is also used to check the time paths of in the variables. 
The study uses quarterly data. Quarterly data on real GDP is taken from Kemal 
and Arby (2004), and quarterly data on Consumer Price Index (CPI) of base year 2000 
and money supply are taken form International Financial Statistics (IFS) CD-ROM from 
1975:1 to 2003:4. 
 
4.  EMPIRICAL FINDINGS 
ADF test is applied on all the three variables (seasonal dummies are also used as 
explanatory variables). Table 1 shows that all the variables, i.e., log of CPI (P), log GDP 
(y) and the log of M2 (m) are non-stationary variables but integrated of the same order, 
i.e. order one. 
 
Table 1 
Results of Stationarity (ADF Test) 
Variables Constant  Lags  Constant  and  Trend  Lags 
  P  –0.002 15  –0.079*  15 
  Lip  –0.489* 7  –0.498  7 
  Y  –0.027* 11  0.013  11 
  Lly  –2.027* 10  –4.427*  10 
  M  –0.002 12  –0.096*  12 
  Llm  –0.569* 10  –0.692*  10 
Note: * Indicates the level of significance at 1 percent level. 
 
Johansen co integration test using all the three variables is checked at different 
lags. Johansen test is applied at different lags and AIC is minimum at lags 1, 3, and 12 
using a constant in both co integrating and VEC equations. Trace test and maximum 
eigenvalue tests in Table 2 show that the three variables are linearly dependant on each 
other. 
Cointegrating equation shows (Table 3) positive long run association of inflation 
and  money  supply  and  negative  and  significant relationship with income. This implies  
 
7Variables, x, y and z are said to be cointegrated if they are non stationary but integrated of the same 
order and their linear combination is integrated of the order less than the order of the integration of these 
variables. 
8There are certain shortcomings of each tests, [see Madalla and Kim (1998)]. 
9For further details, [see Enders (2004)]. 
10To read further on the methodology, [see Enders (2004)]. Is Inflation in Pakistan a Monetary Phenomenon? 
 
217 
Table 2 
Results of Trace and Eigenvalues Tests 
Unrestricted Cointegration Rank Test (Trace) 
No. of Cointegrating 
Vectors Eigenvalues
Trace  
Statistic 
Critical Value 
(5%) Probability** 
None *  0.21  31.57  29.80  0.03 
At most 1  0.06  7.21  15.49  0.55 
At most 2  0.01  1.37  3.84  0.24 
Maximum Eigenvalues 
None *  0.21  24.36  21.13  0.02 
At most 1  0.06  5.84  14.26  0.63 
At most 2  0.01  1.37  3.84  0.24 
  * Denotes rejection of the hypothesis at the 5 percent level of significance. 
 **MacKinnon-Haug-Michelis (1999) p-values. 
 
Table 3 
Results of Cointegration and Error Correction  
(GDP Growth, Inflation Rate and Money Growth) 
Variables Coefficients 
pt–1  1.00 
mt–1  –1.02 
  [–12.84] 
yt–1  1.28 
 [  5.68] 
Constant –5.54 
Error Correction Mechanism 
  ∆p  ∆m  ∆y 
Coefficient 0.02  0.11  –0.25 
t-values  [ 0.98]  [ 2.69]  [–3.82] 
Note:   *, **, *** Indicate level of significance at 1, 5, and 10 percent level. 
            Values in parenthesis are t-values. 
 
that in the short run (in one year) the policy of achieving the objectives of more 
employment and output may be optimal but in the long run it only contributes to 
inflation. Negative association between inflation and output implies that any increase in 
output in the short run resulting form demand stimulus results in a decline in the output 
and higher prices overlong run. 
We can check the QTM hypothesis whether there is one to one relationship 
between money and the prices by checking the coefficient of money, i.e., whether it is 
equal to one. The test shows that coefficient of money supply is not significantly different 
from one which shows that the QTM holds in the long run. Error correction results show 
(Table 3) that in the short run when there is a disequilibrium, and both money and output 
adjust to restore equilibrium. M. Ali Kemal 
 
218
The VAR results (Table 4) show that inflation is strongly associated with the 
short-run movements in the money supply but is affected by the lag. In the estimated 
equation, it affects inflation in the third quarter. Due to missing information (AIC is the 
minimum using these lags) about other lags, it is not possible to ascertain other lag levels 
which affect inflation in the short run. 
 
Table 4 
VAR Results for GDP Growth, Inflation Rate, and Money Growth 
Variables  ∆p  ∆m  ∆y 
∆pt–1 0.10  –0.08  0.92 
 [  0.93]  [–0.48]  [3.40]* 
∆pt–3  0.06 –0.31  0.08 
 [  0.59]  [–1.86]***  [0.28] 
∆pt–12  0.01 0.30 0.16 
  [ 0.16]  [ 2.25]**  [0.74] 
∆mt–1  0.02 0.03  –0.01 
  [ 0.39]  [ 0.30]  [–0.04] 
∆mt–3  0.13 0.18  –0.18 
 [  2.03]**  [1.74]***  [–1.06] 
∆mt–12  –0.04 0.04 0.15 
 [–0.69]  [  0.48]  [1.06] 
∆yt–1  –0.05 –0.02  0.04 
 [–2.62]*  [–0.49]  [0.72] 
∆yt–3  0.03 –0.06 –0.09 
 [  1.62]  [–2.19]**  [–1.94]*** 
∆yt–12  0.00 0.16 0.69 
 [  0.22]  [5.04]*  [13.02]* 
Constant 0.01  0.03  –0.02 
 [  2.61]*  [3.68]*  [–1.49] 
R
2 0.33  0.65  0.96 
Adjusted R
2 0.25  0.61  0.95 
F-statistic 0.33  0.65  0.96 
Note:  *, **, *** Indicate level of significance at 1, 5, and 10 percent level of significance. 
           Values in parenthesis are t-values. 
 
Results of impulse response function (IRF) in Graph 2 show that both money 
and output adjusts in response to exogenous shock in inflation but inflation does not 
adjust to its own shock. However, the equilibrium is not restored fully. Inflation 
adjusts while output overshoots in response to money supply shock. GDP adjusts 
significantly to its own shock and money supply adjusts slightly. Inflation does 
respond well to the shock in GDP but equilibrium is not stable. This implies that 
system does not converge to equilibrium in the short run if the shock appears in any 
of the three variables. Is Inflation in Pakistan a Monetary Phenomenon? 
 
219 
Graph 2.  Impulse Response Function 
-.004
.000
.004
.008
.012
.016
.020
1 2 3 4 5 6 7 8 9 10
Response of LP to LP
-.004
.000
.004
.008
.012
.016
.020
1 2 3 4 5 6 7 8 9 10
Response of LP to LM2
-.004
.000
.004
.008
.012
.016
.020
1 2 3 4 5 6 7 8 9 10
Response of LP to LY
.000
.004
.008
.012
.016
.020
.024
1 2 3 4 5 6 7 8 9 10
Response of LM2 to LP
.000
.004
.008
.012
.016
.020
.024
1 2 3 4 5 6 7 8 9 10
Response of LM2 to LM2
.000
.004
.008
.012
.016
.020
.024
1 2 3 4 5 6 7 8 9 10
Response of LM2 to LY
-.02
-.01
.00
.01
.02
.03
.04
1 2 3 4 5 6 7 8 9 10
Response of LY to LP
-.02
-.01
.00
.01
.02
.03
.04
1 2 3 4 5 6 7 8 9 10
Response of LY to LM2
-.02
-.01
.00
.01
.02
.03
.04
1 2 3 4 5 6 7 8 9 10
Response of LY to LY
Response to Cholesky One S.D. Innovations
 
 
5.  CONCLUSIONS 
In the long run money supply impacts the inflation rates. QTM holds in the long 
run, which implies that inflation is a monetary phenomenon. In the short run, the impact 
of money on inflation is not instant; it affects inflation with lags of about 3 quarters. 
Important conclusion that emerges from the study is that system does not converge to 
equilibrium for long period if shocks appear in any of the three variables. 
 
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Is Inflation in Pakistan a Monetary Phenomenon?

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