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Introduction:

Inflation means the rise in the general price level or fall in the value of
good and purchasing power of money. It is opposite of deflation. Inflation is one of the hot
issues in world economy and present era because it has a serious effect on growth and income
distribution (Kemal.A.M, 2006). Inflation and its effect on economy is enormous, it is
influenced by all the major macroeconomic indicators (Consumer price indices, Industrial
production, Agricultural production, Export, Import, money supply, exchange rate, interest
rate, & Debt) which has adverse effect on an economy (Bokhari.H.S and Feridun.M,2006).
Inflation also adversely affects the economy of Pakistan by all the above mention
macroeconomic indicators. Federal Bureau Statistic of Pakistan has published inflation rates of
11.18%, 9.04%, 3.66%, 7.39% 9.50%,10.7 % and11.17% during 1991-1994, 1995-1998,
1999-2002, 2003-2006, 2007-2008, 2008-2009and 2009-2010 respectively which are quite
high and bad for the economy.(www.statepak.gov.pk). Inflation is favorable when it is in a
prescribed limit and if it’s cross the limit it become unfavorable for the economy of country.
Inflation can create problems for future profitability of investment, growth and economics
condition of the country. Due to the different economic conditions the causes of inflation may
be different in the cases of developing and developed countries. (Kemal.A.M, 2006). Budget
deficit also play an important role in creating inflation in the economy as higher deficit lead to
higher inflation even in the absence of monetization by Central banks because of this
governments borrowing requirement will increase the net credit demands in the economy
which drive up the interest rates and crowd out private investment. As a result growth rate of
the economy will reduced and the amount of goods produced in the country or the total
production level will decreases for a given level of cash balances and hence the increase in the
price level lead to inflation(Akcay.C.O and et,al,1996). Economists, central bankers and
policymakers of Pakistan have often emphasized the costs associated with high and persistent
inflation. Inflation imposes negative impact on the economy when it interferes with an
economy’s efficiency. Inflation can lead to uncertainty about the future profitability of
investment projects especially when there is hyper inflation. It leads to more traditional
investment strategies and ultimately leads to lower level of investment and economics growth.

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The problem which is focused in this study is to investigate the effects of budget deficit on
inflation in the economy of Pakistan. This problem will be focused by controlling the Govt

borrowing, and depreciation exchange rate that create budget deficit which ultimately will
result in higher inflation in the economy of Pakistan.
To investigate the effects of budget deficit on inflation, many research studies have been
conducted in the past. E.g. Metin.K, 1998 concluded that budget deficit (as well as income
growth and debt monetization) significantly affect inflation in Turkey. Sowa, (1994) found that
inflation in Ghana is influenced more by output volatility than by monetary factors, both in the
long run and in the short run. Solomon.M and W A de Wet, (2004) found that Tanzanian
economy establishes the causal link that runs from the budget deficit to the inflation rate, and
with the existence of a stable long run relationship between the budget deficit, exchange rate,
GDP and inflation he found a significant impact of the budget deficit on inflation in Tanzania.
Agha.I.A and Khan.S.M, (2006) found that similar to other countries inflation is called a
monetary expansion in Pakistan and it is generally associated with fiscal imbalance, price
fluctuation and money expansion. It is also found that the main causes behind high rate of
inflation could be large monetary expansion, fiscal imbalances, economic growth and exchange
rate depreciation.
As many studies have been done to estimate or examine the factors of macroeconomics which
effect inflation in the Pakistan in different scenarios like economic growth, financial sector
development, population (Kemal.A.M, 2006), devaluation of money, increase in money supply,
change in oil and wheat prices (Bokhari.H.S and Feridun.M, 2006), monetary expansion, fiscal
imbalances (Agha.I.A and Khan.S.M, 2006), uncertainty (Sill 1999) and political instability
(Khan.U.S and Saqib.F.O, 2009). But besides these variables there is another variable which also
deeply effect inflation and not much studied by the researchers in Pakistan but studied in other
countries like Turkey, Greece (Metin.K, 1998). And the variable is Deficit budgeting it occurs
when the Govt revenues are less than its expenditure. This is the deficiencies of the past
researchers and in this study I would try to over come these deficiencies by examines that
whether budget deficit effect inflation in Pakistan.
The importance of this study for an audience will be to contribute knowledge and explore how
we could control the inflation rate at their lower level by minimizing or controlling the budget
deficit in the country and discuss all the issues and problems that would raised by the changes
of inflation rate.

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The purpose of this study would be to explore the effect and responsiveness of budget deficit
toward inflation in Pakistan and what would be the monetary and fiscal policies the
government, monetarist and economist used to control the inflation of the country.

. Objective of the Study:


This study will be of value in number of ways:

 Most of all the study is vital in determine relationship among the budget deficit
and inflation in Pakistan and dimensions that can help to reveal the underlying
logic of economics activities and can help the economists and central bankers in
evaluating strategies about budget deficit.

 Many studies have conducted to check the relationship between budget deficit
and inflation in developed and developing countries. This study tests that budget
deficit effect inflation in developing country’s economy like Pakistan.
Therefore, the present study assumes that the findings of the present study will
help the economists of Pakistan in particular and those in developing countries
in general to answer the long standing question of how to control inflation.

 From practical perspective the studies draw economists, and policy maker
attention, that they should adopt such fiscal and monetary policy which improve
the inflation rate and control the budget deficit.

 For an academic perspective this study is expected to yield additional insight


into said research particular in non-western developing countries (Pakistan) with
duality of values that is traditional societal values and work related values.

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Research Question and hypothesis:
The present study will explain the impact of budget deficit on inflation in Pakistan
economy. With the following research questions to be addressed;

4.1 (MAIN QUESTION)

What are the impacts of budget deficit on inflation in Pakistan economy?

4.2 (SUB-QUESTIONS)

Further sub-questions are:

 Does depreciation of exchange rate increases the budget deficit in Pakistan?

 Does Govt borrowing increases the money supply in Pakistan?

 Does budget deficit effect inflation through depreciation exchange rate and Govt
borrowing?

4.3 (Main Hypothesis)

HA: Budget deficit are positively related with inflation.

4.4 (Sub-Hypothesis)

HA – 1: Depreciation of exchange rate has positive relationship with

budget deficit

HA – 2: Budget deficit has positive relationship with Govt borrowings

HA – 3: Budget deficit has positive effect on inflation through depreciation of


exchange rate and Govt borrowing.

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LITERATURE REVIEW:

Inflation adversely affects the overall growth, the financial sector development and the
weak segment of the population it is clear that Inflation is always damage real growth of the
economy due to which poor segment become poorer and rich segment become richer. Number of
theories including the demand-pull, the cost-push inflation, and the quantity theory of money
explaining the causes of inflation. The possible sources of inflation include rising costs such as
wages, profits, imported inflation—exchange rate, commodity prices, external shocks,
exhaustion of natural resources and taxes.(Qayyum, 2006). Inflation creates uncertainty and
decrease real income or real growth of the economy. (Cecchetti, 2000). Due to such adverse
impacts of inflation on the economy all the other countries are agrees that the price stability is the
major objective of monetary policy. [King, (1999); Blejer, etal. (2000)]. Quantity theory identify
that the money supply is the key factor that effect the changes in price level as changes in income
arise due to the changes in prices and output is remain stable therefore, the price level is
determined by the money supply via the operation of real income effect (Allsopp and Vines,
2000). If growth in the velocity is relatively constant then it indicates that inflation and growth in
nominal quantity of money supply relative to real income are proportional. Otherwise there is no
considerable relationship between the inflation and the growth in nominal quantity of supply
relative to real income (Dwyer and Hafer, 1999).

Inflation and Budget deficit


The previous study the researcher checked the empirical relationship between inflation
and the budget deficit for the Turkish economy by using multivariate Cointegration analysis and
he concluded that budget deficit (as well as income growth and debt monetization) significantly
affect inflation in Turkey. (Metin.K, 1998). (Choudhary and Parai 1990) found that budget

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deficits, as well as the growth rate of money supply, have significant impacts on inflation.
Similarly, (Dogas 1992) found that the public deficit affects inflation in Greece. (Hondroyiannis
and Papapetrou 1994) also found a relationship between the Greek government budget and price
level. Using an error-correction model, Sowa (1994) found that inflation in Ghana is influenced
more by output volatility than by monetary factors, both in the long run and in the short run.
Solomon.M and W A de Wet, (2004) examine that Tanzanian economy has experienced a
relatively high inflation rate, accompanied by high budget deficits for a long period in the
absence of any hyperinflation. Tanzanian economy establishes the causal link that runs from the
budget deficit to the inflation rate and with the existence of a stable long run relationship
between the budget deficit, exchange rate, GDP and inflation he found a significant impact of the
budget deficit on inflation in Tanzania. According to the monetarist view, budget deficits can
lead to inflation, but only to the extent that they are monetized (Hamburger and Zwick, 1981).

Inflation, Budget deficit and Govt Borrowings


Sachs and Larrain (1993) concluded that borrowing today to reduce budget deficit might
postpone inflation, but at the risk of even higher inflation in the future. Sargent and Wallace
(1981) observe that when the fiscal authority sets the budget deficit independently, the monetary
authority can only control the timing of inflation. Haan and Zelhorst, (1990) analyzed the
relationship between government budget deficit and money growth in the developing countries
and he conclude that government budget deficit did not much influence monetary expansion and
create inflation. Chaudhary and Parai (1991), concluded that the country's huge budget deficit as
well as high rates of growth of money did have a significant impact on the inflation rate. Like
other countries inflation is called a monetary expansion in Pakistan and it is generally associated
that the fiscal imbalance plays a vital role in the price fluctuation and money expansion. In
Pakistan, the rate of inflation is very high at different time periods, main causes behind high rate
of inflation could be large monetary expansion, fiscal imbalances, sources of financing deficits,
economic growth.

Inflation, Budge deficit and Exchange rate depreciation


Exchange rate depreciation and it is suggested that a positive relationship between
deficits and inflation can be found even outside a system in which fiscal policy is dominant.
(Agha.I.A and Khan.S.M, 2006). Researcher finds that an increase in money supply over the
long-run leads to higher rate of inflation and provides support for the quantity theory of money

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and it also establish that inflation is essentially a monetary phenomenon while he concluded that
the impact of money on inflation in the short-run is not instant however it affects inflation with
lags of about 3 quarters and system does not converge to equilibrium for long period.
(Kemal.A.M, 2006). Similarly it is 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. (Khan and
Schimmelpfennig, 2006). Previous researcher discuss that permanent increase in money growth
leads to equal increase in inflation and does not affect the output and velocity in the long run
while in short run money supply might have a positive impact on output growth. (Grauwe and
Polan, 2005). Some other researchers show that the monetary tightening leads first to a fall in
domestic demand, taking loan from bank to meet this fall in demand, which translates into a
gradual reduction in price pressures that eventually reduces the overall price level which means
inflation does not respond to money supply spontaneously in short-run (Ahmad, et al. ,2005).
Pakistan has a great deal of political instability ranging from dismissals, assassinations, coups, or
cabinet changes. This greatly undermines the proficiency of a government and diminishes its
elasticity to contain shocks that eventually results in macroeconomic disequilibrium such as
inflation. To show the link between political instability and inflation, researchers take the time
series data from1951 to 2009 and uses two different models FTPL (Fiscal Theory of Price Level)
and the PEMP (Political Economy of Macroeconomic Policy). The monetary model suggest that
the effects of monetary determinants are rather marginal and that they depend upon the political
environment of Pakistan while The Fiscal model establish a positive association between
measures of political instability and inflation. Because of the obvious association of polity with
higher number of Government crises and cabinet changes, the democratic regimes are positively
associated with inflation in Pakistan. (Khan.U.S and Saqib.F.O, 2009). Political instability is due to
the disagreement over the composition of public expenses hat gives rise to very high budget
deficits {Alesina and Tabellini, 1990) ,.Previous researches support this argument that economies
with political instability and weak governmental institutions do not have efficient tax system that
increases their trust on seigniorage. Therefore, to meet the demand for public expenses they end
up printing extreme money that eventually leads to inflation (Cukierman et al, 1992 and Aisen &
Veiga, 2006).
From the whole above discussion, it is concluded that inflation can play an important role in the
downfall of a developed and developing countries. It adversely affects the overall growth, the
financial sector development and the weak segment of the population, damage the real growth of

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the economy due to which poor segment become poorer and rich segment become richer. As
developing countries has very high rate of inflation at different time periods which main causes
could be large monetary expansion, fiscal imbalances, sources of financing deficits, economic
growth and exchange rate depreciation and political instability due to the disagreement over the
composition of public expenses that gives rise to very high budget deficits and to meet the
demand for public expenses they end up printing extreme money that eventually leads to
inflation.

Data sources:
Secondary data sources is used for collection data the inflation rate and budget deficit
rate is obtained from Federal Bureau Statistic of Pakistan and annual economics surveys
by the government of Pakistan and the publication of SBP.

Data:
years INF bd
9.0621
1980 18 -5.7
9.9135
1981 33 -5.0
9.3716
1982 55 -4.9
5.2740
1983 82 -6.4
9.6535
1984 49 -5.5
4.5349
1985 45 -6.9
3.2920
1986 05 -7.2
4.5181
1987 99 -7.0
9.6175
1988 61 -7.8
8.5850
1989 54 -6.7
6.4519
1990 98 -6.1
13.061
1991 4 -7.9
10.057
1992 08 -7.2
1993 8.6964 -6.8

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74
12.889
1994 33 -5.0
13.874
1995 64 -4.9
8.3736
1996 1 -5.9
13.383
1997 51 -5.3
7.5260
1998 37 -6.3
5.8622
1999 86 -5.1
23.824
2000 58 -5.4
7.7293
2001 08 -4.3
2.4448
2002 82 -4.3
4.3993
2003 83 -3.6
7.8328
2004 7 -2.4
9.7974
2005 03 -3.3

Model

Govt: Borrowings

BUDGET 9
DEFICIT INFLATION

Depreciation of exchange rate


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Theoretical Framework:
Higher deficit lead to higher inflation through govt’s
borrowing, when there is high budget deficit in the country then the government’s borrowing
obligation will increase the net credit demands in the economy which drive up the interest rates
and crowd out private investment. The resulting cutback in the growth rate of the economy will
lead to a decrease in the amount of goods accessible for a given level of cash balances and hence
the increase in the price level.(O. Cevdet Akcay.C.O and Alper.E.C, 1996)
Higher deficit lead to higher inflation through depreciation of exchange rate, when there is high
budget deficit in the country then the government’s borrowing obligation will increase and when
devaluation of money makes our currency cheap in terms of foreign currency. It will also makes
all those good cheap whose prices are in terms of rupees and makes all those good’s prices are
high which deals in term of dollar or foreign currency. As a result export price fall and imports
price rise. To payback the loan central bank printed money in excess amount due to the
deprecation of the exchange rate which create excess money supply and high prices which finally
lead to inflation (Solomon’s and W A de Wet, 2004).
As some studies have been done on this relationship budget deficit and inflation in other
countries but not much studies have been done in Pakistan so in this study we would use the
positivism research paradigm and used deductive method to test the theory and experiment that
Whether budget deficit effect inflation in Pakistan.

Methodology:
Paradigm:
In this study we would use the positivism research paradigm (Quantitative research
method approach) and used deductive method to test the theory that whether budget deficit effect
inflation in Pakistan.

Sampling Technique:
In this study we would use the Cluster Random Sampling Technique, because in
which we drive sample out of aggregations of populations (cluster) that will be access at the
same time i.e 20 years inflation rates (cluster) from Pakistan economy.

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Sample size:
Sample size is the selected sample for the study to be conducted. In this research I take
the data from 1985 to 2005. I will use the data of 20 years as we want to investigate the
Impact of budge deficit on inflation in Pakistan.

Population:
The population of this study will be the economy of Pakistan, because we check the
Impact of budge deficit on inflation in Pakistan.

Results:

Dependent Variable: C
Method: Least Squares
Date: 04/16/10 Time: 00:53
Sample: 1985 2005
Included observations: 21

Variable Coefficient Std. Error t-Statistic Prob.

INF 0.017498 0.005728 3.055117 0.0065


BD -0.133503 0.009572 -13.94737 0.0000

Mean dependent var 1.000000 S.D. dependent var 0.000000


S.E. of regression 0.131725 Akaike info criterion -1.125815
Sum squared resid 0.329676 Schwarz criterion -1.026336
Log likelihood 13.82105 Durbin-Watson stat 1.408072

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REFERENCES

Pakistan Economic Survey 2008-09


Ahmed, N., H. Shah, A. I. Agha, and Y. A. Mubarik (2005) “Transmission Mechanism of
Monetary Policy in Pakistan”. The State Bank of Pakistan. (Working Paper No. 9.)

Aisen, A. and F. Veiga (2006). “Does Higher Inflation Political Instability Lead to? A
Panel Data Analysis.” Journal of Money, Credit, and Banking, 38: 1379-1389.

Akcay.C.O and Alper.E.C, et, al (1996),” Budget Deficit, Money Supply and Inflation:
Evidence from Low and High Frequency Data for Turkey” Bogazici University

Department of Economics, P.K. 2, Bebek 80815 Istanbul.

Alesian, A. and G. Tabellini (1990). “Voting on the Budget Deficit.” American Economic
Review, 80: 37-49.

Allsopp, C., and D. Vines (2000). “The Assessment: Macroeconomic Policy”. Oxford
Review of Economic Policy 16:4, 1–32.

Asif Idrees Agha and Muhammad Saleem Khan (2006),” An Empirical Analysis of Fiscal
Imbalances and Inflation in Pakistan”, SBP Research Bulletin Volume 2, Number 2,
2006.
Anušić. Z “BUDGET DEFICIT AND INFLATION

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Cecchetti, S. G. (2000) Making Monetary Policy: Objectives and Rules. Oxford Review
of Economic Policy 16:4, 43–59.

Cukierman, A, S. Edwards, and G. Tabellini (1992). “Seigniorage and Political


Instability.” American Economic Review, 82: 537-555.

Dogas, D.(1992),”Market power in a Non monetarist Inflation Model for Greece”,


Appled Economics, 24,367-378.

Dwyer, G. P., and R. W. Hafer (1999) Are Money Growth and Inflation Still Related?
Federal Reserve Bank of Atlanta Economic Review Second October, 32–43.

Fischer, S. (1993). “The Role of Macroeconomic Factors in Growth.” Journal of


Monetary Economics, Vol.32: 485-512.

Friedman, M. (1963) Inflation: Causes and Consequences. New York: Asia Publishing
House.

Grauwe, P. D., and M. Polan (2005) Is Inflation Always and Everywhere a Monetary
Phenomenon? Scandinavian Journal of Economics 107:2, 239–59.

Kemal.A.M, (2006),” Is Inflation in Pakistan a Monetary Phenomenon?” , The Pakistan


Development Review 45 : 2 (Summer 2006) pp. 213–220

Khan, M. S., and A. Schimmelpfennig (2006) Inflation in Pakistan: Money or Wheat?


International Monetary Fund. (Working Paper 06/60.)

Khan, M.S. and S.A. Senhadji (2001). Threshold Effects in the Relationship between
Inflation and Growth. IMF Staff Papers, Vol. 48, No. 1.

Khan.U.S and Saqib.F.O (2009),” Political Instability and Inflation in Pakistan”,


Pakistan Institute of Development Economics.

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