Inflation in Pakistan: Monetary or Fiscal Phenomena — IPRI Policy Brief Pt. 1

About the Authors

Zafar Masud

Zafar Masud is an international banker and entrepreneur, currently serving as a Member of the Board of Governors at the Islamabad Policy Research Institute (IPRI). With extensive experience in senior roles at multinational banks in Pakistan and abroad, he has also contributed to the IMF’s Task Force on Framing SOE Law, established by the Ministry of Finance. Drawing on his deep expertise in banking and finance, Zafar regularly writes for local media on topics such as finance, economics, and energy. He is the author of two publications: “Out of the Box,” an eBook compiling his articles, and “PK8303 – The Plane Crash Survivors Account,” detailing his survival of a plane crash in May 2020.

Dr. Aneel Salman

Dr. Aneel Salman holds the OGDCL-IPRI Chair of Economic Security at the Islamabad Policy Research Institute (IPRI), where he is recognized as a leading international economist. His expertise spans Monetary Resilience, Macroeconomics, Behavioural Economics, Transnational Trade Dynamics, and Climate Change. Dr. Salman’s research has significantly influenced strategic planning and policy formulation in Pakistan. Additionally, he is a Master Trainer, sharing his knowledge with bureaucrats, law enforcement agencies, military personnel, diplomats, and other key stakeholders to promote informed economic decision-making and resilience.

Syed Sayem Ali

Syed Sayem Ali is an experienced economist with a deep understanding of Pakistan’s economic landscape. He has contributed significantly to discussions on economic policy, energy dependency, and fiscal challenges. Throughout his career, Sayem has held senior roles in various multinational financial institutions, bringing a wealth of knowledge and expertise to his work. He is also an active commentator on economic issues, regularly contributing to local media on topics such as finance, economics, and energy. His insights have been influential in shaping economic thought and policy in Pakistan. Additionally, Sayem is an academic who has taught at the Institute of Business Administration (IBA) Karachi, further enriching his contributions to economic thought and policy in the country.

Maryam Ayub

Maryam Ayub holds an M-Phil in Economics and Finance from PIDE. Her areas of expertise are Macroeconomics, Climate Finance and Development Economics.

Acknowledgement

The authors express their sincere gratitude to Dr. Khurrum Mughal, Economist and former State Banker, for their valuable comments and insights, which significantly enhanced the quality of this paper.

Executive Summary

Price stability has always been an important concern for policymakers. Post-COVID inflationary episodes, the Russia-Ukraine war, Supply chain disruptions, and increased commodity prices the issue resurfaced across all economies.

Monetary policy is considered to be responsible for controlling inflation across all economies. However, recent inflationary conditions came as a realisation for most economies that controlling inflation through monetary policy alone is insufficient and inflation is not always a monetary phenomenon.

The fiscal theory of price level suggests that for countries with high fiscal deficits and debt liabilities, inflation becomes more of a fiscal problem and can be addressed by having a mix of fiscal and monetary policy with fiscal policy guiding the monetary policy. Also, expectations of future inflation and policy rates are important for effectively setting the policy rate.

To effectively accommodate the expectations in the inflation-targeting process, the State Bank of Pakistan (SBP) needs transparency and autonomy. Monetary policy transparency may be improved by publishing the minutes of the Monetary Policy Committee (MPC). By introducing reforms in the taxation and energy sector, restructuring State-Owned Enterprises (SOEs), and improving the investment climate of the country, the government can effectively improve the fiscal conditions of the country.

Policy Recommendations

• Design a fiscal policy that takes charge of controlling inflation with support of monetary policy in such a way that the living conditions of the general public are not worse off.
• Introduce tax reforms by incorporating well-performing sectors into the tax net and focusing on welfare taxation.
• Restructuring of State-owned enterprises and reforms in the energy sector to reduce circular debt. Investment in human capital, infrastructure development, increased expenditure in education and health sector.
• Work on improving the investment climate of the country by facilitating the investors and simplifying the process of industry setup to attract investors.
• PBS can update the consumer basket every 5 years like the practice adopted by most of the countries. Relevant consumer items can be added and irrelevant can be excluded.
• Also, PBS may update the number of selected urban and rural sectors for data collection for a more representative CPI.
• By regularly updating the CPI basket, the government may better understand consumer behaviour. This will help the government to make better policies to address the challenges faced by consumers.
• SBP may set the policy rate in line with the market expectations of consumers and businesses. Inflation targeting can be done in the best way possible by incorporating the future expectations of policy rates and inflation.
• To incorporate the consumers and business expectations the SBP may use the New Keynesian Philips curve instead of relying on the Taylor-type rules.
• For effectively targeting inflation and incorporating inflation expectations, the SBP needs to have a due autonomous status for transparency in policy policy-setting process. For effectively targeting inflation and incorporating inflation expectations, the SBP needs to have a due autonomous status for transparency in the policy-setting process. To improve the communication and transparency of monetary policy, SBP may publish the minutes of MPC timely with a detailed discussion of the voting preferences of individual members.
• SBP may reassess the constitution of the Monetary Policy Committee (MPC) as the policy decision rests completely at the discretion of the governor.
• PBS may construct a PCE price index for Pakistan as a measure of inflation that serves as a better measure of inflation

Introduction

Inflation is generally defined as the rate at which prices rise over time. It is broadly measured as an overall price increase or a consumer’s cost of living. ¹

Therefore, Price stability is essential for every economy. It is often believed that slow and stable inflation promotes economic growth in a way that it promotes savings, and investment and directs the economy towards economic progress.

Globally, macroeconomic policies prioritise long-term economic development and price stability as primary objectives. Monetarist Economists like Milton Friedman believed that inflation is solely a monetary phenomenon and is only caused by the increase in money supply. ²

Non-monetary theorists relate rising prices to factors including the cost-push effects, fiscal policies, and changes in private expenditures.³

However, an increased supply of money is considered to be the cause of inflation globally. Therefore, to support sustainable economic growth, price stability is the primary objective of almost all the central banks around the world.

Money supply and interest rates in the economy are controlled by the use of different instruments of monetary policy to maintain stability in overall price levels and financial markets. The State Bank of Pakistan (SBP) Act 1956, outlines the objectives of monetary policy as follows:

1. maintaining domestic price stability by regulating Pakistan’s monetary and credit system,
2. contributing to the stabilisation of the financial system, and
3. assisting the economic policies of the government to promote development and fuller utilisation of country’s resources.⁴

Up Next: Is CPI Truly Reflecting the Economic Reality of Pakistan? — IPRI Policy Brief Pt 2

Inflation in Pakistan: Monetary or Fiscal Phenomena

IPRI — Islamabad Policy Research Institute

Policy Brief by

• Zafar Masud
• Dr. Aneel Salman
• Syed Sayam Ali
• Maryam Ayub

August 2024

OGDCL – IPRI Chair Economic Security

1. Ceyda Oner, “Inflation: Prices on the Rise” https://www.imf.org/en/Publications/fandd/issues/Series/Backto-Basics/Inflation accessed on 12 June 202 ↩︎
2. Humphrey, Thomas M. “A monetarist model of the inflationary process.” Economic Review 61 (1975): 13-23, accessed on 12 June 2024 ↩︎
3. Humphrey, Thomas M. “A monetarist model of the inflationary process.” Economic Review 61 (1975): 13-23, accessed on 12 June 2024 ↩︎
4. “Monetary Policy Objectives”, State bank of Pakistan. https://www.sbp.org.pk/m_policy/mpf-01.asp
   accessed on 13 June 2024 ↩︎