An Exploratory Analysis of Inflation Episodes in Pakistan by Riaz Riazuddin Economic Adviser State Bank of Pakistan

1. An Exploratory Analysis of Inflation Episodes in Pakistanby Riaz RiazuddinEconomic AdviserState Bank of Pakistan The Fourth Annual Conference on Management of the Pakistan Economy Lahore School of Economics 24-25 April, 2008

2. Roadmap Findings of Exploratory Analysis FY58-FY07 Approach followed Interactions between Money and Inflation Interactions between Money and Food Inflation Interactions between Inflation and Real GDP Growth Policy Implications What happens when policy prescriptions are not followed (Examples from “The History of Inflation in Turkey”)

3. 1. Findings of Exploratory Analysis FY58-FY07 Old wine in old bottle Inflation is primarily a monetary phenomena Quantity theory of money works in Pakistan at money growths of at least 9% per annum. Quantity theory of money does not seem to work at money growth rates of less than 9%. Food inflation is also a monetary phenomena Inflation is independent of growth.

4. 2. Approach Followed Old wine in new bottle Use of sturdy application of statistics in bio-medical science to dismal science of economics Does an allopathic medicine really work to remove a sickness? In order to answer above question, explore a four-fold table (contingency table) and apply an appropriate statistical test

5. 2. Approach Followed (cont’d) In order to prove that real medicine is significantly superior to placebo, pharmacists have to reject the following hypothesis: Ho : Probability of sickness when placebo is given is higher than Probability of sickness when real medicine is applied.

6. 2. Approach Followed (cont’d) In above table, pharmacists have to show that 0.750 is greater than 0.269, not as a result of coincidence, but due to use of scientific medicine. Statisticians use either Chi-square test (when cell values are (large), or Fisher’s Exact Test (when cell values are very low) before deciding the case in favour or against a medicine. In above example superiority of placebo (over real medicine) gets rejected for removing a sickness. This means that real medicine is effective in curing the sickness.

7. 3. Interactions between Money and Inflation Above table is exactly what I show in page 2 of my paper. Result of Test: Reject: High money growth is effective in containing inflation to low levels. Accept: Low money growth is effective in containing inflation to low level.

8. 3. Interactions between Money and Inflation (cont’d) Since our lables are arbitrary, as opposed to precise definitions of ‘Sickness’, ‘Healthy’, ‘Placebo’ and ‘Real Medicine’ in medical sciences, therefore we need to be careful and find a way to remove arbitrariness from our approach. So let us do this for all possible (if not all, for a large number of) interactions of money growth (high-low) and inflation (high-low) next year. 105 interactions have been ‘chosen’ by taking M2 growth cut-offs (4,5,6,……, 18; i.e 15 values) and inflation cut-offs (4,5,6,……,10; i.e 7 values); this gives 15x7 = 105 interactions.

9. 3. Interactions between Money and Inflation (cont’d) Table 5 of my paper shows that medicine of low money growth works very effectively at money growth rates of higher than 9% and lower than 12%. Placebo i.e., high money growth was found to work as effectively as the real medicine when money growth rates are lower than 9%! Simple monetary rule of keeping money growth lower than 12% is derived by inspection of 105x4 = 420 probabilities shown in Figure 3 and Table 4 of my paper

10. 4. Interactions between Money and Food Inflation FY58-FY07 Same approach also found money growth to be associated with food inflation of next year. Simple monetary rule for keeping food inflation at low levels is to keep money growths further lower by one percentage point, required for keeping inflation at low levels. Tests were not carried out because of the obvious similarity of results with earlier interactions, but these can be performed very easily.

11. 5. Interactions between Real GDP Growth and Inflation FY58-FY07 Same exploration gave 9x7 = 63 interactions of Real GDP Growth (1,2, …., 9%; 9 cut-off values) and inflation (4,5, ……., 10%; 7 cut-off values). Result is very surprising, but in full conformity with common sense, as well as economic theory. The result is that inflation and real GDP growth are independent factors.

12. 6. Policy Implication Hence, inflation should be attacked by policies fully independently from government’s policies of pursuing economic growth.

13. 7. What happens when monetary policy is not independent of growth policies? (Examples from “The History of Inflation in Turkey”) The reflection of a salary earner on various days of the month… Two glasses of water are worth one slice of bread! Eat and drink, don’t worry… You can save by eating less! Cemal Nadir Caricature Album, Aksam Publishing house 1933, p. 51.

14. 7. What happens when monetary policy is not independent of growth policies? Inflation hits everyone… Inflation: 18.9% 22.5% 6 2.0% 101.4% (1980) Cumhuriyet, 18.02.1980

15. Thanks