Interest rate is the most popular instrument of monetary policy to control inflation around the globe. It is assumed that the tight monetary policy, such as an increase in interest rate, will reduce inflation by reducing aggregate demand in the economy. However, in reality, the use of monetary tightening could be counterproductive. The monetary tightening may increase inflation dates back to 1923 when Gibson (1923) observed that correlation between interest rate and inflation is positive.

There are different opinions about how the interest rate affects inflation. The most famous is called Monetary Transmission Mechanism (MTM). According to the demand side channel of MTM, increase an interest rate, therefore the aggregate demand will decrease and finally, the price level will decrease. However, the supply side channel of MTM, states that the rise of interest rate will increase the cost of production, shifting up the aggregate supply curve. This will create a rise in the general prices level.

The problem in that, there are many channels of MTM which can be categorized into demand side and supply side. Many researchers take one channel and make single equation, this leads to missing variable bias. Therefore there is need to take them simultaneously which can be done by (SEM) Structural equation modeling. This research study is very significant, because this research combines both demand and supply channel simultaneously, and removes biasedness through (SEM) structural equation modeling.

The Augmented Dickey-Fuller (ADF) test finds that all the variables are stationary at first difference i.e. I (1), except inflation and investment. Firstly, unrestricted structural equation model (USEM) has estimated. The mostly coefficient of USEM has found to insignificant i.e. their probability value more than 50 percent. To remove the insignificant coefficient, we are given these unnecessary coefficients the regression weight is zero for the purpose of getting significant results. Secondly, the restricted structural equation model (RSEM) is estimated. The estimated results reveal that; interest rate has a positive relation with exchange rate and industrial inputs prices, while negative relation with the price of equity and investment. Therefore, the exchange rate, price of imports, price of exports and consumption have a positive relation with inflation while investment, loan, and output have a negative relationship with inflation.

Finally, the interest rate is not a significant determinant of inflation. Therefore, the exchange rate and cost channel are responsible for the transmission mechanism of interest rate to inflation in Pakistan. This study can be extended in several ways. First, this study focus on how monetary policy effect inflation, further includes in this study fiscal policy. Lastly, a regional analysis can serve as the best extension of this research. Our work was focused on Pakistan only, however a regional comparison can be appropriate.

Keywords: monetary policy, output, interest rate, MTM, inflation, cost channel, demand channel, structural equation modeling

For citation: Uddin, I. (2020). What determine inflation in Pakistan: an investigation through structural equation modeling by using time series data for a period from 1975 to 2017. Economic consultant, 32 (4), 54-72. doi: 10.46224/ecoc.2020.4.6

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Information about the author: 

Ijaz Uddin (Pakistan, Matta Swat) – Student, MPhil or MS Econometrics. Pakistan Institute of Devolvement Economics (Islamabad, Pakistan). E-mail: ijazuddin01@gmail.com

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