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Role of Demand and Supply Shocks in Driving Inflation: A Case Study of Pakistan

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  • Khan, Mahmood ul Hassan
  • Hanif, Muhammad Nadim

Abstract

This study attempts to measure the relative significance of structural shocks in explaining inflation. We use monthly time series data on key macroeconomic variables of Pakistan from July 1992 to June 2011, and structural vector auto-regressions (SVAR) to understand the role of supply and demand shocks as key drivers of inflation. Long-run restrictions according to standard aggregate demand and aggregate supply framework are employed to identify structural shocks in the system. The results indicate that inflation follows a sluggish time path in response to supply shock as compared to demand shock of nominal nature. Specifically, around 75 percent of long-run impact of supply shock on inflation is realized over a period of one year horizon as compared with 90 percent for demand shock. In terms of relative significance, supply side disturbances explain 48 percent of variation in inflation over the estimation period. Within demand side, nominal shocks are relatively more important than the real demand shock. The share of real demand shock was around 10 percent, while the reaming 42 percent was attributed to nominal shock. These results suggest that in addition to monetary factors, supply side disturbances should be taken into account for better understanding of and ‘handle’ on inflation in Pakistan.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 48884.

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Date of creation: 31 Jul 2012
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Handle: RePEc:pra:mprapa:48884

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Keywords: Supply Shock; Demand Shock; SVAR; Long run restrictions; Inflation;

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References

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  1. M. Ali Kemal, 2006. "Is Inflation in Pakistan a Monetary Phenomenon?," The Pakistan Development Review, Pakistan Institute of Development Economics, Pakistan Institute of Development Economics, vol. 45(2), pages 213-220.
  2. Qayyum, Abdul & Khan, Sajawal & Khawaja, Idrees, 2005. "Interest Rate Pass-through in Pakistan: Evidence from Transfer Function Approach," MPRA Paper 2056, University Library of Munich, Germany, revised 2005.
  3. Mohsin S. Khan & Axel Schimmelpfennig, 2006. "Inflation in Pakistan," IMF Working Papers, International Monetary Fund 06/60, International Monetary Fund.
  4. Faiz Bilquees, 1988. "Inflation in Pakistan: Empirical Evidence on the Monetarist and Structuralist Hypotheses," The Pakistan Development Review, Pakistan Institute of Development Economics, Pakistan Institute of Development Economics, vol. 27(2), pages 109-129.
  5. Quah, Danny, 1995. "Misinterpreting the dynamic effects of aggregate demand and supply disturbances," Economics Letters, Elsevier, Elsevier, vol. 49(3), pages 247-250, September.
  6. Olivier Jean Blanchard & Danny Quah, 1988. "The Dynamic Effects of Aggregate Demand and Supply Disturbance," Working papers, Massachusetts Institute of Technology (MIT), Department of Economics 497, Massachusetts Institute of Technology (MIT), Department of Economics.
  7. Quah, Danny, 1992. "The Relative Importance of Permanent and Transitory Components: Identification and Some Theoretical Bounds," Econometrica, Econometric Society, Econometric Society, vol. 60(1), pages 107-18, January.
  8. Blanchard, Olivier Jean & Quah, Danny, 1993. "The Dynamic Effects of Aggregate Demand and Supply Disturbances: Reply," American Economic Review, American Economic Association, American Economic Association, vol. 83(3), pages 653-58, June.
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Cited by:
  1. Hanif, Muhammad Nadim, 2012. "A Note on Food Inflation in Pakistan," MPRA Paper 45009, University Library of Munich, Germany, revised 11 Mar 2013.

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