Correlation and Causality between Inflation and Selected Macroeconomic Variables: Empirical Evidence from Pakistan (1990-2012)

Abstract

Inflation is regarded as one of the most chronic problems in Pakistan and the recent surge of inflation (10.8) in consumer price index is a matter of serious concern in the economy [1]. Inflation imposes high cost on economies and societies; disproportionately hurts the poor and fixed income groups, creates uncertainty throughout the economy and undermines macroeconomic stability. It also results in inefficient resource allocation and hence reduces potential economic growth. High inflation has always penalized the poor. Lowering inflation therefore, directly benefits the low and fixed income groups. The present study focuses to examine the impact of various macroeconomic variables on inflation in Pakistan and to find their correlation and causal relationship with economic and econometric criterion by using time series data over the period of 1990 to 2012. To achieve this objective, regression analysis, correlation coefficient and granger causality test are used. Results from regression analysis indicate that money supply, government expenditure, government revenue, foreign direct investment and gross domestic product have positive impact on inflation in Pakistan, while interest rate shows negative impact. Correlation analysis confirms that there exists a positive association of inflation with money supply, government revenue, interest rate, foreign direct investment, gross domestic product, exchange rate and trade openness. The findings of the study also reveal that money supply as well as balance of trade granger causes inflation in the selected time period. I recommend that monetary and fiscal measures should be wisely coordinated in order to control the consistent increase in prices. The government should curtail expenditure and reduce money supply. Similarly, domestic production should be encouraged and trade deficit should be narrowed by increasing exports in the country.