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

Abstract

Generally, inflation refers to a reduction in purchasing power per unit of money and is considered a consequence of negative trends in monetary activity. As a number of factors may lead to inflation in an economy, this study attempts to measure the relative significance of structural shocks in explaining infiation. Monthly time series data is used on key macroeconomic variables of Pakistan from July 1992 to June 2011, and structural vector auto-regressions (SVAR) to understand the role ofsupply and demand shocks as key drivers of infiation. 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 oflong-run impact ofsupply 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 ofreal 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 infiation in Pakistan.