Empirical Study of Relationship between Budget Deficits and Inflation: A Case Study of Pakistan

Abstract

The purpose of this study is to determine the empirical relationship between budget deficits and inflation based on CPI, and to find empirical evidence of sources of inflation in Pakistan, considering data from 1973 to 2006. The main source of data has been the State Bank of Pakistan and the Federal Bureau of Statistics. Univariate analysis along with simple statistical analysis is utilized to determine the time series properties of each variable. Ordinary Least Square (OLS) method is used to analyze the relationship between the variables of Interest. Co-integration and Error Correction Mechanism (ECM) are used to determine the long run and short run relationships respectively. The results of this study indicate that there is a long run relationship between inflation and Budget Deficit to GDP Ratio (BDGR). Further sources of inflation in Pakistan have been budget deficits, GDP growth, and international inflation, reserve Money and weighted average lending rates. The implications are that tight monetary policy can serve as an effective anti-inflationary measure but a restrictive fiscal policy (reduction in government expenditures) can also help to minimize inflation in Pakistan.