Why the State Bank of Pakistan should not Adopt Inflation Targeting

This paper attempts to examine the determinants of inflation and output growth for Pakistan over the period of 1972–2004, using ARDL approach to cointegration. The results presented in this paper indicate that the growth rate of import prices is the most important determinant of inflation in Pakistan, both in the short run and long run, which is followed by growth rate of output. The effect of monetary policy on inflation is negligible and statistically insignificant at the conventional 5 percent level, both in the short and long run. Monetary policy has a very strong effect on output both in the short run and long run. The hypothesis that there exists a proportionate relationship between money growth and output growth rate cannot be rejected in the long run. Evidence presented in this paper suggests that Pakistan’s economy is operating at a very horizontal portion of the supply curve and the major cause of inflation is an increase in import prices, not in the mismanagement of monetary policies. Thus, monetary authorities in Pakistan should not switch to inflation targeting because any attempt to reduce inflation through monetary policies will push the economy into severe recession.