Pakistan has been through many phases of inflation and a tremendous amount of research is conducted. The research gap identified was the effect on inflation in Pakistan by plunging crude oil prices. This article focuses on the impact of plunging oil prices on Pakistan’s economy from October 2011 to February 2016 in addition to other determinants of inflation in Pakistan. Pakistan is not an oil-producing but rather an oil-importing country. A major decrease in the oil price should lead to low inflation. The findings showed that the crude oil prices have no effect on the producer price index of Pakistan whereas; the global economy has seen a decrease in global inflation.
Since the 1970s movement in oil prices has created difficulties for policymakers and business leaders. In particular, price swings in the last 10 years or so have been quite dramatic. International oil prices fluctuated around US$ 20 per barrel in the 1990s before rising. Especially since 2004-2005, oil prices experienced a sharp upward trend to reach an all-time high of close to US$ 150 per barrel at one point in mid-2007-20081, later decreasing to US$ 30 per barrel by the end of 2007-2008. After that decline, oil prices swelled again (with minor plunges in between) and averaged around US$ 104 per barrel in 2012-2013. Yet in the last quarter of 2014, there has been a deep fall in the price of oil close to US$ 57 per barrel, which even dropped to US$ 47 per barrel at the beginning of 2015.
Generally, there is a consensus among macroeconomists that oil price shock reduces economic activity and increases inflation simultaneously (Malik, 2010). As remarked by Lescaroux and Mignon (2008) various transmission channels exist through which oil prices may influence economic activity and inflation. For instance, an increase in the price of crude oil is passed on to the price of petroleum products and, from the consumer perspective (households, industry, and government) the energy bill grows, while from the production perspective, companies have to deal with an increase in unit costs. In other words, crude oil prices have a direct effect on the prices of energy-related items, such as household fuels, motor fuels, and electricity. Likewise, an increase in oil prices instigates a productivity decline which is passed on to real wages and employment, core inflation, profits, and investment, as well as stock market capitalization. Moreover, the transmission of energy prices is influenced by the real adjustments in the economy in the short and medium to long run, as well as structural determinants of the pass-through to consumer prices. The combination of these factors and the policy response of central banks eventually explain the transmission of energy price fluctuations to overall inflation.
A considerable amount of research has indicated that the oil price shocks have affected the real output; only a few emphasize the effects of inflation in a country. In the global scenario, the effects of oil prices on inflation appeared to decline over time. By realizing the research gap in the scenario of plunging crude oil prices and their effect on inflation in Pakistan, this paper tends to investigate this phenomenon for the specific case of Pakistan. For example, (De Gregorio, Landerretche, & Nielson 2007) found in a sample of 23 countries for 1980- 2005, that a 10 percent decrease in oil prices (in local currency) would lower inflation by around 0.2 percentage points. Oil price declines have been followed by temporary falls in global inflation. The decline in inflation has been quite pronounced in high-income countries, and the impact across countries has varied significantly, reflecting, in particular, the importance of crude oil prices in consumer baskets, exchange rate developments, the stance of monetary policy, the extent of fuel subsidies and other price regulations.
In general, the pass-through from oil prices to inflation appears to have declined over time (De Gregorio, Landerretche & Nielson 2007; Blanchard and Gali 2007) owing in part to the reduced oil dependence of production and consumption and better anchoring of inflation expectations. This has significantly reduced the second-round effects of oil price fluctuations on core inflation. The dynamics of the propagation of commodity price shocks across a sample of 46 countries studied in (Pedersen, 2011) also confirmed a limited impact of oil price changes on core inflation, contrasting with the more lasting effect of food price shocks, particularly in emerging and developing economies. In order to gauge the likely impact of changes in crude oil prices on inflation, two simple econometric models are estimated by (Baffes, Kose, Ohnsorge & Stocker, 2015) using data for G20 countries.
The change in the price of oil was added to a standard Phillips curve model, in which inflation is a function of inflation expectations and economic loose. Second, a simple vector autoregression (VAR) model is estimated to study the dynamic interactions between headline consumer prices, producer prices, output gap, exchange rate, and the price of oil. All regressions are country-specific and estimated at a monthly frequency over the period 2001-14. Research indicated that the pass-through to headline inflation in most cases is modest, with a 10 % decline in the oil price reducing inflation by up to 0.3 percentage points at its peak impact. This is in line with other estimates in the literature. For example, (De Gregorio et al., 2007) found, in a sample of 23 countries for 1980-2005, that a 10 percent decrease in oil prices (in local currency) would lower inflation by around 0.2 percentage points. To be more appropriate country-specific circumstances could in some cases influence the impact of oil prices on domestic inflation. For example, for economies that import large volumes of oil, currency appreciation (depreciation) would reinforce (mitigate) the deflationary impact of the oil price decline.
In countries where the government subsidizes household energy consumption, the passthrough of global oil prices to local energy prices may be dampened. (Jongwanich and Park, 2009) results indicated that, among high-income countries, the estimated impact of oil price developments on consumer price inflation is more marked in the United States than in the Euro Area or Japan, and among developing countries, more significant in India, Indonesia, and Turkey than in China or Brazil, owing in part to different mixes of energy consumption, price regulations, and exchange rate patterns. The impact of oil price movements on global inflation was estimated by (Baffes et al., 2015) to be essentially a one-off, peaking after three to five months, before fading gradually. In particular, a 45 % decline in oil prices, if sustained, would reduce global inflation by about 0.7-1.2 percentage points through 2015. Global researchers have examined a big chunk of data and their findings are reliable to be more relevant, if the research conducted in the same oil-importing countries had found the relation between crude oil prices and inflation like in India, then this phenomenon should also be present in Pakistan. Countries like Pakistan, which are importing oil from the international market, will be more convincing.
As, (Bhattacharya and Bhattacharya, 2001) attempted to study the transmission mechanism of an increase in petroleum prices on the prices of other commodities and output a case study for India. The empirical result of the paper showed a bidirectional causality between oil and non-oil inflation in India. The most recent and relevant research was done in the neighboring country of Pakistan i.e. India. The Indications in the research empirically estimated the decline of crude oil prices and the position of India’s oil industry and especially the crude oil prices’ effect on India’s inflation. In India, they have two popular measures of inflation: CPI (consumer price index) WPI (wholesale price index). The CPI measures prices at the retail consumer level
Impact on Global Economy
The latest World Economic Outlook projections were based on an assumed path of oil prices that is about $5/barrel lower in 2001 and 2002 than suggested by futures markets during October and November 2000. Higher oil prices affect the global economy through a variety of channels:
- There will be a transfer of income from oil consumers to oil producers. As the propensity to spend of those who lose income (energy consumers) is generally larger than the propensity to spend of those who gain income (energy producers), there will be some fall in demand. On an international level, the transfer is from oil importing countries to oil exporters, and oil exporters tend to expand demand only gradually (in the past, they have spent about 1/3 of their additional revenues after one year, rising to 75 percent after 3 years).11 In addition, a reduction in demand can also occur within producing countries that allow higher oil prices to feed through to consumers, as energy producers tend to have a lower propensity to consume than energy consumers.
- There will be a rise in the cost of production of goods and services in the economy, given the increase in the relative price of energy inputs, putting pressure on profit margins. As the oil intensity of production in advanced countries has fallen over the past three decades, the supply side impact for a given increase in oil prices can be expected to be less than in past episodes. In developing countries, however, where the oil intensity of production has declined less, the impact may be closer to that in the earlier period.
- There will be an impact on the price level and on inflation. Its magnitude will depend on the degree of monetary tightening and the extent to which consumers seek to offset the decline in their real incomes through higher wage increases, and producers seek to restore profit margins. These responses can create a wage/price spiral, as was the case, for example, during the oil shocks in the 1970s-see Annex.
- There will be both direct and indirect impacts on financial markets. Actual as well as anticipated changes in economic activity, corporate earnings, inflation, and monetary policy following the oil price increases will affect equity and bond valuations, and currency exchange rates.
- Finally, depending on the expected duration of price increases, the change in relative prices creates incentives for suppliers of energy to increase production (to the extent that there is scope for doing so) and investment, and for oil consumers to economize.
Impact on Developing and Transitional Economies
- Table 1. Emerging Markets-Estimated Effects After 1 Year of a $5 Oil Price Hike
| Real GDP | Inflation | Current Account | |||||
| First Round | External Effect (percent)1 | Total | First Round | External Effect (percent of GDP)1 | Total | ||
| Latin America | -0.0 | -0.1 | -0.1 | 0.6 | 0.1 | -0.1 | 0.0 |
| Argentina | -0.1 | -0.1 | -0.2 | 0.1 | 0.2 | -0.1 | 0.1 |
| Brazil | -0.1 | -0.1 | -0.2 | 1.0 | -0.1 | -0.1 | -0.2 |
| Chile | -0.1 | -0.2 | -0.2 | 1.0 | -0.4 | -0.3 | -0.7 |
| Mexico | 0.1 | -0.1 | 0.0 | 0.1 | 0.3 | -0.1 | 0.2 |
| Asia | -0.2 | -0.2 | -0.4 | 0.7 | -0.3 | -0.2 | -0.5 |
| China | -0.2 | -0.2 | -0.4 | 0.4 | -0.2 | -0.1 | -0.3 |
| India | -0.4 | -0.1 | -0.5 | 1.3 | -0.5 | -0.1 | -0.6 |
| Indonesia | 0.5 | -0.4 | 0.1 | 1.0 | 1.0 | -0.4 | 0.6 |
| Korea | -0.4 | -0.5 | -0.9 | 0.8 | -0.8 | -0.2 | -1.0 |
| Malaysia | 0.2 | -0.4 | -0.2 | 1.0 | 0.5 | -0.5 | 0.0 |
| Philippines | -0.5 | -0.3 | -0.8 | 0.8 | -0.7 | -0.3 | -1.0 |
| Thailand | -0.4 | -0.5 | -0.9 | 0.4 | -1.0 | -0.5 | -1.5 |
| Emerging Europe and Africa | 0.4 | -0.2 | 0.1 | 0.3 | 0.6 | -0.3 | 0.2 |
| Pakistan | -0.4 | -0.1 | -0.5 | 0.4 | -0.8 | -0.2 | -1.0 |
| Poland | -0.2 | -0.1 | -0.3 | 0.0 | -0.2 | -0.2 | -0.4 |
| Russia | 1.0 | -0.3 | 0.7 | 0.0 | 2.1 | -0.3 | 1.8 |
| South Africa | -0.2 | -0.2 | -0.4 | 1.2 | -0.6 | -0.3 | -0.9 |
| Turkey | — | -0.2 | -0.2 | — | — | -0.3 | -0.3 |
- Source: Staff estimates.
- 1The external shock is calculated by the Research Department and is the sum of two second-round effects on the current account: a decline in exports due to a fall in global demand of 0.3 percent (assuming an export elasticity of two), and an increase in short-term debt payments, owing to the increase of world interest rates of 80 basis points, except for Asia where it is a scaled version of a similar exercise computed by APD
- The first-round effects on the current account are, on the whole, similar to those for growth. For all countries, the external effects of the reduction in export demand and an increase in interest rates lead to a deterioration in the external accounts, although these effects tend to be much smaller than the first-round effects, particularly for oil importers. Among the oil-importing countries, the largest impact on GDP growth and the balance of payments is expected to be felt in India, Korea, Pakistan, Philippines, Thailand, and Turkey. Both Pakistan and Turkey were already expected to run sizable current account deficits, and given the oil price increase their current account deficits are expected to worsen by a further ½ percent of GDP.
- The oil price hike generally benefits the six oil exporters in the sample, and the external current account position universally improves substantially. The impact on activity, however, is more ambiguous. Domestic demand and output can fall even in oil exporting countries, as the propensity to consume of oil producers within each economy is lower than the propensity to consume of oil consumers and second-round effects due to lower demand for exports and higher U.S. interest rates also slow activity. Overall, growth is projected to rise in Russia and Indonesia but fall in Argentina, China, Mexico, and Malaysia
Method and Methodology
In the current study to investigate the impact of oil prices and exchange rate on inflation, we have applied the Co-integration technique. First of all, the non-stationarity features of the individual
variables have been checked informally using a graphical representation and the correlograms of the Autocorrelation function and partial autocorrelation function and Ljung & Box test proposed by Ljung & Box (1978). Formally, the stationarity of the selected series was assessed by applying the Augmented Dickey-Fuller(ADF) unit root test proposed by Dickey and Fuller (1981) and Phillips –Perron(PP) unit root test by Phillips and Perron (1988). Both tests have been applied with No intercept, with intercept, and with trend and intercept. In case of the existence of unit roots the same order, then run the regression equation of the form:
Where we assign variables to the following terms to derive an equation:
a = Monthly inflation rate in terms of CPI
b = Monthly Exchange Rate in Pakistani Rupees / US $
c = Prices of Pak Petroleum in Rupees/ Barrel
d = Error Term
The OLS method of estimation has been applied to estimate the parameters of the above equation and residuals of the fitted model will be obtained. The testing of the unit root of the residuals is carried out through ADF and PP unit root tests. The stationarity of the residuals of the fitted model leads to conclude that there is Cointegration among the selected variable. Afterward, the significance of the variables is checked to explain the impact of exchange rates and oil prices on inflation.
Discoveries
Augmented Dickey-Fuller test showed the data of all the variables is non-stationary except the data of Effective Exchange Rate as the p-value is less than the alpha i.e. 0.05 or 5%. The Johansen cointegration test found that there is co-integration in the data by checking the p-value which is less than the alpha i.e. 0.05 or 5%. Findings showed that there is an inverse relationship between COP and PPI which means that, when COP will plummet by 0.525, PPI will rise by 1.000.
Result and Discussions
In this section, we present the data and the results based on the methodology discussed in the previous section. All the relevant tests and their findings show that there is a relationship between the independent (COP) and dependent (PPI) but the interesting fact was found that the relationship was inverse. As this research paper was keen to find which type of relationship exists between the plunging crude oil prices and inflation in Pakistan. As, the results showed that, there exists an inverse relationship between plunging crude oil prices and inflation which is quite amazing and thoughtful, all around the globe the relationship between Crude oil Prices and inflation is direct and inflation rises with the rise in crude oil prices and vice versa, then why does the relationship become inversed in the situation of Pakistan.
Conclusions and Policy Implications
For much of the period, since the October 2000 World Economic Outlook was completed, oil prices have averaged $5 per barrel higher than assumed in that exercise. A sustained oil price increase of that size would imply a permanent transfer of about ¼ percent of GDP from global oil importers to oil exporters, relative to the WEO baseline, with additional transfers of income from oil consumers to oil producers within countries. Such terms of trade shock would affect the global economy through supply and demand effects as well as via second-round effects on inflation, for example, through higher wage claims. This in turn would affect the extent to which central banks raise interest rates to offset inflationary pressures, and therefore the impact of the oil price increase on real activity. The impact on asset prices and financial markets would provide additional channels.
While it is still too early to make a final judgment, the latest data suggest that the impact on core inflation in advanced countries has been relatively modest to date and there is little sign of feeding through into wage claims. Although there has been a decline in consumer and business confidence, they so far remain relatively strong and although stock prices have fallen, the decline appears to be much more due to non-oil-related factors. On the other hand, however, there are signs that expenditure by oil-producing countries may be lower than the staff’s model suggests, which would tend to increase the adverse effects on global growth, and the impact of higher prices of other fuels-notably gas- also needs to be taken into account. Overall, were oil prices in 2001 to be $5/barrel higher than anticipated in the WEO baseline, the overall impact on global growth would likely be of the order of ¼ percent in terms of yearly average growth, with the effects concentrated in 2001. If oil prices were to fall back-as the most recent futures market data suggest-the $5/barrel shock would be temporary rather than permanent in nature, and the impact on activity therefore reduced.
In developing countries, the impact of a sustained $5/barrel oil price increase would vary widely across countries. It would be the largest in Asia, where there are relatively few oil producers. Given current account surpluses or small deficits in many of these countries, the balance of payments is not in most cases a concern, but there would be an unwelcome brake on activity in present circumstances. The impact would generally be smaller in Latin American countries, while many of the HIPC and several CIS economies would be quite seriously affected.
With regard to policy implications, as experience in previous oil shocks shows (see Annex), monetary policy in advanced countries will need to prevent second-round price effects. This will help ensure that there is only a price level effect, but not a continuing impact on the rate of inflation. This is likely to be helped at the current juncture by generally greater flexibility of labor markets in most advanced countries. The underlying fiscal stance should in general remain broadly unchanged, although automatic stabilizers can play a role in supporting activity. On the microeconomic side, any adjustment of taxes on gasoline and other petroleum products would need to be considered in terms of what is appropriate from the overall fiscal and macroeconomic situation. If the oil price increase appears to be temporary, there would appear to be little merit in adjusting taxes. However, if prices remain or are expected to remain, at a higher level and ad valorem taxes generate revenue increases greater than required for fiscal policy considerations, there is bound to be some rethinking of the best use of the revenue windfall. The appropriate strategy will depend upon the tax structure of the country concerned.
References
1.1. Michael Mussa
1.2. International Monetary fund (IMF)
2.1. Afia Malik
2.2. Research Gate
3.1. Muhammad Jahanzaib
3.2. BB Shaheed University
4.1. Tahira Qasim
4.2. Hina Ali
4.3. Maria Khakwani
www.wikipedia.org
www.imf.org
www.researchgate.com
www.reads.scrpd.org
