Macroeconomic effects of global food and oil price shocks to the Pakistan economy: a Structural Vector Autoregressive (SVAR) analysis.
Khan, Muhammad Arshad ; Ahmed, Ayaz
This study examines the transmission channels through which the
global food and oil price shocks affects selected macroeconomic
variables including inflation rate, output, money balances, interest
rate and real effective exchange rate for Pakistan using monthly data
over the period 1990M1-2011M7. An empirical analysis is carried out by
employing structural vector autoregressive (SVAR) framework. Generalised
Impulse Response Functions and Generalised Forecast Variance
Decompositions are employed to track the impact of oil and food price
shocks to Pakistan's economy. Results suggest that oil price shock
affects industrial production, appreciates real effective exchange rate
negatively and affect inflation and interest rate positively. Whereas,
following food price shocks, industrial output increases. Similarly,
interest rate and inflation rate responds positively following food
price shocks. However, the variation in interest rate due to food price
shock is relatively larger than that of oil price shocks. Generalised
impulse response functions reveal that real effective exchange rate is
most important source of disturbances following either oil price or food
price shocks. Generalised forecast variance decompositions analysis also
supports the findings based on generalised impulse response functions.
The result clearly reveals that oil and food price shocks significantly
affect output, short-term interest rate, inflation rate and real
effective exchange rate. However, among all, real effective exchange
rate has seen a dominant source of variations in Pakistan. This implies
that supply-side and demand-side disturbances originated by external
shocks are the major sources of inflation (stagflation) in Pakistan.
Keywords: Oil and Food Price Shocks, SVAR, GIRFs, GFEVDs, Pakistan
INTRODUCTION
Recent rise in oil and food prices have been a major cause of
concern for policymakers around the globe and Pakistan's economy is
not the exception. Changes in the global oil and food prices have been
viewed as major source of macroeconomic fluctuations. Upsurge in global
commodity prices, particularly food and oil prices during 2007-2008
leads to increase cost of production which hinders industrial
productivity and fall in output growth. An unprecedented rise in food
and oil prices during 2007-2008, coupled with global recession,
financial crises and slowdown in the US economy has posed a number of
serious challenges to the world economy. Movements in international
commodity prices have been largely considered as a main source of
business cycle and there is a plethora of literature that shows a
negative correlation between the international commodity prices and
macroeconomic performance of oil importing countries through the
supply-side and demand-side channels.
It is well documented in the literature that crude oil was trading
between US$18 and US$23 in the 1990s. It crossed the US$40 mark in 2004,
and rose to around US$60 in 2005. During the summer of 2007, the oil
price jumped above US$70 per barrel and even crossed to US$174 per
barrel mark in July 2008 before a sharp downturn. This upsurge of oil
prices produces adverse impacts on oil-importing countries. The rise in
the crude oil prices exerts adverse effect on consumers and producers
via pass-through effect on petroleum products. From the consumer
standpoint, rise in oil prices causes energy bills to grow, whereas from
the producer standpoint, firms contend a rise in unit costs [Lescaroux
and Mignon (2008)]. Similarly, food costs have increased sharply since
2007. Prices of rice, palm oil and wheat rose by 62 percent, 94 percent
and 107 percent respectively in the first quarter of 2008, compared to
39 percent for overall food prices [Jongwanich and Park (2009)]. It can
be argued that higher oil prices have indirect effect on consumer prices
whereas higher food prices have more direct effect on inflation. This is
because oil is productive input but food is consumed directly
[Jongwanich and Park (2011)]. A rise in oil prices may causes a drop in
productivity, which in turn produces adverse affects on real wages and
employment, selling price and core inflation, profits and investment as
well as stock market capitalisation [Lescaroux and Mignon (2008). On the
other hand, increase in food prices has a sizable impact on overall
consumer price level because food accounts for a sizable part in the
consumption basket in developing countries [Jongwanich and Park (2011)].
Theoretical and empirical studies showed that increases in oil
prices negatively affect macroeconomic activities of oil-importing
countries through the supply-side and demand-side channels. Hamilton
(1983) argued that seven of the eight postwar recessions in the United
States were proceeded by a spike in crude oil prices. Similarly, Brown
and Yucel (2002) concluded that rising oil prices proceeded eight of the
nine post-World War II economic recessions.
Subsequent to Hamilton's seminal work, a large body of
empirical work is devoted to explore the relationship between oil price
shock and aggregate economic performance of various economies [for
example, Burbidge and Harrison (1984); Gisser and Goodwin (1986); Mork
(1989); Mork, et al. (1994); Lee, et al. (2001) and Cologni and Manera
(2008), among other]. These studies can be divided in to three main
categories [Tang, et al. (2010)]. The first category includes a number
of studies that have investigated the theoretical transmission channels
through which the oil price increase may reduce potential output and
increase inflation [Bruno and Sachs (1982); Barro (1984); Rasche and
Tatom (1981); Darby (1982); Burbidge and Harrison (1984); Gisser and
Goodwin (1986); Mork (1989); Lee, et al. (1995); Hamilton (1996); Hooker
(1996); Abel and Bernanke (20010; Pappetrou (2001), among others]. The
second category of studies carried out by MorT (1993), Cunado and Perez
de Gracia (2003), Lee, et al. (2001), Lee and Ni (2002) and Lardic and
Mignon (2008) has focused on the empirical investigation on the
relationship between change in oil prices and aggregate activities.
These studies were verified linear, non-linear and symmetric or
asymmetric, the mathematical relationship for developed countries over
the period 1970s to the 1990s. The third group of studies, inter alia,
by Haung, et al. (2005), Cologni and Manera (2008) and Leduc and Sill
(2004) have targeted on the role of macroeconomic policies in dealing
with the oil price shock. These studies have examined the possibility of
weakening relationship between oil price fluctuations and macroeconomic
activity. Some other studies conclude that oil price deteriorates terms
of trade for oil importing countries [Dohner (1981) and Husain, et al.
(2008)]. Oil prices affect real money balances as it increases money
demand, interest rates and retard economic growth [Pierce and Enzler
(1974) and Mork (1994)]. Hooker (2002) suggests that the reaction
function of monetary authorities is the main driver of second-round
effects of oil price shocks; fiscal and monetary policy response may not
be neutral to positive oil price shock and negative food price shocks.
Oil price generates inflation [Burbidge and Harrison (1984); Hamilton
(1983, 1996)].
In developing countries like Pakistan, the government subsidises
the food and fuel prices for political reasons and consumers do not face
the true market prices of these commodities. The government subsidies
distort the price of food and oil products; therefore, consumer prices
will not fully adjust to higher international prices [Jongwanich and
Park (2011)]. Producers also tend to shift the burden of higher input
prices on consumer prices after a time lag. Similarly, exchange rate
movements, particularly weakening of domestic currency against U.S.
dollar also generate inflationary pressure because oil is denominated in
U.S. dollars.
Since 2007-08 Pakistan is facing episode of stagflation--very low
economic growth combined with very high inflation. The root cause of
current stagflation includes a series of supply-side shocks. (1) These
shocks adversely affect the supply-side performance through constraining
output growth, which is not sufficient to meet the demand pressures. (2)
As a result, there is unprecedented increase in domestic inflation,
unemployment and poverty levels [Amjad, et al. (2011)].
Against this back drop, the main objective of this paper is to
examine empirically the extent to which higher food and oil prices
translate into higher domestic prices in Pakistan by employing
Structural Vector-Autoregressive (SVAR) modeling approach and
Generalised Impulse Response Functions (GIRFs) developed by Koop, et al.
(1996) and Pesaran and Shin (1998). This technique is unique since it
yields outcomes that are invariant to the ordering of variables. We
examine the effects of food and oil price shocks on domestic output,
inflation, interest rate and exchange rate of Pakistan using monthly
data over the period 1990M1 to 2011M7. The rest of the paper is
organised as follows: Section 2 discusses the transmission channels of
oil and food price shocks. Methodology and specification of SVAR model
is outlined in Section 3. Section 4 reports empirical findings. Policy
implications are discussed in Section 5, while some concluding remarks
are given in the final section.
2. THE TRANSMISSION CHANNELS OF OIL AND FOOD PRICES
It can be argued that in the short-run oil price shocks affect
macroeconomic performance through various channels. Theoretical
literature has identified six transmission channels through which oil
price changes affect the performance of macroeconomic variables [Brown
and Yucel (2002); Jones, et al. (2004); Tang, et al. (2010), among
others]. These transmission channels include the supply-side shock
effect, wealth transfer effect, inflation effect, real balance effect,
sector adjustment effect and the psychological effect. Figure 1 depicts
the transmission channels through which raising oil and food prices
affect the macroeconomic variables.
According to supply-side effect, rising oil prices are indicative
of the reduced availability of a basic input to production, leading to a
reduction of potential output [Lescaroux and Mignon (2008)].
Consequently, there is an increase in the marginal costs of production
and the growth of output and productivity are slowed [Lescaroux and
Mignon (20080 and Tang, et al. (2010)]. The decline in productivity
growth negatively affects real wages and increases unemployment [Kumar
(20090; Chuku, et al. (2010)]. Figure 1 provides an illustration of the
supply-side shocks: increase in oil prices reduces output in the
short-run due to the reduction of capacity utilisation which, ill turn,
increases unemployment and reduces income. (3)
[FIGURE 1 OMITTED]
The second important transmission channel of oil price shocks is
the wealth transfer effect. This channel suggests that increase in oil
prices shifts purchasing power from oil-importing countries to
oil-exporting countries. A persistent rise in oil price would consider
being a significant windfall in revenue and improvement in balance of
payments of oil-exporting countries. The transfer of wealth is expected
to reduce the aggregate demand of the oil-consumer countries while
opposite is expected in the case of oil-producing countries [Galesi and
Lombardi (2009)], because it is assumed that marginal propensity to
consume in the oil-exporting countries is higher. The oil price shocks
in oil-importing countries are transmitted through the demand-side by
triggering the reduction of demand for goods and services. High oil
prices may affect consumer expenditures via four complementary channels:
discretionary income effect, uncertainty effect, precautionary saving
effect and operating costs effects [Kilian (2010) and Chuku, et al.
(2010)]. This implies that an increase in oil prices deteriorates terms
of trade for oil-importing countries [Dohner (1981)].
Besides the slowing down total output, a hike in oil price
generates inflationary pressures in the economy [Hooker (2002) and Tang,
et al. (2010)]. Since oil-based products are an important components of
consumer price index. The first round effect of high oil prices is a
sudden increase of the headline inflation. However, the degree of
passthrough effect depends on the domestic response to the shocks
[Galesi and Lombardi (2009)]. Evidence suggests that reduced output and
inflation are the two most likely effects ofoil price shocks [Chuku, et
al. (2010)]. An oil price shocks constitutes a cost of production
shocks, operating through supply-side effect which produces upward
pressure on labour costs and prices [Ibid (2010)]. Barsky and Kilian
(2004) showed that increases in oil price generate high inflation. This
can also be interpreted as price shock second round effects, giving rise
to wage-price loops [Galesi and Lombardi (2009)].
According to the real balance effect transmission channel, an
increase in oil prices would lead to increase in demand for money. Since
the monetary authorities failed to meet growing money demand with
increased money supply. Consequently, there is an increase of interest
rates and retard of economic growth [Brown and Yucel (2002)].
Alternatively, working through the price-monetary transmission
mechanism, oil price shocks can reduce investment due to the reduction
in producer's profits and equally reduces money demand (Figure 1).
The monetary policy channel is another important channel through
which monetary authorities respond to oil price shocks. For example,
tightening of monetary policy through increased interest rates (Figure
1) to combat inflationary pressure caused by rising oil prices,
discourage investment and worsens output in the long-run [Tang, et al.
(2010)]. Brenanke, et al. (1997) documented that tightening of monetary
policy and oil price shocks produced depressing effects on real economy.
The sectoral adjustment effect channel shed light on the asymmetric
impact of oil price shocks within the sectors of the economy. Brown and
Yucel (2002) offers the possible explanations for this asymmetry
adjustment would be rely on monetary policy, adjustment costs, adverse
effects of uncertainty on the investment environment and asymmetry in
the petroleum product prices [Lardic and Mignon (2006, 2008, and
Lescaroux and Mignon (2008)]. When oil price rises, slowing economic
activities is further retarded by adjustment costs. Conversely, when oil
price falls, stimulated economic activities is somewhat offset by
adjustment costs [Brown and Yucel (2002 and Chuku, et al. (2010)]. Such
costs could arise from sectoral imbalances and lack of coordination
between firms or because energy-to-output ratio is embedded in the
capital stock [Brown and Yucel (2002) and Lescaroux and Mignon (2008)].
In the presence of sectoral imbalances, an increase (decrease) in oil
price would require contraction (expansion) of oil intensive sectors and
expansion (contraction) of oil efficient sectors [Lilien (1982) and
Hamilton (1988)]. These realignments in production require adjustments,
which cannot be achieved in the short run-known as dispersion hypothesis
[Kumar (2009)]. Furthermore, asymmetry in oil prices will result in
under-utilisation of resources and rising unemployment.
Finally, psychological effect implies that given the uncertainty
about how long will oil prices remain high can adversely affect economic
activities by reducing investment demand of firms and consumer's
demand-known as the uncertainty channel. Uncertainty causes firms and
consumers to postpone irreversible investment and consumption decisions
following positive oil price shocks [Burnanke (1983): Pindyck (1991);
Ferderer (1996) and Galesi and Lombardi (2009)]. (4) If energy-to-output
ratio embedded in the capital stock, the firms must choose
energy-intensive production process when purchasing capital. For
consumer, the uncertainty mainly applies to consumer durables,
especially energy-using consumer durables. Uncertainty about future oil
price causes upward and downward movements in oil prices. It is worth
noting that when future oil prices become increasingly uncertain, the
value of postponing the investment (or consumption) decisions increases,
and the net incentive to invest (or consume) decreases, thereby
dampening long-term prospects of output [Chuku, et al. (2010)].
The literature also reveals that food and oil prices are
responsible for slowing down world economic growth [Headey and Fan
(2008); Abott, et al. (2009); Galesi and Lombardi (2009); Hakro and
Omezzine (2010); Alom (2011) and Jongwanich and Park (2011)]. The
transmission channel (Figure 1) suggest that increase in food prices
leads to increase import bills which decreases net exports and causing
domestic output to fall-referred net export channel. On the other hand,
when food price increases globally the demand for food exports decreases
which ultimately reduces net exports--a part of national income [Alom
(2011)]. Increase in food and oil prices also increases the demand for
money and interest rates which produces adverse effect on exchange
rates.
In general it is very difficult to quantify the net effect of oil
and food price hike. The pass-through effect of global commodity price
changes on domestic prices can be analysed into three channels. First,
the direct or the first-round effect, which refers to the rise in prices
of energy products. Second, the indirect effect which refers
pass-through of higher energy-related costs of production to the prices
of other goods and services. Third, the second-round effect, which
occurs due to an increase in the cost of living, worker's demands a
higher wage in order to maintain their real income [Galesi and Lombardi
(2009)]. The effect of the first two channels is likely in the short-to-
medium term. However, the second-round effect is expected to be more
prolonged and may result, wage-price spiral, causing inflation to
accelerate [Galesi and Lombardi (2009)].
Bruno and Sachs (1985) suggest that after the oil price shocks of
the 1970s, monetary authorities adopted expansionary monetary policies
which eventually aggravated effects on inflation. However, nowadays
monetary authorities commit themselves to rapidly counter inflationary
measures to enhance the credibility of monetary authorities. Galesi and
Lombardi (2009) argued that a credible inflation-countering strategy
would create a stable environment of low inflation, anchoring the
inflation expectations and influencing the price-setting behaviour.
3. METHODOLOGY: SPECIFICATION OF STRUCTURAL VECTOR AUTOREGRESSIVE
(SVAR)
To address the issues related to food and oil price shocks, we make
use of Structural Vector Autoregressive (SVAR) modeling approach. The
advantage of the SVAR over the other classes of vector autoregressive
models is that it has better empirical fit and allows indentifying
structural shocks with respect to economic theory. Furthermore, SVAR
also makes it possible to examine the net effects of unexpected change
in one or more variables on other variables in the system [Chuku, et al.
(2011)].5 To analyse the transmission channels of oil price and food
price shocks in Pakistan, we make use with a reduced form Vector
Auto-Regressive (VAR) model. Since oil and food prices can directly
increases domestic inflation and will cut producer's profit rates,
which together with interest rate adversely influences domestic output
through the channel of investment.
Following Breitung, et al. (2004) we start with the following
structural VAR(p) system:
A[X.sub.t] = [A.sub.1] [X.sub.t-1] + [A.sub.2] [X.sub.t-2] + ... +
[A.sub.p] [X.sub.t-p] + [[epsilon].sub.t]] (1)
Where [X.sub.t] is a (n x 1) vector of endogenous variables
([X.sub.t] = ([p.sup.o.sub.j], [p.sup.f.sub.t], [y.sub.t], [m.sub.t],
[i.sub.t], [q.sub.t], [[pi].sub.t])), A is an invertible (n x n) matrix
of coefficients of contemporaneous relations on the endogenous
variables; [A.sub.i]'s are (n x n) matrices which captures dynamic
interactions between the k variables in the model, and ~t is a (n x 1)
vector of structural error terms, p is the number of lags. It can be
argued that VAR estimation is very sensitive to lag order of variables.
A sufficient lag length may help to reflect the long term impact of
variables on others. However, by selecting longer lag length may cause
multicollinearity problems and will reduce the degrees of freedom (DOF)
[Wooldbridge (2006); Tang, et al. (2010) and Chuku, et al. (2010)].
Tang, et al. (2010) argued that for any p [greater than or equal to] 11,
the model will become divergent with at least one autoregressive roots
greater then unit. Therefore, sequential modified Likelihood Ratio (LR)
test suggest that lag order 1-3 is best for this nature of models
[Wooldbridge (2006); Tang, et al. (2010) and Chuku, et al. (2010). SVAR
models are more suited to track and identify structural shocks with
respect to underlying economic theory [Chuku, et al. (2011)]. Hence, it
is necessary to impose relevant restrictions on the system of equations
to retrieve structural shocks of the model.
The model residuals are assumed to be linearly related to
structural shocks, denoted by [u.sub.t], so that [u.sub.t] =
[B[epsilon].sub.t], where B is (n x n) matrix of structural coefficients
representing the effects of structural shocks. It is further assumed
that [[epsilon].sub.t] is mutually orthogonal so that the dynamic
impacts of each individual structural shock can be expressed in
isolation. Thus, [[epsilon].sub.t] is a n x 1 vector of the structural
shocks assumed normally distributed with zero mean and normalised
diagonal variance-covariance matrix [OMEGA] = I. Therefore, system (1)
can be expressed as:
A[X.sub.t] = [A.sub.1] [X.sub.t-1] + [A.sub.2] [X.sub.t-2] + ... +
[A.sub.p] [X.sub.t-p] + B[[epsilon].sub.t] (2)
The structural model represented by system (2) must be identified
for the purpose of policy analysis and must be given economic
interpretation [Leeper, et al. (1996)]. The fundamental problem here is
that model (2) is not directly observable and cannot directly estimated
to derive the true values of ~t and coefficients in A and
[A.sub.i]'s. The reduced form of the model (2) can be obtained by
pre-multiplying the model (2) with [A.sub.-1] as written below:
[X.sub.t] = [A.sup.*.sub.1] [X.sub.t-1] + [A.sup.*.sub.2]
[X.sub.t-2] + ... + [A.sup.*.sub.p] [X.sub.t-p] + [u.sub.t] (3)
Where [A.sup.*.sub.i] = [A.sup.-1] [A.sub.i], [u.sub.t], denotes
the reduced-form VAR residuals vector uncorrelated with variables in
[X.sub.t], and normally independently distributed with
variance-covariance matrix [OMEGA] = E([u.sub.t], [u.sup.'.sub.t]).
Thus ordinary least squares (OLS) estimation gives consistent estimates
of [A.sup.*.sub.i]. Similarly the estimates of [OMEGA] can be obtained
from the fitted residuals.
Since only the lagged terms are listed on the right-hand side of
the VAR equation and a reduced-form VAR is unable to trace the
contemporaneous relationship among variables which causes
cross-correlation among residuals series. Although, the covariance
matrix of residuals [OMEGA] = E([[epsilon].sub.t]
[[epsilon]'.sub.t]) [not equal to] 1, but it does not influence the
unbiasedness and efficiency properties of estimation [Tang, et al.
(2010)]. The contemporaneous relationship may affect the impulse
responses. As Equation (2) is not directly observable, the solution is
obtained through another relation between the reduced form VAR model (3)
and the structural VAR model (2) as:
A[u.sub.t] = B[[epsilon].sub.t] = [u.sub.t] = [A.sub.-1]
B[[epsilon].sub.t] (4)
The structural coefficients in Equation (2) can be recovered from
the reduced-form Equation (3), using relations (4). To identify
structural form parameters it is necessary to impose sufficient
restrictions on either matrix of parameters A, B or both. For the just
identification we need ([n.sup.2] + n)/2 restrictions on the A and B.
Furthermore, we need additional [n.sup.2] - ([n.sup.2] + n)/2
restrictions on matrix B [Amisano and Giannini (1997)]. In our case we
have seven variables model; therefore, we need 21 additional
restrictions to estimate the model.
3.1. SVAR Model for the Pakistan Economy
There is no consensus on the number of variables required in SVAR
model to provide a plausible interpretation of an economy. Dungey and
Pagan (2000) included eleven variables in SVAR, while Kim and Roubini
(2000) and Brichetto and Voss (1999) argued that seven variables are
enough [Naqvi and Rizvi (n. d.)]. For the smaller economies like
Pakistan, world oil and commodity prices are assumed to be exogenous.
Hence, we specify a VAR model that involves a set of variables
represented by the following vector [X.sub.t].
[X.sub.t] = ([p.sup.o.sub.t], [p.sup.f.sub.t], [[gamma].sub.t],
[m.sub.t], [i.sub.t], [q.sub.t], [[pi].sub.t]) (5)
Where [p.sup.o.sub.t] is the world oil price in terms of US dollar,
[p.sup.f.sub.t] is the international food price index, [y.sub.t] is the
output proxied by industrial production index, [m.sub.t] is money supply
(M2 definition), [i.sub.t] is the short-term interest rate proxied by
the overnight call money rate, [q.sub.t], is the real effective exchange
rate and [[pi].sup.cpi.sub.t] is the consumer price inflation proxied by
the log difference of consumer price index (CPI). Lower case letters
represents the logarithmic form of the variables except for interest
rate.
World oil prices and international food prices are the key
variables of interest. The variables [p.sub.o.sub.t] and [p.sup.f.sub.t]
are determined exogenously relative to the policy shocks. They serve as
instruments to isolate exogenous monetary policy shocks. Furthermore,
world oil and food prices are included to examine the international
price shocks on domestic economy. Overnight call money rate and exchange
rate are included to captures the effect of monetary policy shocks and
exchange rate shocks on other variables.
For the identification, we impose following set of restrictions on
the contemporaneous structural parameters following Kim and Roubini
(2000), Naqvi and Rizvi (n. d) and Alom (2011). The summary of
identification scheme based on the Equation (4), [u.sub.t] =
B[[epsilon].sub.t] is as follows:
[MATHEMATICAL EXPRESSION NOT REPRODUCIBLE IN ASCII] (5)
Where [[epsilon].sup.o], [[epsilon].sup.f], [[epsilon].sup.y],
[[epsilon].sup.m], [[epsilon].sup.i], [[epsilon].sup.q]
[[epsilon].sup.[pi]] and are the structural disturbances, that is, oil
price, food price, output, money demand, interest rate, real effective
exchange rate and inflation rate shocks respectively, while [u.sup.o],
[u.sup.f], [u.sup.y], [u.sup.m], [u.sup.i], [u.sup.q] and [u.sup.[pi]]
are residuals in the reduced form equations.
We imposes identifying contemporaneous restrictions on the
structural parameters following the information-based approach of Sims
(1999), Gordon and Leeper (1994), Sims and Zha (1998), Kim and Roubini
(2000), Kim (2001) and Lee and Ni (2002). We assume that oil price is
exogenous, this means that food price ([p.sup.f.sub.t]), output
([y.sub.t]), money supply ([m.sub.t]), short-term interest rate
([i.sub.t]), real effective exchange rate ([q.sub.t]) and consumer price
inflation ([[pi].sup.cpi.sub.t]) are not determinants of oil prices at
period t. Equation (2) is food price ([p.sup.f.sub.t]) function which is
assumed to be affected only by changes in oil price ([p.sup.o.sub.t]).
Both oil price and food prices capture the effect of international
supply shock on inflation--the cost push inflation. Equation (3) is
output ([y.sub.t]) function which captures demand shock and is assumed
to be affected by oil prices, money balances and inflation rate. The
fourth equation is money demand function which depends upon the real
income proxied by industrial production index, inflation rate and
short-term nominal interest rate. The monetary policy reaction function
is represented by Equation (5). Sek (2009) argued that interest rate
respond contemporaneously, to inflation, output and exchange rate.
Therefore, in line with Sek (2009) the monetary policy reaction function
includes oil price, money supply, real effective exchange rate and
inflation rate. Real effective exchange rate is included to capture the
effect of exchange rate shocks on inflation and is assumed to be
affected by interest rate, money supply, output, food and oil prices.
Finally, inflation rate receives contemporaneous effects of all
variables in the system. In other words, inflation rate responds
contemporaneously to demand shocks, exogenous supply shocks, monetary
policy shocks and exchange rate shocks.
On the whole, the structural shocks consist of various blocks. The
first two equations represent exogenous shocks originated from the world
economy, the oil price and food price shocks. The third equation
describes the good market equilibrium. Equations four and five represent
money market equilibrium condition and monetary policy reaction
function. Equation six associates to foreign exchange market, while the
last equation describing domestic price setting behaviour.
3.2. The Data
We employed monthly data over the period January 1990 to July 2011
for Pakistan. The rationale behind the selection of this period is to
capture oil price and global food price shocks of the mid-2008. Our
primary focus is to examine the impacts of oil price and international
food price shocks on inflation rate, real income, money balances,
nominal effective exchange rate and nominal short-term interest rate. To
this end, we have selected five endogenous variables ([y.sub.t],
[m.sub.t], [i.sub.t], [q.sub.t], [[pi].sub.t],) and two external
variables ([p.sup.o.sub.t], [p.sup.f.sub.t]) to capture the
inter-relationship with in the SVAR framework.
Real GDP ([y.sub.t]) on monthly frequency is not available; hence
we have used an industrial production index as proxy for real GDP.
Inflation rate ([[pi].sub.t]) is calculated by taking the log difference
of the consumer price index (CPI) multiplied by 100. Money supply M2
definition ([m.sub.t]) is included to capture the influence of monetary
sector. This is because the State Bank of Pakistan responds oil price
shocks, which may affect the economic activities in Pakistan. For the
nominal short-term interest rate ([i.sub.t]) we have used overnight call
money rate. To capture the effects of oil price shocks and food price
shocks on exchange rate, we have included trade weighted real effective
exchange rate ([q.sub.t]). For oil prices ([p.sup.o.sub.t]) we choose
the West Texas spot crude oil price in dollar term. We eliminate the
influence of exchange rate fluctuations by transforming the dollar price
of Pak-rupee using the average corresponding Pak-rupee-U.S. dollar
exchange rate. For global food price, we used food price index. Data on
these variables are retrieved from the International Monetary
Fund's International Financial Statistics-IFS CDROM-2008 and
updated using monthly IFS Bulletins (various issues). All the variables
are expressed in logarithmic form except for interest rate.
4. ESTIMATION RESULTS: STRUCTURAL VAR ANALYSIS
4.1. Impulse Response Analysis
The main objective of this study is to track out the impact of oil
price and food price shocks on inflation rate, domestic output, money
balances, interest rate and real effective exchange rate by mean of
Generalised Impulse Response analysis. In other words, the study mainly
traces how domestic variables respond to oil price and food price
shocks. For this purpose we estimated SVAR model in levels of the
variables. For the policy analysis it is important that one should add
sufficient number of lags to remove serial correlation and make the
errors stationary (i.e. I (0)) and proceed to the analysis. Hence, there
is no need to worry about non-stationarity of the variables. (6)
"Sims (1980) and Sims, et al. (1990) recommended against
differencing even if the variables contain a unit root. They argued that
the goal of a VAR analysis is to determine the interrelationships among
the variables, not to determine the parameter estimates. Differencing of
variables may lose important information concerning the co-movements in
the data [Enders (2004), p. 270]". Similarly, McCallum (1993)
argues that the estimation of SVAR in levels is appropriate if the error
terms of each VAR equations are stationary and serially uncorrelated
[Parrado (2001)]. Our preliminary results suggest that residuals
characterise vector white noise processes. (7)
The SVAR model is estimated using three lags on the basis of Akiake
Information Criteria (AIC). Given the structural factorisation specified
by Equation (5), we impose 21 just-identifying restrictions on SVAR
model. Table 1 reports the contemporaneous coefficient estimates based
on the SVAR model. These coefficients provide baseline intuition of the
basic relationship that exists among the variables.
The contemporaneous coefficients will indicate immediate response
of domestic prices, domestic output, money balances, interest rate and
exchange rate to world oil and food price shocks. We imposed 21
restrictions to just-identified the model. The LR test is 4.25 which
indicate that restrictions are valid and hull hypothesis cannot be
rejected.
In order to investigate the short-run dynamics we employ
Generalised Impulse Response Functions (GIRFs) proposed by Koop, et al.
(1996) and Pesaran and Shin (1998). GIRFs are more appealing compared to
Sims's (1980) orthogonalised impulse response functions as they are
invariant to the ordering of the variables [Galesi and Lombardi (2009)].
GIRFs trace out the responsiveness of dependent variable to shocks to
each of the variables in the SVAR model. For each equation, a positive
standard unit shock is applied to the oil and food prices respectively
up to a limit of twenty four months horizon. Since our main interest is
to measure the oil and food price shocks on selected macroeconomic
variables, we only traces out the responses of independent variables. In
our SVAR model we assume that oil prices do not react to disturbances to
other macroeconomic variables. The literature suggests that oil price
shock usually have immediate and direct effect on inflation and on
output, so we choose the ordering [[pi].sub.t], [y.sub.t], [m.sub.t],
[i.sub.t], [q.sub.t], while food price react positively to only oil
prices.
4.2. A Shock to Oil Prices
Figure 2 display GIRF of each variable to a positive one unit
standard deviation shock to oil prices. As expected, initially inflation
shoots up following the oil price shock and after one month it starts
declining. After 3-month period inflation starts accelerating and the
maximum impact is reaches around 11 to 12-months. This implies that oil
price shocks cause inflationary pressure on the Pakistan's economy.
Javid and Munir (2011) obtained almost similar results for Pakistan.
We observed negative responses of domestic output following oil
price shock. In response to oil price shock, output falls down
immediately and hits the bottom at around second month and starts
increasing and attains the peak level in seventh month. However, after
seventh month output starts declining and remains stagnant over next
fourteenth to twenty-fourth month. This implies that after oil price
shock output declines quickly and recovers slowly. The pattern of GIRF
suggests that oil price increases may reduce the supply of intermediate
goods industries and the demand for final goods industries [Lee and Ni
(2002)]. Lee and Ni (2002) also obtained similar findings.
The response of money balances to oil price shock is initially
negative and after a lag of two months money balances starts increasing
and completely dies out after 17th month. This implies that the monetary
authorities cut money supply following an oil price shock up to the
second month. The rationale for this policy stance could be to check the
inflationary pressure that may generated by oil prices. However, after
the second month, money supply rises again over and above levels before
oil price shock.
The response of short-term interest rate indicates that short-term
interest rate declines immediately after the oil price shocks. However,
after 3rd month it starts increasing and reaches its maximum level in
5th month, and then it falls slowly and completely dies out over the
next 12th months. This result is consistent with monetary contraction
after an inflationary oil price shock [Kim and Roubini (2000) and Javid
and Munir (2011)].
[FIGURE 2 OMITTED]
The real effective exchange rate appreciates immediately following
the oil price shocks up to the fourth months. The real effective
exchange rate revert its tendency and starts depreciation over the next
24-months. This implies that the exchange rate appreciation will be
transitory and will revert to above its pre-shock levels after all
prices and wages have adjusted. This mean-reverting behavior of real
effective exchange rate is consistent with the long-run implications of
overshooting monetary exchange rate models [Kim and Roubini (2000)].
4.2.1. Generalised Forecast Error Variance Decompositions Analysis
The Generalised Forecast Error Variance Decompositions (GFEVDs)
analysis provides a tool of analysis to identify relative importance of
each dependent variable in explaining the variations in the explanatory
variables [Chuku, et al. (2010)]. Furthermore, GFEVDs provide insights
on the transmission channels through which policy-specific shocks
spillovers. The results of GFEVDs over a 24 months horizon for oil price
shocks are displayed in Table 2.
As can be seen from the Table 2 that the contribution of oil price
shock to output is 6.78 percent over the period of 24-months horizon.
This implies that oil price shocks significantly affect real output and
the impact is persistent over the longer horizon. This result confirms
the earlier findings of Javid and Munir (2011). The results suggest that
the contribution of the money supply is negligible, it is equal to 0.06
percent and 1.16 percent between 4-month and 24-month horizon
respectively. Similarly, the impact of short-term interest rate is 2.54
percent in 4-months. Its contribution increases over time and reaching
9.39 percent after two years. This implies that the monetary authorities
react against oil price shocks.
The oil price shocks explain large part fluctuations in real
effective exchange rate. The contribution of oil price shock to
effective exchange rate is 1.27 percent in 4-month period. It increases
gradually over time and passing over 24 percent after two years. Thus
the exchange rate innovations tends to increase over time and more
dominate source of fluctuations. This implies that exchange rate
innovations may perceived more permanent and tend to pass-through to the
domestic inflation faster than any other variable under investigation.
Finally, the impact of oil price shock to inflation over a 24-month
horizon ranges between 0.07 percent to 2.39 percent. This low impact of
oil price shock on inflation may suggest the existence of domestic price
stickiness with respect to international oil prices. In other words,
this implies the slow adjustment of domestic prices to international
price level.
In overall term, the results suggest that oil price shock
significantly affect domestic economic activities. Oil price shocks
together with exchange rate depreciation generates inflationary
pressures in Pakistan. The inflationary shocks are mainly explained by
real effective exchange rate (24.20 percent), short-term interest rate
(9.39 percent) and domestic output (6.78 percent). Therefore, SVAR
analysis reveals the topical role of the real effective exchange rate
and short-term interest rate in controling inflation in Pakistan.
4.3. A Shock to Food Prices
Figure 3 displays the GIRFs of each variable to a positive unit
standard deviation shock to food prices. As expected, consumer price
inflation shoots up immediately following the food price shock and
reaches its maximum levels in 13th month. After 13th month it falls
steadily over the next 11-months and remains to above the pre-shock
level. This effect of food price shock partially reflects the weight
that the food component has in consumer price basket. Since food price
is important component of the CPI, therefore, food price shock
significantly generates inflationary pressures on Pakistan's
economy.
The effect on the output proxied by the industrial production index
is clearly different form oil price shocks. Initially output responds
positively to food price shock, reached its peak levels in third month.
Then it falls gradually and dies out after two years from the shock
(i.e. 24th month). This implies that food commodities are different from
crude oil prices and are not broadband production factors. Thus a rise
in their prices does not generally lead to a decrease in output [Alom
(2011)].
The effect on the money balances is not much significant and
remains persistent over the horizon of 24-months. However, the response
of short-term interest rate to food price shock is positive and reaches
at the peak levels in third and 12th months respectively. Then it
remains persistent over the next 12-months.
A positive one unit standard deviation shocks to international food
prices appreciates real effective exchange rate up to 2-months and then
starts depreciation over the next 2- months. Real effective exchange
rate starts appreciation following the food price shock and reaches its
peak levels in 9th month. Then it depreciates gradually and after
24-month the real depreciation is 0.03 percent. This mean-reverting
behavior of real effective exchange rate is consistent with the long-run
implications of overshooting monetary exchange rate models [Kim and
Roubini (2000)]. However, the mean-reversion is relatively slow than
that of oil price shocks.
[FIGURE 2 OMITTED]
On the whole, increases in international food prices significantly
generates inflationary pressure on Pakistan's economy and also
causes exchange rate fluctuations which may considered as major source
of disturbance.
4.3.1. Generalised Forecast Error Variance Decompositions Analysis
The results of GFEVDs over a 24 months horizon for food price
shocks are reported in Table 3.
It can be seen from the Table 3 that food price shocks explain
3.38-10.11 percent variations in domestic output, 1.08-33.06 percent
variations in real effective exchange rate and 0.39-2.84 percent
variations in inflation rate. However, GFEVDs reveals that money
balances and short-term interest rate are mildly effected by food price
shocks. The analysis suggest that the dominant source of inflation in
pakistan is the persistent depreciation of exchange rate followed by the
food price shocks.
5. POLICY IMPLICATIONS
We found that Pakistan's economy is relatively less affected
by international oil and food price shocks. The findings related to oil
price shocks suggest that oil price increases adversly affects
industrial production. However, the effect of oil price shock on
industrial production is relatively small. The reason could be that
heavy industries in Pakistan are partially dependent on electricity
generated by imported oil. Oil accounts for 29 percent of total energy
used in Pakistan, while natural gas accounts for 40 percent [Malik
(2010)]. The other reason for the reduction of industrial production
could be that due to food price hike the labour force in the industrial
sector may demand higher wages and thus demand for labour decreases
which decreases output in the industrial sector [Alom (2011)].
Furthermore, increase in the price of food products put negative impact
on import bills. Food and oil price shocks found to be transmit through
interest rate and exchange rate chennels, therefore, other variables are
not much responsive to the oil and food price shocks. This result is
consistent with the earlier findings of Rafiq, et al. (2009). The reason
could be the increase in money demand due to excess import bills.
Exchange rate is again found to be important channel in terms of food
price shock. Besides interest rate, the major channel through which oil
and food price shocks transmit to Pakistan's economy are real
effective exchange rate because real effective exchange rate is under
pressures because of excess import bills due to oil and food price
increase.
Our results imply that impact of international oil and food price
shocks is transmitted through interest rate and exchange rate channels
which create inflationary pressures and constraints economic activities
in Pakistan. Therefore, there is need to reduce undue emphasis on
international oil and food prices as key determinants of consumer prices
inflation and place more emphasises on the prudent monetary, fiscal and
exchange rate policies in macroeconomic policy formulation to deal with
inflation, recession and poverty. Furthermore, the findings suggest that
Pakistan may design effective policy measures to cope with oil price
shocks. Renewable energy sources could be the important option to
accommodate oil price shocks. To cope with the food price shocks there
is need to increase food reserves and enhance domestic food production.
5. CONCLUSION
In this study we have applied SVAR methodology to investigate the
short-run impact of oil and food prices on consumer price inflation for
Pakistan using monthly data over the period 1990M1 to 2011M7.
Generalised Impulse Response analysis reveals that oil and food price
shocks have different inflationary effects. The impulse response
analysis suggests that following oil price shocks, inflation immediately
increases. After second month it follows downward trend up to 4-months.
Then it again increases and reaches its maximum levels in 10th month and
remains stable over the next 13-months. Whereas, following food price
shock domestic price inflation gradually increases up to 12-months and
then starts decreasing and remains above the pre-shock level by the end
of two years. Furthermore, following a positive oil price shock, output
initially decreases and after second month it tend to increases
gradually between fourth to seventh month and stabilises over the next
17-months. On the other hand, following a positive food price shocks,
output increases up to third month and then starts falling and
completely dies out after two years. Similarly, interest rate responds
positively following the oil and food price shocks. However, the
variation in interest rate due to food price shock is relatively larger
than that of oil price shocks. The GIRF reveals that real effective
exchange rate is most important source of disturbance following either
oil price or food price shocks. In either case initially exchange rate
appreciates and then it depreciates gradually over the 24month horizon.
Generalised forecast variance decompositions analysis also supports
the findings based on GIRFs. The result clearly reveals that oil and
food price shocks affect output, short-term interest rate, inflation
rate and real effective exchange rate. However, among all, real
effective exchange rate has seen a dominant source of variations in
Pakistan. This implies that supply-side and demand-side disturbances due
to external shocks are the major sources of stagflation in Pakistan.
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(1) Supply shocks include energy shortages, rising global commodity
prices and unprecedented floods in the summer of 2010 [Amjad, et al.
(2011)]
(2) High borrowings by the government of Pakistan from the State
Bank of Pakistan and the Commercial Banking System to finance fiscal
deficits, large increases in remittances, high government subsidized
prices and large increases in the wages of government employees [Amjad,
et al. (2011)].
(3) Since oil is considered to be an important factor of
production, an increase in its price raises the cost of production. As a
result, domestic productivity will be slow.
(4) It can be argued that when oil prices increase, consumers and
producers could postpone their purchases of oil related products and
reduce their oil consumption [Galesi and Lombardi (2009)].
(5) We include two external variables, such as oil price and food
price.
(6) There are two possibilities: (i) Use a recursive VAR (Cholesky
decomposition), but this is adhoc and results are order-dependent, (ii)
impose contemporaneous short-run restrictions on SVAR on levels whether
the variables are 1(1) or 1(0). Add enough lags to get l (0) errors.
With these "'identifying assumptions", correlations can
be interpreted causally. For example, Taylor rule sets the interest rate
equal to lagged inflation and unemployment (instrumental variable
regression) and is the interest rate equation in the VAR.
(7) The results are available from the authors.
Muhammad Arshad Khan <arshadkhan881@hotmail.com> is Associate
Professor, Department of Commerce and Business Administration,
Government Post-graduate College Muzaffarabad (Azad Kashmir). Ayaz Ahmed
<chayaz_1961@yahoo.com > is Senior Research Economist at the
Pakistaa Institute of Development Economics, Islamabad.
Authors' Note: We are grateful to Dr Rehana Siddiqui, Head
Department of Environmental Economics, Mr Muhammad Nasir Khan and other
participants for their invaluable suggestions.
Table 1
Contemporaneous Structural Coefficients
Coefficients Standard Error Z-statistic Probability
[b.sub.21] 0.057 0.020 2.87 0.004
[b.sub.31] 0.038 0.077 0.493 0.622
[b.sub.34] 1.280 1.088 1.18 0.239
[b.sub.37] -0.007 0.017 -0.41 0.685
[b.sub.43] -0.066 0.141 -0.47 0.638
[b.sub.45] -0.025 0.026 -0.96 0.337
[b.sub.47] 0.043 0.049 0.87 0.382
[b.sub.51] 2.981 3.005 0.99 0.321
[b.sub.54] 132.200 67.440 1.96 0.050
[b.sub.56] 102.145 58.586 1.75 0.081
[b.sub.57] 1.650 0.772 2.14 0.033
[b.sub.63] -0.002 0.015 -0.11 0.910
[b.sub.64] -0.323 0.390 -0.83 0.408
[b.sub.71] 3.778 2.153 1.76 0.079
[b.sub.72] -19.509 9.494 -2.06 0.040
[b.sub.73] 0.157 6.628 0.02 0.981
[b.sub.74] 98.615 62.544 1.58 0.115
[b.sub.75] -0.257 0.262 -0.98 0.327
[b.sub.76] -13.026 38.943 -0.33 0.738
Likelihood Ratio (LR) test for over-identifying restrictions:
[chi square] (2) = 4.25[0.1141.
Table 2
Generalised Forecast Error Variance Decompositions of Crude Oil Price
Period Std. Error [p.sup.o.sub.t] [p.sup.f.sub.t] [y.sub.t]
1 0.080 100.000 0.000 0.000
4 0.177 93.630 2.340 0.089
8 0.235 75.661 7.844 2.224
12 0.268 62.808 8.361 4.734
16 0.288 55.352 7.373 6.080
20 0.301 50.992 7.134 6.675
24 0.310 48.431 7.636 6.784
Period [m.sub.t] [i.sub.t] [q.sub.t] [[pi].sub.t]
1 0.000 0.000 0.000 0.000
4 0.064 2.538 1.271 0.068
8 0.183 4.932 7.859 1.296
12 0.608 6.402 15.242 1.845
16 0.920 7.438 21.183 1.654
20 1.086 8.378 23.898 1.837
24 1.164 9.393 24.201 2.391
Note: Cholesky Odering: [p.sup.o.sub.t], [p.sup.f.sub.t], [y.sub.t],
[m.sub.t], [I.sub.t], [q.sub.t], and [[pi].sub.t].
Table 3
Generalised Forecast Error Variance Decompositions of Food Prices
Period Std. Error [p.sup.o.sub.t] [p.sup.f.sub.t] [y.sub.t]
1 0.078 3.120 96.880 0.000
4 0.177 1.756 92.928 3.348
8 0.235 1.170 83.945 6.296
12 0.268 0.807 73.793 7.513
16 0.288 0.627 64.267 8.736
20 0.301 0.535 56.862 9.594
24 0.310 0.540 51.666 10.107
Period [m.sub.t] [i.sub.t] [q.sub.t] [[pi].sub.t]
1 0.000 0.000 0.000 0.000
4 0.322 0.187 1.075 0.385
8 0.856 0.087 6.512 1.133
12 1.069 0.080 15.729 1.008
16 1.121 0.083 24.255 0.912
20 1.062 0.073 30.275 1.599
24 0.974 0.116 33.763 2.84
Note: Cholesky Odering: [p.sup.o.sub.t], [p.sup.f.sub.t], [y.sub.t],
[m.sub.t], [i.sub.t], [q.sub.t], and [[pi].sub.t].