How Inflation responds to Interest Rate: Time Series Analysis for Pakistan

Abstract

Inflation has been a menace for the world and is one
of the most important factors in destabilizing the economy of
Pakistan. The study examines the dynamic relationship among
inflation and key macroeconomic variables (fiscal deficit,
interest rate, and imports) for Pakistan. The study utilizes time
series data from 1980-2021, with Johansson Co-integration Test
and the (VECM) Vector Error Correction Model, to estimate the
long-run and short-run relationships. This study is interested in
understanding the relation of interest rate with prices which is
also termed as Fischer effect in literature. So whether this effect
prevails for Pakistani economy or not is the goal of this paper.
The results show that in long-run, inflation has a significant
positive relationship with interest rates, while showing an
inverse relationship with fiscal deficits and imports. These
results offer valuable insights into the role of monetary policy
and prices in Pakistan. Through interest rate and imports the
inflation can be controlled, while the study shows a weak
relation of fiscal deficit with inflation in the study period.