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.