Th Pakisan Dvlopmn Rviw 50: (Summr 011) pp. 145 16 Th Conmporanous Corrlaion of Srucural Shocks and Inflaion-Oupu Variabiliy in Pakisan MUHAMMAD NASIR AND WASIM SHAHID MALIK * Monary policy has changd in a numbr of ways in h las wo dcads. Along wih ohr characrisics, modrn monary policy is forward-looking and oday cnral banks, o mainain crdibiliy, rspond conmporanously o srucural shocks ha migh mak inflaion dvia from h arg in fuur. This sudy aims a invsigaing his aspc of monary policy for Pakisan. Using h modifid vrsion of Srucural Vcor Auorgrssion (SVAR) dvlopd by Endrs and Hurn (007), h auhors hav found a wak policy rspons o supply sid shocks as h corrlaion cofficin bwn dmand and supply shocks is only 41. Morovr, h rsuls show ha h dmand shocks hav no significan conribuion in oupu variabiliy. On h ohr hand, boh dmand and supply shocks, along wih forign supply shocks, significanly conribu o inflaion variabiliy. JEL classificaion: E31, E4, E5, E58 Kywords: Monary Policy, Conmporanous Corrlaion, Pakisan, Srucural Shocks, Vcor Auorgrssion 1. INTRODUCTION In h las wo dcads monary policy has changd in a numbr of ways. I all sard wih h adopion of inflaion arging as monary policy by h Rsrv Bank of Nw Zaland (RBNZ) in 1989. Afr rcogniion ha inflaion arging was a br opion o conrol inflaion, acadmicians and rsarchrs sard working on horical modlling of h framwork [for arly conribuions, s for insanc, Svnsson (1997, 1999); Brnank and Mishkin (1997) among ohrs]. 1 Among ohr hings a modrn monary policy would announc an xplici inflaion arg and mak is achivmn is prim objciv, nsur ransparncy of policy dcisions and implmnaion, mak h monary auhoriy crdibl, h cnral bankrs accounabl and kp policy dcisions forward-looking. This las characrisic maks cnral banks o rspond conmporanously o srucural shocks ha ar xpcd o dvia inflaion from h arg in fuur. Any conmporary nws ha is rlvan o Muhammad Nasir <nasirawan84@yahoo.com> is Rsarch Economis a h Pakisan Insiu of Dvlopmn Economics, Islamabad. Wasim Shahid Malik <wsmalick@gmail.com> is Assisan Profssor, Dparmn of Economics, Quaid-i-Azam Univrsiy, Islamabad. 1 For criics on h subjc, [s Calvo and Mndoza (000); Calvo (001) and Ball and Shridan (003), among ohrs].
146 Nasir and Malik inflaion is rflcd in h inflaion forcas, which in urn calls for changs in h opraional arg or policy insrumn. Doing so maks dmand and supply shocks conmporanously corrlad. A supply shock, which may rsul in h dviaion of inflaion from h arg, calls for policy rspons ha in urn affcs h aggrga dmand. This issu is of paricular imporanc for dcomposiion of srucural innovaions ino dmand and supply shocks. Mor dails on h issu ar givn in Blanchard and Quah (1989) and Endrs and Hurn (007). Work on his aspc of monary policy issus rlaing o Pakisan is limid. Th auhors may b righ in hinking hir sudy o b h firs such amp o sima h conmporanous rspons of dmand o supply shocks and o find h conribuion of srucural shocks in oupu and inflaion variabiliy. Th prim objciv of his sudy, hrfor, is o invsiga h prsnc of conmporanous corrlaion bwn dmand and supply shocks in Pakisan. For his purpos h mhodology of Endrs and Hurn (007) has bn usd which is a modificaion of h Blanchard and Quah (BQ) mhod. Th scond objciv is o us h idnifid srucural shocks, which ohrwis ar unobsrvd, o sima h conribuion of dmand and supply shocks in oupu and inflaion variabiliy wih h hlp of impuls rspons funcions (IRFs) and forcas-rror varianc dcomposiion. Th rs of h sudy procds as follows: Scion discusss h horical modl whras conomric mhodology usd in h sudy is xplaind in Scion 3. Th fourh scion dals wih daa and h consrucion of variabls. Th rsuls and discussion ar givn in Scion 5, and Scion 6 concluds h sudy idnifying som policy implicaions.. THEORETICAL FRAMEWORK In a forward-looking monary policy, inflaion forcas is usd as an inrmdia arg. Consqunly, any shock which affcs inflaion forcas calls for conmporanous chang in h monary policy insrumn. Th rsulan changs in aggrga dmand inducd by his simulanous rspons mak dmand and supply shocks conmporanously corrlad. Accordingly, w firs dvlop a horical modl ha shows how h monary policy insrumn rsponds o conmporanous shocks of inflaion and conomic aciviy. Considr h following AS-AD modl: y 1 v (.1) y r u (.) Equaion (.1) rprsns xpcaions-augmnd-phillips curv, whr is inflaion ra. 3 Equaion (.) dscribs aggrga dmand rlaionship whr oupu gap, y, ngaivly dpnds on xpcd ral inrs ra, r. 4 Boh u and v ar indpndnly and idnically disribud and conmporanously uncorrlad o dmand and supply shocks. Afr simpl mahmaical manipulaion h abov quaions ak h following form: 5 y 1 1 1 (.3) For his yp of modl, s for insanc, Svnsson (1997). 3 y 1 is h xpcd valu of aggrga xpndiurs for priod, xpcd in priod 1. 4 r dnos ral inrs ra for priod +1, xpcd in priod. 5 Th daild mahmaical drivaions of Equaions (.3) and (.4) ar givn h Appndix.
y Conmporanous Corrlaion of Srucural Shocks and Inflaion-Oupu Variabiliy 147 1 y1 r (.4) Th cofficins and ar assumd o b posiiv; whr as 1 is non-ngaiv and lss han 1 and 1 may b lss han or qual o 1. In cas h monary policy is forward-looking, h objciv of h cnral bank in priod is o choos an arrangmn of currn and fuur cours of acion for policy ras ha minimiss h xpcd sum of discound squard fuur dviaions of inflaion from h arg [Svnsson (1997)], is rfrrd for mor dails] Morovr, h choic of a policy ra in priod by h cnral bank is condiional upon h informaion availabl in ha priod. Th priod loss funcion is, hrfor, givn as 1 L ( ) ( *)...... (.5) Taking Equaion (.3) on priod forward and hn making us of Equaions (.3) and (.4) would rsul in h following quaion: whr c c y c r ( 1 ) (.6) 1 1 1 1 3 1 1 1 c ( 1 1), c, c 3 In his cas, h inrs ra in priod will only affc h inflaion ra in priod +1, and onwards, and h inrs ra in priod +1 will only affc h inflaion ra in priod + and onwards, and so on. Hnc, h soluion o h opimisaion problm can b obaind by assigning h policy ra in priod o hi, on an xpcd basis, h inflaion arg for priod +1. Th sam is possibl for h fuur priods. Thus, h cnral bank can find h opimal policy ra in priod as h soluion o h simpl priod-by-priod problm: mine L( 1) (.7) i whr is h discoun facor whos valu lis bwn 0 and 1. Th firs-ordr condiion for h minimisaion of Equaion (.7) wih rspc o i givs h following rsul: 1/ * (.8) whr +1/ dnos E +1. According o Equaion (.8), h policy ra in priod should b such ha h forcas of h on-priod forward inflaion ra, condiional upon informaion availabl in priod, quals h inflaion arg. Consqunly, w can wri h loss funcion as: i 1 L ( 1/ ) ( 1/ *) (.9) Th xpcaions of Equaion (.6) illusra ha h on-priod inflaion forcas is affcd by boh h prvious and h currn sa of h conomy as is vidn from Equaion (.10) blow: c c y c r 1 / 1 1 1 3 1 (.10)
148 Nasir and Malik Assuming * = 0 and quaing h rms on h righ hand sid of Equaions (.8) and (.10) would rsul in opimal racion funcion of h cnral bank, whr r d 1 1 dy1 d3 d4 (.11) c1 c 1 d1, d, d3, and c c c 3 3 d 4 c 3 Equaion (.11) is lik h Taylor (1993) yp rul. From his quaion i is clar ha h dmand sid variabl, r, is conmporanously corrlad wih h supply sid shock,. This xplains why h mhodology of Endrs and Hurn (007) has bn usd o idnify srucural shocks, allowing for conmporanous rspons of aggrga dmand o aggrga supply shocks. Morovr, Equaion (.11) sas ha his conmporanous rspons is possibl only if monary policy is forward-looking. In cas monary policy minimiss h loss funcion dscribd in Equaion (.5), rahr han ha givn in Equaion (.9) whn h policy is no forward-looking h conmporanous rspons of aggrga dmand o supply shock will b zro. 3. EMPIRICAL METHODOLOGY Economrics go nw lif from Sims (1980), in which h inroducd h Vcor Auorgrssion (VAR) modl. Sims rspondd o Lucas Criiqu givn in Lucas (1976) by raing all variabls in h modl as ndognous. Th VAR in sandard form is a rducd form mhodology which could b simad by Ordinary Las Squars. This, howvr, gav birh o h idnificaion problm, which calls for imposing rsricions on som of h srucural paramrs so ha idnificaion could b achivd. On rspons cam in h form of Cholsky dcomposiion which providd an addiional quaion for h idnificaion of h srucural modls [Endrs (004)]. Howvr, h VAR analysis was criicisd by many conomiss arguing ha hs modls could only b usd for forcasing purpos and no for policy analysis [Sargn (1979, 1984); Larnr (1985)]. In rspons o his criicism, h Srucural Vcor Auorgrssion (SVAR) approach was dvlopd by Sims (1986), Brnank (1986) and Blanchard and Wason (1986). Th SVAR approach allows for imposing rsricions on h basis of conomic hory. Nvrhlss, h SVAR dvlopd by h abov mniond auhors imposd only shor-run rsricions on h srucural paramrs for idnificaion purpos. An xnsion o h SVAR of Sims (1986) and ohrs wr mad by Shapiro and Wason (1988) and Blanchard and Quah (1989) by imposing long-run rsricions on h srucural paramrs. Espcially, h mhodology dvlopd by Blanchard and Quah (1989), hncforh B-Q, go rmndous populariy among h conomiss bcaus h assumpions usd by his mhodology for h xac idnificaion of srucural shocks wr innocuous. This mhodology assums ha h srucural shocks ar orhogonal; hs shocks ar normalisd o hav uni varianc; and on srucural shock has no long run ffc on on of h variabls. In an AD-AS modl, h firs assumpion would man ha h aggrga dmand and aggrga supply shocks ar uncorrlad, whil h hird assumpion would imply ha h aggrga dmand shocks hav no ffc on oupu in h long run.
Conmporanous Corrlaion of Srucural Shocks and Inflaion-Oupu Variabiliy 149 Howvr, h assumpions of B-Q also facd criicism by boh conomiss and conomricians. For xampl, h Nw Kynsian conomiss argu ha monary shocks nd no b nural [Mankiw and Romr (1991)]. On h ohr hand, Waggonr and Zha (003) and Hamilon, al. (004) gav informaion abou h imporan consquncs for saisical infrnc of diffrn normalisaions in a srucural VAR. Similarly, Covr, al. (006) argus ha hr ar sound conomic rasons for allowing a conmporanous corrlaion bwn h aggrga dmand and aggrga supply shocks. Spcifically, i poins o h inrmporal opimising modls and h Nw Kynsians modls in which aggrga supply may rspond posiivly o a posiiv aggrga dmand shock. Hnc, Covr, al. (006) allowd for h conmporanous corrlaion bwn h srucural shocks and his corrlaion was found o b 0.576 for h US. Endrs and Hurn (007) hn xndd h alrnaiv mhodology dvlopd in Covr, al. (006) for a small opn conomy and allowd for h conmporanous corrlaion bwn h srucural shocks for h rason ha h conomy was following an inflaion arging policy. Th corrlaion bwn h srucural shocks was found o b 0.736. In h following lins w discuss h conomric mhodology usd in h sudy. W discuss boh h B-Q mhodology, proposd by Blanchard and Quah (1989), and h alrnaiv mhodology dvlopd by Endrs and Hurn (007) for a small opn conomy, as boh h mhodologis ar usd in h sudy. 3.1. Th Blanchard-Quah Mhodology Suppos h ral forign oupu, h ral domsic oupu, and h domsic inflaion ra ar rprsnd by y ˆ, y and rspcivly. Thn a VAR modl for a small opn conomy, as in Endrs and Hurn (007), can b wrin as: k y ˆ 11ˆ y j 1 j1 k k k y 1ˆ y j y j 3 j j0 j1 j1 k j0 k k 31ˆ y j 3y j 33 j 3 j1 j1 (3.1) I is obvious from h srucur of h abov quaion ha h forign oupu volvs indpndnly of domsic variabls for h rason ha h domsic counry is assumd o b a small opn conomy. Nonhlss, h sam small-counry assumpion rquirs h domsic variabls o b dpndan on h currn and laggd valus of forign oupu. Th rgrssion rsiduals, 1, and 3 ar assumd o b linkd o ach ohr hrough hr diffrn srucural shocks, namly, a forign produciviy shock, 1, a domsic supply shock,, and a domsic dmand shock, 3. On of h imporan asks is h idnificaion of h hr srucural shocks, 1, and 3, from h VAR rsiduals, sinc hs srucural shocks ar no obsrvabl. Suppos h unobsrvabl srucural shocks and h obsrvabl VAR rsiduals ar linkd by h following rlaionship:
150 Nasir and Malik 1 3 h h h 11 1 31 h h h 1 3 h h 3 h 13 33 1 3 (3.) So hr ar fifn unknowns in his s-up ha nd o b idnifid. Ths unknowns includ nin lmns, h ij, of h marix H, and hr variancs along wih h hr covariancs 1,, 1 3 3,, 1 3 of h varianc-covarianc marix of h srucural shocks. Th varianc-covarianc marix of h VAR rsiduals is givn by: H H (3.3) s Hnc, six of h fifn rsricions, rquird for h xac idnificaion, ar providd by h disinc lmns of h varianc-covarianc marix of h VAR rsiduals. Th sandard Blanchard-Quah mhodology assums ha all h variancs ar normalisd o uniy ( 1) and all covariancs ar qual o zro ( 1 = 13 = 3 = 1 3 0). Morovr, h domsic shocks do no affc h larg counry, h h 0, and 1 13 finally and mos imporanly, h dmand shocks hav no ffc on domsic oupu in h long run: k 3 1 33 1 0 1 33 k h j h 1 3 j (3.4) i i Thus, wih all hs fifn rsricions, h idnificaion is achivd in h B-Q mhodology. Howvr, Waggonr and Zha (003) and Hamilon, al. (004) hav warnd ha normalisaion can hav ffcs on saisical infrnc in a srucural VAR. Th main objcion, nonhlss, is raisd by Covr, al. (006) and Endrs and Hurn (007) abou h assumd orhogonaliy of h srucural shocks in BQ mhodology. Thy argu ha, in h prsnc of a normal dmand curv, a ngaiv supply shock will rduc oupu and incras inflaion. Howvr, if h counry is following h inflaion arging sragy, hn h monary auhoriis will conmporanously rais h policy ra o shif h dmand curv inward in ordr o kp inflaion on arg. Th rvrs will b don in cas of a posiiv supply shock. This implis ha h corrlaion bwn h dmand and supply shocks may no ncssarily b zro. Th orhogonaliy assumpion of B-Q mhodology dos no l dmand o rspond o supply shocks and hnc in his mhodology h corrlaion is forcibly s qual o zro. 3.. Th Alrnaiv Mhodology Endrs and Hurn (007) sar wih h following simpl AD-AS modl: s y E 1 y ( E 1 ) 1 d d y E 1 ( y ) 3 s d y y (3.5)
Conmporanous Corrlaion of Srucural Shocks and Inflaion-Oupu Variabiliy 151 In his modl, E 1 y and E 1 ar h xpcd domsic oupu and inflaion in priod condiional upon h informaion availabl a h nd of priod 1. Th suprscrips s and d rprsn supply and dmand, rspcivly. I is obvious ha h firs quaion is h Lucas supply curv and h scond quaion rprsns aggrga dmand rlaionship. This AD-AS modl is consisn wih a VAR if agns form hir xpcaions basd on i. Taking on priod lag of Equaion (3.1) and hn aking h condiional xpcaions will rsul in E 1 y and E 1. Th paramrs of h macroconomic modl nr ino h following marix H, placing rsricions on h rlaionships bwn h rgrssion rsiduals and h srucural shocks: h 11 0 0 H /(1 ) 1/(1 ) /(1 ) (3.6) /(1 ) 1/(1 ) 1/(1 ) Hr h six lmns of h simad varianc-covarianc marix of VAR rsiduals can b usd for h idnificaion of hr variancs and hr covariancs of srucural innovaions along wih h 11,,. For h idnificaion of h whol sysm, hr mor rsricions includ h 11 = 1, 1 = 0, and h long-run nuraliy of dmand shock. This dcomposiion diffrs from h sandard BQ dcomposiion in hr ways. Firs, h assumpion of normalisaion of all srucural shocks o uniy is no imposd. Scond, no rsricion has bn imposd on h conmporanous corrlaion bwn srucural shocks. I is allowd o b drmind indpndnly wihin h modl. Third, h small counry assumpion oulins ha domsic shock has no ffc on global conomy. 4. DATA AND CONSTRUCTION OF VARIABLES This sudy uss quarrly daa ovr h priod 1991:4 o 010: for Pakisan s conomy. 6 Th consan pric GDP is usd o rprsn domsic ral oupu. For his purpos, w nd o hav h sris of quarrly ral GDP for Pakisan. Kmal and Arby (004) hav consrucd such sris for Pakisan for h priod 1975-004, whras w us daa up o 010:. Nonhlss, h absnc of rnds and h ngligibl varianc in h alrady idnifid shars for h rspciv quarrs in diffrn yars jusify h us of avrag of hs quarrly shars for h nx fw yars o obain h valus of quarrly ral GDP. Daa on GDP is hn sasonally adjusd using X1 mhod. Furhrmor, h domsic inflaion ra is calculad using h daa on CPI. W hav no usd Unid Sas GDP o rprsn forign oupu. Du o is larg siz of h conomy and bing h major rading parnr of many counris, h Unid Sas is xpcd o affc h conomic nvironmn of is parnrs. Tha is why mos sudis ak h ral GDP of h US as proxy for h nir xrnal scor, [for insanc in Endrs and Hurn (007)]. Howvr, his may no b a ru rprsnaiv of an xrnal shock. Subsqunly, h US GDP may no b a suiabl proxy of forign oupu for 6 Th rason for no xnding his priod byond 1991 is ha h SBP was no indpndn in sing h policy insrumn bfor financial scors rforms iniiad in 1989.
15 Nasir and Malik Pakisan as i is no h only rad parnr which can hav significan ffcs on Pakisan s conomy. Alhough h US has major shar in h xpor composiion of Pakisan, Saudi Arabia has a major impor shar in h impor porfolio. In ordr o avoid any ambiguiy, hrfor, w hav consrucd an indx of h forign oupu whr major rading parnrs of Pakisan ar rprsnd. Ths counris includ h US, UK, Japan, Grmany, Saudi Arabia, Kuwai and Malaysia. Th indx is consrucd by aking h wighd avrag of is parnrs GDP whr h wighs ar Pakisan s rad shars wih ach counry. 7 Th sourcs of daa for consrucion of h indx of forign oupu includ Inrnaional Financial Saisics (IFS) and various issus of Economic Survy of Pakisan. 5. RESULTS AND DISCUSSION 5.1. Uni Roo and Coingraion Tss Th applicaion of Vcor of Auorgrssion (VAR) rquirs absnc of uni roos in variabls. Morovr h variabls should no b coingrad. Thrfor, in ordr o chck whhr h variabls ar saionary or ingrad o som ordr, h Augmnd Dicky-Fullr (ADF) s has bn usd. Th rsuls of h ADF s ar rpord in Tabl 1 blow. Tabl 1 Rsuls of h Uni Roo Ts Saisics Variabls Lvl Firs Diffrnc Conclusion Forign Oupu 1.190 3.610 ** I(1) Domsic Oupu 1.464 1.30 *** I(1) Inflaion 1.490 6.395 *** I(1) No: Th rgrssions includ a consan. Th ** and *** show rjcion of null hypohsis a 5 prcn and 1 prcn lvls of significanc rspcivly. Th rsuls of h ADF s in h abov abl indica ha all variabls ar nonsaionary a convnional lvls of significanc. Howvr, all hs variabls ar saionary a firs diffrnc and hnc ar ingrad of ordr 1. Nonhlss, h applicaion of h VAR modl ncssias h absnc of any coingraing rlaionship among h s of non-saionary variabls. Thus i is dsirabl o chck h numbr of coingraing vcors among hs variabls. For his purpos, w mak us of Johansn s approach o invsiga h rlaionship among h hr variabls. Tabl porrays h rsuls. 7 A problm ha is confrond is h unavailabiliy of boh Ral GDP in volum and GDP Indx for som counris such as Saudi Arabia and Kuwai on quarrly basis. So w hav akn h Indx of Crud Prolum Producion as proxy of GDP Indx for hs wo counris.
Conmporanous Corrlaion of Srucural Shocks and Inflaion-Oupu Variabiliy 153 Tabl Johansn Ts for h Coingraing Rlaionship No. of CE(s) Trac Saisics 5% Criical Valu Max. Eign Saisics 5% Criical Valu Non 15.131 9.797 8.833 1.131 A mos 1 6.97 15.494 5.560 14.64 A mos 0.737 3.841 0.737 3.841 No: Th Johansn coingraion s is conducd using wo lags which ar chosn using AIC. Th s usd h spcificaion which allows for an inrcp rm bu hr is rnd nihr in coingraing quaion nor in VAR. Rsuls in Tabl rval ha h null hypohsis of h absnc of coingraing rlaionship canno b rjcd a h convnional significanc lvls. Boh rac saisics and maximum ignvalu saisics confirm h absnc of any coingraion vcor. Th absnc of coingraing rlaionship ncssias h applicaion of VAR in h firs diffrnc. 5.. Esimaion Rsuls 5..1. Rsuls of h Sandard B-Q Dcomposiion Th rsuls of h sandard Blanchard-Quah dcomposiion bring forh h drminans of oupu and inflaion in Pakisan. 8 I is vidn from h forcas-rror varianc dcomposiion rpord in Tabl 3 ha dmand shocks do no xplain any significan variaion in domsic oupu a any forcasing horizon. Afr hr priods, h xplaind variaion in oupu du o dmand shocks rmains a 0.1 prcn for h rs of h horizon. On h ohr hand, domsic supply shocks hav a dominan rol in oupu variaion. Almos 88 prcn of variaion in oupu is aribud o domsic supply shocks. Howvr, h forign GDP shocks xplain lil (around 11.7 prcn) oupu variabiliy. Rsuls in Tabl 3 also dmonsra h drminans of inflaion variabiliy. Inrsingly, all h hr shocks conribu o inflaion variabiliy. For h firs wo quarrs, for insanc, boh domsic supply shocks and forign GDP shocks xplain 3 prcn and 38 prcn variaions rspcivly. Howvr, byond his wo-sp horizon, h xplaind variaion by h wo shocks changs o 36 prcn and 33 prcn rspcivly. Likwis, h dmand shocks iniially xplain 38 prcn variaion in inflaion which hn slids down o 30.5 prcn afr h wo-priod horizon. Tabl 3 Forcas-rror Varianc Dcomposiion Using B-Q Dcomposiion Prcnag Variaion in Domsic Oupu du o Prcnag Variaion in Domsic Inflaion du o Horizon FGDPS DSS DDS FGDPS DSS DDS 1 11.437 88.484 79 38.114 3.454 38.340 194 89.0 85 38.6 3.396 38.377 3 11.350 88.530 0.119 33.003 36.07 30.95 4 11.655 88.4 0.11 33.083 36.96 31 5 11.683 88.196 0.11 33.137 36.61 30 6 11.74 88.156 0.11 33.18 36.19 30.563 7 11.79 88.150 0.11 33.15 36.5 30.559 8 11.733 88.146 0.11 33.5 36.0 30.555 9 11.734 88.145 0.11 33.5 36.0 30.554 10 11.735 88.145 0.11 33.6 36.0 30.554 No: FGDPS= Forign GDP Shock, DSS= Domsic Supply Shock, DDS= Domsic Dmand Shock. 8 Th simaion rsuls ar obaind using RATS sofwar.
154 Nasir and Malik Th rsuls of Tabl 3 highligh som imporan issus ha call for anion. Firs, h forign GDP shocks xplain smallr variaion in oupu and rlaivly grar variaion in inflaion. So h ffcs of h shocks ransmi mor o pric lvl han o oupu in Pakisan. This is ru for mos dvloping counris which confron h problm of capaciy uilisaion du o various rasons such as unskilld workforc, nrgy criss, wak infrasrucur c. Furhrmor, his parn is mor likly if h bask of impord goods conain mor finishd producs han inrmdia producs. Th scond issu is concrnd wih h ffcs of h shock on diffrn forcas horizons. As is vidn from h abov abl, afr h wo-sp horizon, h inflaion variabiliy, xplaind by forign oupu shocks, rducs whras ha by h domsic supply shocks incrass. On possibl inrpraion is ha h ffcs of forign shocks ransla ino domsic supply shocks. For xampl, an advrs oil pric shock is iniially a forign supply shock for Pakisan. Howvr, afr som im h ffcs of incrasd oil pric ransmi o domsic prics which ulimaly rsul in backward shif of h aggrga supply curv. Th impuls rspons funcions for h sandard B-Q modl ar illusrad in Figur 1. On can asily obsrv h similariy of rsuls shown boh by h varianc dcomposiion and h impuls rspons funcions. Panl a of Figur 1 dmonsras ha on uni shock in forign oupu shifs h domsic oupu up by 0.35 unis in h firs quarr, 9 sandard dviaion in h scond quarr, and 8 sandard dviaions in h hird quarr. Afrwards, h succssiv valus of domsic GDP sadily convrg o zro. Th rason for h posiiv ffc of forign GDP shock on domsic oupu is mor han obvious. A favourabl oupu shock in forign counris will rais hir naional incoms. Sinc a counry s xpors dpnd on hr rading parnrs incom, hr will b an incras in dmand for Pakisani xpors, hrby boosing h domsic oupu. Panl b confirms ha h domsic supply shocks hav significan ffc on oupu. Th ffc, howvr, is shor-livd as i convrgs o zro in h scond quarr. Dmand shocks do no affc oupu as is vidn from Panl c. Th possibl rason could b h assumpions in h sandard Blanchard- Quah modl ha call for long run nuraliy of dmand shocks and h zro corrlaion bwn aggrga dmand and aggrga supply shocks. Th rsuls in panl d illusra ha forign oupu shocks hav posiiv ffcs on domsic inflaion as wll. As xplaind arlir, h ffc of forign shocks, whhr posiiv or ngaiv, ar absorbd mor by h pric lvl han by domsic oupu. Panl suggss ha a favourabl domsic supply shock will rduc inflaion in h firs quarr. Though i gos up in h scond quarr, possibly du o h cobwb phnomnon, i convrgs o zro in h fourh quarr. Panl f indicas ha dmand shocks posiivly affc inflaion. A on uni dmand shock incrass inflaion by 0.97 unis in h firs quarr. Howvr, h succssiv valus of h ffc on inflaion, hrafr, convrg o zro. This mans ha in h B-Q mhodology, approximaly h whol ffc of h dmand shock is absorbd by inflaion only. Covr, al. (006) and Endrs and Hurn (007) argu ha hs rsuls may b h consqunc of h assumpions of sandard B-Q modl. W now urn o h rsuls obaind by using Endrs and Hurn (007) mhodology.
Conmporanous Corrlaion of Srucural Shocks and Inflaion-Oupu Variabiliy 155 Fig. 1. Plos of h Sandardisd Impuls Rspons Funcions for B-Q Dcomposiion Ral GDP Rsponss Ral GDP Rsponss Inflaion Rsponss Inflaion Rsponss Panl a: Panl Rspons a: o o Forign Forign GDP ShockGDP Shock Panl d: Panl Rspons d: o o Forign Forign GDP ShockGDP Shock 0. 0. -0. 0 1 3 4 5 6 7 8 9-0. 0 1 3 4 5 6 7 8 9 Panl b: Rspons Panl b: o Domsic Domsic Supply Shock Supply Shock Panl : Rspons Panl : Rspons o o Domsic Supply Shock Supply Shock 0. 0. -0. - -0. - - - 0 1 3 4 5 6 7 8 9-0 1 3 4 5 6 7 8 9 Panl c: Panl Rspons c: o Dmand o Dmand Shock Shock Panl f: Panl Rspons f: o Dmand o Dmand Shock Shock 0. 0. -0. 0 1 3 4 5 6 7 8 9-0. 0 1 3 4 5 6 7 8 9 5... Rsuls of h Alrnaiv Dcomposiion Inrsingly, h rsuls obaind by using h alrnaiv modl ar no much diffrn from hos of h sandard Blanchard-Quah modl. This is obvious from boh Tabl 4 and Figur. Boh h forcas-rror varianc dcomposiion and h impuls rspons funcions obaind using h idnifid srucural shocks dmonsra almos h sam parn as was found for B-Q dcomposiion. Tabl 4 rsuls indica ha dmand shocks xplain only 0.16 prcn variaion in oupu byond a wo-sp horizon. This suggss ha dmand shocks do no hav significan ffc on oupu in Pakisan. On h ohr hand, oupu variabiliy is xplaind mor (88 prcn) by h domsic supply shock. Forign oupu shocks xplain only 11.86 prcn of h variaion in oupu.
156 Nasir and Malik Tabl 4 Forcas-rror Varianc Dcomposiion Using Alrnaiv Dcomposiion Prcnag Variaion in Domsic Prcnag Variaion in Domsic Oupu du o Inflaion du o Horizon FGDPS DSS DDS FGDPS DSS DDS 1 11.564 88.311 0.16 33.370 33.568 33.06 119 88.849 0.13 33.479 33.416 33.105 3 11.474 88.361 0.165 9.666 4.948 7.387 4 11.78 88.05 0.167 9.774 43.074 7.15 5 11.810 88.03 0.166 9.86 43.036 7.138 6 11.851 87.98 0.166 9.903 4.991 7.107 7 11.856 87.977 0.166 9.901 4.995 7.104 8 11.861 87.973 0.166 9.910 4.990 7.100 9 11.861 87.97 0.166 9.910 4.990 7.100 10 11.86 87.97 0.166 9.911 4.989 7.099 As rpord in Tabl 4, all h hr yps of srucural shocks conribu in xplaining variaion in inflaion vn in his dcomposiion. Howvr, h variaion xplaind by domsic supply shocks incrasd o 43 prcn in h currn dcomposiion compard o 36 prcn obaind using h BQ mhod. Nvrhlss, h conribuion of dmand shocks and forign oupu shocks o inflaion variabiliy dclins from 30.5 prcn and 33 prcn o 7 prcn and 30 prcn rspcivly. Hnc, h rsuls obaind from alrnaiv dcomposiion do no significanly diffr from hos obaind hrough B-Q dcomposiion. Howvr, h findings of his work ar in significan conras o boh Endrs and Hurn (007) and Covrs, al. (006) who found ha h ffc of dmand shocks was mor on oupu and lss on inflaion. Th rsuls of impuls rspons funcions in Figur ll a similar sory. Ths rspons funcions ar obaind using srucural shocks idnifid by alrnaiv dcomposiion. Rsuls in panl a show ha a on uni forign GDP shock raiss h oupu by 0.35 unis in h firs quarr, and afr h hird quarr, h succssiv valus of h shock convrg o zro. I is clar from panl b ha a favourabl domsic supply shock has immdia ffc on oupu, and h ffc sars dclining o zro afr h scond quarr. Y again, dmand shocks fail o show any significan impac on oupu as is vidn from Panl c. Th impac of forign oupu shocks, domsic supply shocks, and dmand shocks on inflaion ar porrayd in Panls d, and f rspcivly. Ths rspons funcions confirm and valida h rsuls shown by h forcas-rror varianc dcomposiion.
Conmporanous Corrlaion of Srucural Shocks and Inflaion-Oupu Variabiliy 157 Fig.. Plos of Sandardisd Impuls Rspons Funcions for Alrnaiv Dcomposiion Ral GDP Rsponss Ral GDP Rsponss Panl a: Rspons o Forign GDP Shock Panl a: Rspons o Forign GDP Shock Inflaion Rsponss Inflaion Rsponss Panl d: Rspons o Forign GDP Shock Panl d: Rspons o Forign GDP Shock 0. 0. -0. 0 1 3 4 5 6 7 8 9-0. 0 1 3 4 5 6 7 8 9 Panl b: Rspons Panl b: Rspons o Domsic Domsic Supply Shock Supply Shock 0 Panl : Rspons Panl : Rspons o Domsic Domsic Supply Shock Supply Shock 0.75 0.50 0.5 0 0. -0. -0.5-0.50-0.75-0 - 0 1 3 4 5 6 7 8 9-1.5 0 1 3 4 5 6 7 8 9 Panl c: Rspons o Dmand Shock Panl c: Rspons o Dmand Shock Panl f: Rspons o Dmand Shock Panl f: Rspons o Dmand Shock 0. 0. -0. 0 1 3 4 5 6 7 8 9-0. 0 1 3 4 5 6 7 8 9 5.3. Conmporanous Corrlaion of Dmand and Supply Shocks Th main objciv of his sudy is o sablish whhr or no h Sa Bank of Pakisan (SBP) rsponds conmporanously o supply sid shocks. For his purpos, h conmporanous corrlaion was allowd bwn h wo srucural shocks. Using h alrnaiv dcomposiion mhod mniond abov, h findings suggs ha hr is corrlaion of only 41 bwn h wo shocks which is ngligibl. Consqunly, i may b concludd ha h SBP has no bn rsponding conmporanously o supply sid shocks. 9 This rsul poins o h fac ha h policy has no bn forward-looking in h sampl priod. Anohr possibl rason for his rsul may b h absnc of a propr forcasing modl wih h SBP, a las unil rcnly. 5.4. Esimaion Rsuls for Sub-sampl Priod I is usually blivd ha h appoinmn of Ishra Hussain as Govrnor of h SBP was h bginning of an ra whn h cnral bank sard njoying rlaivly grar 9 Th finding ha h SBP has no bn following inflaion arging policy is consisn wih Malik and Ahmd (007) who find, whil simaing Taylor rul, h cofficin of inflaion is lss han on failing o saisfy h rquirmn of Taylor principl.
158 Nasir and Malik indpndnc from h govrnmn sinc h insiuion of financial scor rforms. This provids h grounds for h us of a sub-sampl priod for his analysis. Using daa ovr h priod 1999:1 o 010:, boh h B-Q and alrnaiv mhodologis hav bn usd for h idnificaion of srucural shocks as wll as for h dcion of any conmporanous corrlaion among hs shocks. Th rsuls of forcas-rror varianc dcomposiion using boh mhodologis ar rpord in Tabl 5 and Tabl 6. I is clar ha hr is no significan diffrnc in oucoms of boh mhodologis. Th rsuls in Tabl 6 show ha h forign oupu shock, domsic supply shock and domsic dmand shock xplain, rspcivly, 31 prcn, 69 prcn and 0.1 prcn of variaion in oupu. Similarly, i is found ha 5 prcn of inflaion variabiliy is xplaind by forign oupu shock, 31.5 prcn by domsic supply shock, and 16.6 prcn by domsic dmand shock. Th rsuls for h B-Q modl ar h sam wih a sligh diffrnc of approximaly 1 prcn. Tabl 5 Forcas-rror Varianc Dcomposiion Using B-Q Dcomposiion Prcnag Variaion in Domsic Oupu du o Prcnag Variaion in Domsic Inflaion du o Horizon FGDPS DSS DDS FGDPS DSS DDS 1 33.417 66.518 64 58.446 19.94.61 370 69.54 85 59.13 18.909 1.968 3 353 69.4 0.106 53.71 8.994 17.94 4 307 69.83 0.110 53.07 9.89 17.081 5 373 69.17 0.110 5.99 9.943 17.065 6 30.758 69.13 0.110 5.97 9.988 17.041 7 30.770 69.119 0.110 5.979 9.988 17.033 8 30.783 69.107 0.110 5.994 9.979 17.07 9 30.784 69.105 0.110 5.997 9.977 17.06 10 30.785 69.105 0.110 5.999 9.976 17.05 Tabl 6 Forcas-rror Varianc Dcomposiion Using Alrnaiv Dcomposiion Prcnag Variaion in Domsic Oupu du o Prcnag Variaion in Domsic Inflaion du o Horizon FGDPS DSS DDS FGDPS DSS DDS 1 33.510 66.416 74 56.816 1.640 1.544 30.767 69.137 96 57.535 1.180 1.85 3 30.751 69.13 0.117 5.584 30.558 16.858 4 30.707 69.171 0.1 51.935 31.407 16.658 5 30.77 69.106 0.1 51.903 31.453 16.643 6 357 69.01 0.1 51.886 31.494 16.60 7 370 69.008 0.1 51.894 31.494 16.613 8 383 68.996 0.1 51.908 31.484 16.608 9 384 68.994 0.1 51.911 31.48 16.607 10 385 68.993 0.1 51.913 31.481 16.606
Conmporanous Corrlaion of Srucural Shocks and Inflaion-Oupu Variabiliy 159 Howvr, h rsuls of his sub-sampl ar much diffrn in rms of xplanaion of variaion in oupu and inflaion from hos of h full sampl. For insanc, wih h alrnaiv dcomposiion, variabiliy in oupu and inflaion xplaind by forign GDP shock incras from 1 prcn and 30 prcn o 31 prcn and 5 prcn rspcivly. This indicas h incrasd xposur of domsic conomy o forign shocks in h sub sampl priod. Likwis, h rol of domsic supply shock in boh oupu and inflaion variabiliy rducs o 69 prcn and 31.5 prcn rspcivly. Nonhlss, i sill rmains h major sourc of variaion in oupu. Inrsingly, h rol of dmand shock in inflaion variabiliy rducs from 9 prcn o 16.6 prcn. This is an imporan rsul for h SBP o considr whn i gos for igh monary policy o rduc inflaion in h conomy. Th lssr shar of dmand shocks in xplaining inflaion variabiliy suggss ha h SBP should b carful whil conrolling inflaion, hrough dmand managmn policy, as i may b causd mor by supply shocks. Y again, dmand dos no play any significan rol in oupu variabiliy for h sub-sampl priod. 10 Finally, h findings of his sudy giv no indicaion of a forward-looking policy vn in his ra of cnral bank indpndnc. In fac, h conmporanous corrlaion cofficin bwn dmand and supply shocks rducs o 1, which is lss han h valu obaind for h nir priod of h analysis. This shows h prsnc of nough fiscal prssur for h SBP o b no abl o arg an xplici inflaion ra. 6. CONCLUSIONS AND POLICY IMPLICATIONS Th objcivs of his sudy includ h idnificaion of srucural shocks, xamining h rlaiv conribuions of hs srucural shocks in oupu and inflaion variabiliy, and h invsigaion of whhr or no h SBP rsponds conmporanously o supply sid shocks. For his purpos, us has bn mad of h Srucural Vcor Auorgrssion (SVAR) by considring boh Blanchard-Quah mhodology and an alrnaiv mhodology iniially dvlopd by Covr, al. (006) and lar xndd by Endrs and Hurn (007). Som imporan findings ar givn in h following lins. Th firs and h main finding of h sudy is ha h SBP has no bn pursuing a forward-looking policy. Th conmporanous corrlaion bwn h aggrga dmand and aggrga supply in Pakisan is only 41, which suggss a ngligibl conmporanous policy rspons o supply-sid shocks. Th scond oucom is concrnd wih h rol of srucural shocks in xplaining variaion in boh inflaion and oupu. Inrsingly, bu no surprisingly, h rsuls of boh mhodologis do no diffr significanly. Th domsic supply shock is considrd o b h major facor conribuing in oupu variabiliy, followd by forign shock. Domsic dmand shock, on h ohr hand, dos no play a significan rol in oupu variaion. Morovr, h domsic supply shock is h cnral caus of variaion in inflaion wih forign supply shock a h scond and domsic dmand shock a h hird plac. Th hird finding concrns h impac of forign supply shock on domsic oupu and inflaion. A posiiv forign supply shock affcs domsic inflaion mor han h domsic oupu. This may b du o h fac ha whnvr du o incras in forign 10 Lik h forcas-rror varianc dcomposiion, hr is no any significan diffrnc in h impuls rspons funcions of h wo dcomposiions for h slcd sub-sampl. Ths rsuls of h IRFs can b obaind on rqus from h auhors.
160 Nasir and Malik oupu, h incom of forignrs and, consqunly, h dmand for Pakisani xpors riss, h conomy dos no rspond posiivly or in a suiabl mannr. Insad of incrasing domsic oupu, h ffc of h shock is allowd o ransmi mor o h pric lvl. Th wak rspons of oupu may b h rsul of an infficin ral scor bcaus of unskilld labour forc, wak infrasrucur, and nrgy consrains c. Th rsuls of his sudy bring forh imporan policy implicaions. Firsly, and mos imporanly, h cnral bank should b carful in conrolling inflaion hrough igh monary policy. An incras in inrs ra in ordr o rduc dmand may no rduc inflaion o h dsird xn as dmand conribus lss o inflaion. Rahr, h cos channl of monary policy may com ino play. In his conx, h coninuous incras in h policy ra by h SBP in rcn ims can b said o b undsirabl. Morovr, a igh monary policy may no b fficin in h absnc of coordinaion bwn dmand managmn policis. Scondly, h policy-makrs should avoid xploiing inflaion-oupu rad-off, sinc h rol of dmand in oupu growh is ngligibl. In his sudy h rsarchrs hav modlld monary policy on h conmporanous rspons of dmand o supply shock. Thrfor, for fuur rsarch, i will b mor appropria if inrs ra is dircly includd in h VAR as a monary policy insrumn. This is imporan as monary policy is no h only facor ha maks changs in dmand. Subsqunly, by including inrs ra in h modl, on can diffrnia among changs in dmand brough abou by monary policy and hos by h ohr facors. or APPENDIX L h xpcaion augmnd Phillips Curv is givn by h following quaion: y 1 v (I) Also w know ha y a( y y ) 1 y 1 ay 1 ( 1 a) y (II) Now aking Equaion (I) on priod backward and solving for following quaion: y givs h 1 1 y 1 v 1 (III) Subsiuing Equaion (III) in Equaion (II) would rsul in following: 1 1 y 1 ay 1 ( 1 a) 1 v 1 (IV) Subsiuing quaion (IV) in Equaion (I) would giv h following rsul: y 1 1 (V)
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