Modelling inflation and the demand for money in Pakistan; cointegration and the causal structure

A popular long-run condition tying down the price level is purchasing power parity (PPP), but prices also figure in the long-run money demand relation ship. This suggests that inflation be modelled within a multivariate cointe gration context, where PPP and money demand form long-run attractors, in a generalisation of the P-Star approach. This is one interpretation of the si ngle-equation results in previous work; but, ideally, a systems estimator i s called for. In Pakistan, long runs of quarterly data are scarce, which ma kes the use of the Johansen technique problematic, as it is profligate with degrees of freedom and has uncertain small sample properties. A SUR system is therefore estimated, with the long-run relationships explicitly identif ied. This methodology meets with some success, and may offer a paradigm for estimation of cointegrating systems for other, similar countries. We find that a well defined money demand relationship can be identified and that bo th PPP and money demand act as long-run attractors for prices (the CPI). Th e loadings indicate that the monetary authority have used the exchange rate as an anti-inflation mechanism, rather than accommodating PPP deviations. When the CPI is below the PPP condition, the exchange rate rises (depreciat es). This feeds into prices via the PPP attractor. Finally, monetary policy accommodates PPP deviations. (C) 1999 Elsevier Science B.V. All rights res erved.