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DOMESTIC DEBT AND INFLATIONARY EFFECTS: EVIDENCE FROM

PAKISTAN

1.1. INTRODUCTION

Since the beginning of the twenty-first century, heavy indebtedness of the developing countries

has been one of the major development policy issues. Public debt is sum of external debt and

domestic debt. Indeed, much of the extraordinary growth in the developing countries since the

1!"#s can be described as debt-related. $omestic debt is a fundamental tool used by the

governments in both developed and less developed countries to finance internal and external

gaps. Similarly, Pa%istan is using domestic borrowing to pay the foreign debt servicing. &Shei%h,

'aridi ( )ari* +"1".

/hen the resources in the form of debt are properly and efficiently utili0ed then this enhances

the productive capacity and economic growth through development related projects. owever, if

the debt is not effectively utili0ed and managed, it creates problems for the economy. It is

observed that, in developing and emerging countries the problem is not the domestic debt but the

cost of domestic debt in the determination of the inflation rate. In developing economies, a

higher price level in accordance with higher costs of borrowing is an important phenomenon that

differentiates developing economies from emerging economies &2ildirici ( 3rsin +""4.

/henever there is an increase in the general price level, the value of money or purchasing power

of money decreases. Inflation is a %ey macroeconomic indicator of a country, providing an

important insight into the state of the economy. 5s borrowing from the central ban% doesn#t

involve a direct cost but carries a serious ris% of inflation due to excess aggregate demand caused

by an increase in money supply. )herefore, if the government borrows directly from central ban%

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in the form of printing money. It is a very inflationary approach and is not usually encouraged.

6n the other hand, if the government has a loan from central ban% to finance its expenditures and

meet financial difficulties, it issues some treasury bills in exchange for debt. If the government

fails to collect revenues through tax or non-tax sources then it lead to increase in the money

supply. )hus price level decreases &7uhammad, 7uhammad ( 8hadija +"1.

)he main objective of the study is to see the impact of domestic debt on inflation. )he

organi0ation of the assignment is as follow9 Section 1. describes the econometric model and its

specification. /hile 1.: discusses the theoretical justification of the variables.

1.2. ECONOMETRIC MODEL AND SPECIFICATION

)he econometric model of the underlying study is as follow9

t t t t t t t GE EX IP TDD M CPI µ α α α α α α ++++++= !;:,1" ,

t t t t t t ER IT DD INT BDCPI µ α α α α α +++++= ;:,1"

<

)he dependent variable of the model is =PI, which is used to show price level. )he focused

independent variables of the study are domestic debt and domestic debt servicing. 'irst e*uation

will estimate by incorporating the domestic debt. /hile, second e*uation contains domestic debt

servicing.

CPI = Consumer Price Index

M2 = Money Supply

TDD = Totl Domestic De!t

IP = Pri"te In"estment

EX = Exports

GE = Go"ernment Expenditures

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BD = Bud#et De$icit

INT%DD = Interest Rte on domestic de!t &Domestic De!t Ser"icin#'

IT = Indirect Txes

ER = Exc(n#e Rte

)= Error Term

)he data used in this study have been ta%en from the various issues of the *nnul Reports of the

State 2an% of Pa%istan and the Economic Sur"ey of Pa%istan by government of Pa%istan. )he

time span of this study is from period 141-4 to "">-". 5ll the variables have been expressed

in millions rupees except =PI and 3xchange ?ate.

1.3. THEORETICAL JUSTIFICATION OF VARIABLES

)here are numerous schools of thought to be found within literature with differing views on the

subject of inflation and its relationship with the other macroeconomic variables.

5ccording to the monetarist school of thought, inflation is a monetary phenomenon. )he

@uantity )heory of 7oney proposed by 7ilton 'riedman suggests a direct and proportional

relationship between the money supply and the price level. )he theory argues that the money

supply has an influence only on the nominal variables i.e. prices and nominal wages while real

variables do not change. /henever the central ban% announces expansionary monetary policy

then this would lead to increase in the price level. So money supply and prices are expected to

have positive relationship.

)he $emand pull inflation approach suggests a positive relationship between aggregate demand

and the price level at a constant level of output. 5s both exports and government purchases are

part of aggregate demand, when there is an increase in the components of aggregate demand, the

price level increases. So this factor relies under the theory of demand pull inflation. Similarly, in

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the same context of demand pull inflation, when the government borrows from the central ban%

to finance its expenditure, money supply increases which lead to increase in the price level. So

domestic debt has expected to be positive relationship with inflation & Shei%h, 'aridi ( )ari*

+"1".

$ebt servicing which is the major focused explanatory variable in the model. $ebt servicing is

burden on budget, when debt servicing increase then burden of budget deficit will increase. )his

lead to increase the price level in the country. So debt servicing and inflation is expected to have

positive relationship.

Ander the devaluation, the prices of export decreases while the prices of import increases. $ue to

increase in exports, shortage may be created domestically. 5s a result, their domestic prices will

increase. )his would create inflation in the country. Similarly, imported goods, raw material and

machinery become expensive and cost of production would increase. =ost-push inflation will be

created in the country and this would lead towards unemployment and reduction in productivity

&Pani00a +"">

)he variable of indirect taxes is included into the model in the light of cost pull inflation. 5s the

indirect taxes are the considerable parts of cost of production. /hen there is a decrease in the

aggregate supply of goods and services due to increase in the cost of production. /ith higher

production costs and productivity maximi0ed, companies cannot maintain profit margins by

producing the same amounts of goods and services. 5s a result, the increased costs are passed on

to consumers, leads to inflation in the country.

)he variable of 2udget deficit has been incorporated according the 8eynesian and neoclassical

framewor%. 5ccording to 5c%ay et l+ +1B, there are two possible channels through which

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higher deficit lead to higher inflation. 'irstly, when the government is in a need of debt then it

increases the net credit demands in the economy. So this drive up the interest rates and crowding

out private investment. )he resulting reduction in the growth rate of the economy will lead to a

decrease in the amount of goods available for a given level of cash balances. )his result into the

increase in the general price level. Secondly, deficit can also lead to higher inflation even when

central ban%s do not moneti0e the debt when the private sector moneti0es the deficits. )herefore,

in this case budget deficit leads to increase the price level in the country. So budget deficit is

expected to have positive relationship with inflation.

5ccording to Caffer#s Supply side theory, this considers that in the short run there is no trade-off

between inflation and unemployment. )his theory argues that both the problem of inflation and

unemployment can be reduced at the same time in the short run only through better policy. 5

decrease in taxes enhances the investment level which thereby increases the output and

employment level &)erra +1>.

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REMITTANCES AND HOUSHOLD WELFARE: A CASE STUDY OF

PAKISTAN

2.1. INTRODUCTION

?emittances are often an important source of income and help in boosting economic growth,

particularly in developing countries +5lfieri ( avinga, ""B. ?emittances contribute at both

micro and macro level. 5t micro level in increases the household income thus lead to increase in

the welfare of the individual. )he role of migration and remittances in poverty reduction and

economic growth is a %ey issue for most labor-sending countries.

Pa%istan is the !th largest country of the world in term of migration of the people. )he main

reason for the migration from Pa%istan are the pull factors such as massive unemployment, high

poverty rate, wage gap between Pa%istan and other countries, terrorism, law and order situation

etc. 7any people migrated for better education, better health facilities and many other factors

which attract the people to migrate from Pa%istan &)aylor, +1.

/or%ers# remittances play a very important role for the improvement of the life of receiving

households. Some people save that money and invest it in future which create job opportunities

and decrease unemployment while other spends this on durable and non durable goods. 7any

studies show that remittances improve the welfare of the households either they spend on basic

necessities or save this and invested it in future &I*bal, ( Sattar, +"1".

$espite the significance of remittances for Pa%istan, a limited number of studies have loo%ed at

the issues relating to migrant households. )his study contributes to the literature by attempting to

identify the probability of migration and remittances along its impact on household welfare.

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)he organi0ation of the assignment is as follow9 Section . describes the econometric model

and its specification. /hile .: discuss the theoretical justification of the variables.

2.2. ECONOMETRIC MODEL AND SPECIFICATION

)he methodology of analysis in this study is based on the microeconomic foundation that human

capital variables impact migration decisions +)odaro 14B, Schult0 1>. 7igration is also

influenced by various household characteristics +Cipton 1>", 5dams 1:. )he (ouse(old

c(rcteristics include age of household head, number of males in the household above 1! years

of age, and household si0e. )he re#ionl c(rcteristics included in the estimation are two

dummy variables to represent urban and rural areas, and developed provinces of Punjab and

Sindh and the rest of Pa%istan. )he three ,elt( c(rcteristics used in the regression are the

s*uared value of property, accumulated savings, and s*uared value of accumulated savings.

'ollowing the methodology of 5dams +""B, this study starts by specifying the probability of a

household to migrate and receive remittances. )he functional and econometric form of model

based on the micro economic data is as follow9

Pro! +- D 7igration D $ ./01 /c(1 Rc(1c(3

it it it it it it

2C/ RC/ /C/ /0 MIG µ α α α α α +++++=;:,1"

)he next model estimates the income function of migrant and non migrant households to assess

the role of remittances. )he estimates are obtained for three different sets of households9

• 7igrant in household but exclude remittance income to see the ex-remittance income

function

• 7igrant in household and remittances included in household income

• ouseholds with no migrants.

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)he dependent variable is per capita household income and the standard ordinary least s*uares

+6CS methodology is used for estimation. 5fter the estimation of the three income functions,

the three predicted mean incomes from the estimations are then compared to observe the

contribution of remittances to the household income or welfare. )he functional and econometric

form of model based on the micro economic data is as follow9

./+ Income 4/+ Si5e3 D # ./01 /c(1 Rc(3

it it it it it

RC/ /C/ /0 PC/I µ α α α α ++++=:,1"

)o complete the analysis, three different expenditure $unctions are also estimated by replacing

income with expenditure. )he main purpose is to also see the impacts of remittances on

expenditure. )he functional along with the econometric form of model based on the micro

economic data is as follow9

./+ Exp 4 /+ Si5e3 D # ./01 /c(1 Rc(1 c(3

it it it it it it

2C/ RC/ /C/ /0 PC/E µ α α α α α +++++=;:,1"

'inally, the household expenditure functions for various commodity groups with and without

remittance variables are also estimated. )he idea is to see the role of remittances in influencing

the share of %ey expenditures on food that can also reflect the welfare status of the household

+i.e., higher welfare status is reflected in the lower share of food expenditure. )he food budget

share function is specified as follows9

6ood Exp+ 4 /+ Exp = ( ./0pcexp1 /c(3

it it it it

/C/ /0pc /E µ α α α +++=,1"

exp

In all e*uations aforementioned e*uationsE

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7t8 re$ers to t(e time period o$ 299:;299< ,(ic( is di"ided into $i"e uintiles+ *nd 7i8 ,(ic( re

t(e cross sections re$er to t(e rurl nd ur!n re#ion+

/0= /umn 0pitl

/ C/ = /ouse(old C(rcteristics

RC/ = Re#ionl C(rcteristics

C/ = elt( C(rcteristics

PC/I= Per Cpit /ouse(old Income

PC/E= Per Cpit /ouse(old Income

/E= /ouse(old Expenditure

)he micro econometric analysis of this study is based on the data from the ousehold Integrated

3conomic Survey +I3S of Pa%istan ""!F""B. )he survey covers 1!,;!: households, but

after data cleaning for the analysis the sample is reduced to around 1;,""" households.

5ccording to the 'ederal 2ureau of Statistics the sample of households has been drawn from

1,1" primary sampling units, of which !:1 are urban and !4> are rural.

2.3. THEORITICAL JUSTIFICATION OF VARIABLES

)he selection of variables is based on evidence that human capital variables impact migration. 5s

the people who have better educational facilities will lead to better employment opportunities in

the urban region as well as in the abroad. So improvement in the human capital is essentially

very important in determining the probability of migration from rural to urban region. )he

)odaro model of migration states that migration is mostly an economic decision, which an

individual finds rational even with the existence of urban unemployment. )herefore, when a

person wants to increase the household welfare by increasing the income then they loo% for the

good employment opportunity which is only possible by improving the human capital. &)odaro

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+14B, Schult0 +1>. owever, even though this migration creates unemployment and

induces informal sector growth, this behavior is economically rational and utility-maximi0ing in

the context of the arrisF)odaro model. Similarly improvement in human capital will lead to

increase in the per capita household income. 5ccording to )he 2ec%er view9 human capital is

directly useful in the production process. 7ore explicitly, human capital increases a wor%er#s

productivity in all tas%s. )his result into the higher income for the individuals.

If migration is seen in the lifecycle perspective, the age of household head and the number of

older household members +i.e., above 1! years of age should play a role in determining the

decision to migrate &Cipton +1>", 5dams +1:. )he main reason behind the migration is the

status of the household members. Sometimes due to more family members, the household head

decide to migrate to the urban region for better employment opportunities. )his is because in the

rural region the wages in are very low and in the agriculture sector, there is a case of disguised

employment.

)he incorporation of wealth variables such as accumulated savings from the past become an

important factor in order to represent the initial costs associated with migration +2arham and

2oucher 1>, Can0ona 1>, while the regional characteristics represent the different levels of

development, available information, networ%ing facilities, and other such factors. )he regional

characteristics also play an important role in migration in a way that poorest rural residents and

sons of rich farmers migrate to urban area for a better job and good education. 5s proper

employment opportunities and education facilities are not available in the rural region. So this is

main factor behind the migration from rural to urban region.

)he importance of remittances has been increasing not just at the macroeconomic level but also

among recipient households. ousehold level impact of remittances help in consumption

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smoothing, improve the affordability of health services, and enable better nutrition, lowering the

incidence of child labor and therefore promoting education. In addition, the increased savings

and asset accumulation can provide collateral for a number of purposes. ousehold that receive

remittances invest more heavily in child education than non remittances households. So,

remittances lead to the improvement in the human capital. If the household income is higher than

the individuals spend more on the human capital. ?esult into the good eduation and health

facilities which lead to the increase in the social welfare. ?emittances increase household income

and therefore considered as a powerful anti-poverty force in developing countries. 5s the

remittances receiving household have higher income and level of consumer spending and lower

chances of poverty as compared to the household who don#t receive the remittances. )he per

capita household income also depends upon the regional and the household characteristics.

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REFERENCES

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inflation9 3vidence from low and high fre*uency data for )ur%eyH, 2oga0ici Aniversity,

$epartment of 3conomics.

• )erra, =. ). +1>. 6penness and inflation9 a new assessment. T(e >urterly ?ournl o$

Economics, @@A+, B;1-B;>.

• Shei%h, 7. ?., 'aridi, 7. ., ( )ari*, 8. +"1". $omestic $ebt and 3conomic Jrowth

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Socil Science, 2+1>, !B-B:.

• =atrinescu, L., Ceon-Cedesma, 7., Piracha, 7., ( @uillin, 2. +"". ?emittances,

institutions, and economic growth. orld De"elopment , A +1, >1-.

•)aylor, 3. K. +1. )he new economics of labour migration and the role of remittances

in the migration process. Interntionl mi#rtion, A +1, B:->>.

• I*bal, ., ( Sattar, 5. +"1". )he contribution of wor%ers# remittances to economic

growth in Pa%istan. orin# Ppers Reserc( Reports, ??-Lo.

• Cipton, 7. 1>". G7igration from ?ural 5reas of Poor =ountries9 )he Impact on ?ural

Productivity and Income $istribution.H orld De"elopment >+191F;.

• Cope0-=ordova, 3. ""!. Jlobali0ation, 7igration and $evelopment9 )he ?ole of

7exican 7igrant ?emittances. IL)5CMI)$ /or%ing Paper Lo. ", Inter-5merican

$evelopment 2an%, /ashington, $=.

• )odaro, 7. 14B. GInternal 7igration in $eveloping =ountries.H International Cabor

6ffice. Jeneva.

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• 2arham, 2., and S. 2oucher. 1>. G7igration, ?emittances and Ine*uality9 3stimating

the Let 3ffects of 7igration on Income $istribution.H ?ournl o$ De"elopment

Economics9 !!9:"4F:1.

• 5dams, ?. . Kr. 11. )he 3ffects of International ?emittances on Poverty, Ine*uality,

and $evelopment in ?ural 3gypt. ?esearch ?eport Lo.>B, International 'ood Policy

?esearch Institute, /ashington, $=.

• Can0ona, C. 1>. G7igration, Self-Selection and 3arnings in Philippine ?ural

=ommunities.H ?ournl o$ De"elopment Economics !B+194F!".

• Schult0, ). P. 1>. GLotes on the 3stimation of 7igration 'unctions.H In ?. Sabot, ed.,

mi#rtion nd t(e !or Mret in De"elopin# Countries. 2oulder9 /estview Press.

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In )nited Ntions Con$erence on Trde nd De"elopment Discussion Pper +Lo. 1>>.

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