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
1950s can be described as debt-related. Domestic debt is a fundamental tool used by the
governments in both developed and less developed countries to finance internal and external
gaps. Similarly, Pakistan is using domestic borrowing to pay the foreign debt servicing. [Sheikh,
Faridi & Tariq (2010)].
When the resources in the form of debt are properly and efficiently utilized then this enhances
the productive capacity and economic growth through development related projects. However, if
the debt is not effectively utilized 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 [Bildirici & Ersin (2007)].
Whenever there is an increase in the general price level, the value of money or purchasing power
of money decreases. Inflation is a key macroeconomic indicator of a country, providing an
important insight into the state of the economy. As borrowing from the central bank doesnt
involve a direct cost but carries a serious risk of inflation due to excess aggregate demand caused
by an increase in money supply. Therefore, if the government borrows directly from central bank

in the form of printing money. It is a very inflationary approach and is not usually encouraged.
On the other hand, if the government has a loan from central bank 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. Thus price level decreases [Muhammad, Muhammad & Khadija (2012)].
The main objective of the study is to see the impact of domestic debt on inflation. The
organization of the assignment is as follow: Section 1.2 describes the econometric model and its
specification. While 1.3 discusses the theoretical justification of the variables.
1.2.

ECONOMETRIC MODEL AND SPECIFICATION

The econometric model of the underlying study is as follow:

CPI t 0 1 M 2 t 2 TDD t 3 IPt 4 EX t 5 GEt t
CPI t 0 1 BD t 2 INT _ DDt 3 ITt 4 ERt t

The dependent variable of the model is CPI, which is used to show price level. The focused
independent variables of the study are domestic debt and domestic debt servicing. First equation
will estimate by incorporating the domestic debt. While, second equation contains domestic debt
servicing.
CPI = Consumer Price Index
M2 = Money Supply
TDD = Total Domestic Debt
IP = Private Investment
EX = Exports
GE = Government Expenditures
2

BD = Budget Deficit
INT_DD = Interest Rate on domestic debt (Domestic Debt Servicing)
IT = Indirect Taxes
ER = Exchange Rate
U= Error Term
The data used in this study have been taken from the various issues of the Annual Reports of the
State Bank of Pakistan and the Economic Survey of Pakistan by government of Pakistan. The
time span of this study is from period 1971-72 to 2008-09. All the variables have been expressed
in millions rupees except CPI and Exchange Rate.
1.3. THEORETICAL JUSTIFICATION OF VARIABLES
There 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.
According to the monetarist school of thought, inflation is a monetary phenomenon. The
Quantity Theory of Money proposed by Milton Friedman suggests a direct and proportional
relationship between the money supply and the price level. The 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. Whenever the central bank 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.
The Demand pull inflation approach suggests a positive relationship between aggregate demand
and the price level at a constant level of output. As 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
3

the same context of demand pull inflation, when the government borrows from the central bank
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 [Sheikh, Faridi & Tariq
(2010)].
Debt servicing which is the major focused explanatory variable in the model. Debt servicing is
burden on budget, when debt servicing increase then burden of budget deficit will increase. This
lead to increase the price level in the country. So debt servicing and inflation is expected to have
positive relationship.
Under the devaluation, the prices of export decreases while the prices of import increases. Due to
increase in exports, shortage may be created domestically. As a result, their domestic prices will
increase. This would create inflation in the country. Similarly, imported goods, raw material and
machinery become expensive and cost of production would increase. Cost-push inflation will be
created in the country and this would lead towards unemployment and reduction in productivity
[Panizza (2008)]
The variable of indirect taxes is included into the model in the light of cost pull inflation. As the
indirect taxes are the considerable parts of cost of production. When there is a decrease in the
aggregate supply of goods and services due to increase in the cost of production. With higher
production costs and productivity maximized, companies cannot maintain profit margins by
producing the same amounts of goods and services. As a result, the increased costs are passed on
to consumers, leads to inflation in the country.
The variable of Budget deficit has been incorporated according the Keynesian and neoclassical
framework. According to Ackay et al. (1996), there are two possible channels through which
4

higher deficit lead to higher inflation. Firstly, 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. The 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. This result into the
increase in the general price level. Secondly, deficit can also lead to higher inflation even when
central banks do not monetize the debt when the private sector monetizes the deficits. Therefore,
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.
According to Laffers Supply side theory, this considers that in the short run there is no trade-off
between inflation and unemployment. This 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. A
decrease in taxes enhances the investment level which thereby increases the output and
employment level [Terra (1998)].

REMITTANCES AND HOUSHOLD WELFARE: A CASE STUDY OF

PAKISTAN
2.1.

INTRODUCTION

Remittances are often an important source of income and help in boosting economic growth,
particularly in developing countries (Alfieri & Havinga, 2006). Remittances contribute at both
micro and macro level. At micro level in increases the household income thus lead to increase in
the welfare of the individual. The role of migration and remittances in poverty reduction and
economic growth is a key issue for most labor-sending countries.
Pakistan is the 5th largest country of the world in term of migration of the people. The main
reason for the migration from Pakistan are the pull factors such as massive unemployment, high
poverty rate, wage gap between Pakistan and other countries, terrorism, law and order situation
etc. Many people migrated for better education, better health facilities and many other factors
which attract the people to migrate from Pakistan [Taylor, (1999)].
Workers 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. Many
studies show that remittances improve the welfare of the households either they spend on basic
necessities or save this and invested it in future [Iqbal, & Sattar, (2010)].
Despite the significance of remittances for Pakistan, a limited number of studies have looked at
the issues relating to migrant households. This study contributes to the literature by attempting to
identify the probability of migration and remittances along its impact on household welfare.

The organization of the assignment is as follow: Section 2.2 describes the econometric model
and its specification. While 2.3 discuss the theoretical justification of the variables.
2.2.

ECONOMETRIC MODEL AND SPECIFICATION

The methodology of analysis in this study is based on the microeconomic foundation that human
capital variables impact migration decisions (Todaro 1976, Schultz 1982). Migration is also
influenced by various household characteristics (Lipton 1980, Adams 1993). The household
characteristics include age of household head, number of males in the household above 15 years
of age, and household size. The regional characteristics 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 Pakistan. The three wealth characteristics used in the regression are the
squared value of property, accumulated savings, and squared value of accumulated savings.
Following the methodology of Adams (2006), this study starts by specifying the probability of a
household to migrate and receive remittances. The functional and econometric form of model
based on the micro economic data is as follow:
Prob (Y = Migration) = f [HK, Hch, Rch,Wch]
MIG 0 it 1 HK it 2 HCH 3 RCH 4WCH
it

it

it

it

The next model estimates the income function of migrant and non migrant households to assess
the role of remittances. The estimates are obtained for three different sets of households:

Migrant in household but exclude remittance income to see the ex-remittance income

function
Migrant in household and remittances included in household income
Households with no migrants.

The dependent variable is per capita household income and the standard ordinary least squares
(OLS) methodology is used for estimation. After 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. The functional and econometric
form of model based on the micro economic data is as follow:
[H. Income /H. Size] = g [HK, Hch, Rch]
PCHI 0 it 1 HK it 2 HCH 3 RCH
it

it

it

To complete the analysis, three different expenditure functions are also estimated by replacing
income with expenditure. The main purpose is to also see the impacts of remittances on
expenditure. The functional along with the econometric form of model based on the micro
economic data is as follow:
[H. Exp / H. Size] = g [HK, Hch, Rch, Wch]
PCHE 0 it 1 HK it 2 HCH 3 RCH 4WCH
it

it

it

it

Finally, the household expenditure functions for various commodity groups with and without
remittance variables are also estimated. The idea is to see the role of remittances in influencing
the share of key 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). The food budget
share function is specified as follows:
Food Exp. / H. Exp = h [HKpcexp, Hch]
HE 0 it 1 HKpc exp it 2 HCH
it

it

In all equations aforementioned equations;

t refers to the time period of 2005-2006 which is divided into five quintiles. And i which are
the cross sections refer to the rural and urban region.
HK= Human Kapital
HCH= Household Characteristics
RCH= Regional Characteristics
WCH= Wealth Characteristics
PCHI= Per Capita Household Income
PCHE= Per Capita Household Income
HE= Household Expenditure
The micro econometric analysis of this study is based on the data from the Household Integrated
Economic Survey (HIES) of Pakistan 20052006. The survey covers 15,453 households, but
after data cleaning for the analysis the sample is reduced to around 14,000 households.
According to the Federal Bureau of Statistics the sample of households has been drawn from
1,109 primary sampling units, of which 531 are urban and 578 are rural.
2.3.

THEORITICAL JUSTIFICATION OF VARIABLES

The selection of variables is based on evidence that human capital variables impact migration. As
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. The
Todaro model of migration states that migration is mostly an economic decision, which an
individual finds rational even with the existence of urban unemployment. Therefore, when a
person wants to increase the household welfare by increasing the income then they look for the
good employment opportunity which is only possible by improving the human capital. [Todaro

(1976), Schultz (1982)]. However, even though this migration creates unemployment and
induces informal sector growth, this behavior is economically rational and utility-maximizing in
the context of the HarrisTodaro model. Similarly improvement in human capital will lead to
increase in the per capita household income. According to The Becker view: human capital is
directly useful in the production process. More explicitly, human capital increases a workers
productivity in all tasks. This 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 15 years of age) should play a role in determining the
decision to migrate [Lipton (1980), Adams (1993)]. The 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. This is because in the
rural region the wages in are very low and in the agriculture sector, there is a case of disguised
employment.
The 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 (Barham and
Boucher 1998, Lanzona 1998), while the regional characteristics represent the different levels of
development, available information, networking facilities, and other such factors. The 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. As 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.
The importance of remittances has been increasing not just at the macroeconomic level but also
among recipient households. Household level impact of remittances help in consumption

10

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. Household 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. Result into the good eduation and health
facilities which lead to the increase in the social welfare. Remittances increase household income
and therefore considered as a powerful anti-poverty force in developing countries. As the
remittances receiving household have higher income and level of consumer spending and lower
chances of poverty as compared to the household who dont receive the remittances. The per
capita household income also depends upon the regional and the household characteristics.

11

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