The Influence of Oil Price Volatility on Pakistan's Economic Growth and Inflation

Abstract

This study seeks to identify the long-term relationship between oil price shocks and key macroeconomic variables in Pakistan, using quarterly data from 1993 to 2018. The analysis employs the auto regressive distributed lag bounds testing approach to examine the long-term interactions, alongside various Granger causality tests to explore causal relationships. The auto regressive distributed lag bounds test results confirm the existence of a unique long-term relationship among the variables, indicating that changes in oil prices have a lasting impact on Pakistan's macroeconomic environment. Specifically, the error correction model reveals a unidirectional causal relationship running from oil price shocks to GDP, suggesting that fluctuations in oil prices directly influence economic growth in Pakistan. Additionally, the error correction model identifies a unidirectional causal relationship from the inflation rate to the interest rate, highlighting the endogenous nature of monetary policy in response to rising inflation. The findings indicate that as oil prices rise, there is a corresponding increase in inflation, which prompts the central bank to raise interest rates in an attempt to control inflation. However, the study finds that this increase in interest rates does not significantly curb inflation but rather has a detrimental effect on economic growth. The rising interest rates may dampen investment and consumption, thereby slowing down economic activity. These results have important implications for policymakers in Pakistan. The strong influence of oil price shocks on GDP underscores the need for strategies to mitigate the economy's vulnerability to volatile oil prices. Diversifying the energy mix by investing in alternative energy sources such as renewable energy can help reduce dependence on imported oil and stabilize the economy against external shocks. Moreover, the study's findings suggest that current monetary policy measures, particularly raising interest rates in response to inflation, may not be effective in controlling inflation and can harm economic growth. Policymakers should consider a more nuanced approach to inflation control that balances the need to manage inflation with the goal of sustaining economic growth. This could include structural reforms to improve supply chain efficiency, enhance productivity, and reduce production costs, thereby addressing the root causes of inflation rather than relying solely on interest rate adjustments.