Causal Ordering Between Inflation and Productivity of Labor and Capital: An Empirical Approach for Pakistan

This study attempts to analyze the causal relationship between inflation and productivity of labor and capital, in Pakistan’s economy by covering the period from 1960-M1 to 2007-M12. For this purpose Vector Autoregression (VAR) approach is used, which is based on error correction model (ECM). Using this approach we have showed the causal ordering between inflation and exchange rate management policy controlling for, monetary variables like broad money (M-2) and discount rate, which are endogenous in case of Pakistan. We considered the relationship of inflation with two measures of productivity (average and marginal productivity) of labor and capital controlling for capital labor ratio. The objective of this paper is to identify the relative importance of each of these inflation channels by generating Impulse Response Functions (IRFs) to confirm the response of a shock on a variable upon itself and other variables over the four years of time span. Our study concludes that there is a unidirectional causality from inflation to labor productivity through capital labor ratio. And also, there is bidirectional causality between inflation and capital productivity through capital labor ratio. And lastly each channel takes almost fifteen months (on average) for input productivities to affect or affected by inflation.