International Oil Price Shocks and Monetary Policy Nexus: Understanding Inflation Dynamics in Pakistan through New Keynesian framework

Abstract

This study explores the complex link between inflation in Pakistan and changes in oil price. Analyzing the complicated interaction among these variables in both long and short term using a comprehensive 17-year monthly time series dataset (2006–2023), the study employs Johansen co-integration, Vector Error Correction Modeling (VECM), and Autoregressive Distributed Lag (ARDL). Under-lighting their interdependence, our empirical results reveal a strong long-term association between Consumer Price Index (CPI), Core CPI, and oil prices. VECM analysis reveals persistent inflationary forces, marked by notable disequilibrium adjustments in CPI (13%) and Core CPI (32%), respectively, so highlighting the long-lasting effect of oil price fluctuations on Pakistan's inflation trajectory, so indicating that changes in oil prices have a great impact on Pakistan's inflation landscape.

The results imply that monetary policy can reasonably offset the negative consequences of oil price volatility, hence stabilizing inflation rates. A significant fraction of inflationary pressures is long-term corrected, therefore highlighting the continuation of inflationary factors. Moreover, the study emphasizes the need of differentiating between several price indices in order to evaluate the effect of changes in oil prices and offers important information for legislators trying to improve Pakistan's economic resilience against outside shocks, especially considering the nation's great reliance on oil imports. This work adds to the continuous discussion on appropriate policy reactions to minimize the negative consequences of oil price shocks by clarifying the intricate interactions among oil prices, inflation, and monetary policy.