Revisiting the Financial Development-Inflation Nexus: The Role of Institutional Quality in Pakistan

Abstract

This study examines the relationship between financial development and inflation in In the context of Pakistan, institutional quality, one of the aspects which is under-researched in Pakistan's empirical literature is addressed as moderator. The ARDL bounds testing methodology is used in the estimation of two different specifications using annual data from 1984-2023. The first model captures the direct effect of financial development in addition to other important control variables such as money supply, real effective exchange rate, trade openness and GDP per capita. The second specification uses an institutional quality index and the interaction between it and financial development to determine the impact of institutional quality in determining the relationship between the two. The findings indicate that there are substantial impacts of money supply and financial development to economic outcomes. The findings indicate that the higher the per capita GDP, the higher the inflation, and the lower the trade openness the lower the inflation. Nevertheless, the consideration of the quality of the institutions changes these relations, suggesting a less direct inflationary impact. The positive impact of money supply, GDP per capita and financial development remains the same. However, trade openness, real effective exchange rate and institutional quality and the interaction term has negative relationship with inflation that could help to mitigate the inflationary pressure. These results suggest the double effect of the financial development in the process of inflation. The required monetary expansion and credit growth is always inflationary, but can be kept in check by a massive improvement in institutions. This study offers empirical evidence specific to Pakistan and hence, it validates the importance of institutional quality as a pathway for financial development to achieve disinflationary results. Policies wise, the findings highlight the importance of complementing the institutional measures with greater countries' openness to trade and exchange rate stability in order to be successful in controlling inflation.