Energy inflation has remained a significant topic in
macroeconomic policy for the past few decades. This is due to several
reasons pertaining to both demand and supply sides. In addition, the
history of energy prices has also been characterised by extreme
volatilities, Hamilton (2008). This makes forecasting and modelling of
energy prices difficult, nevertheless it is important to model and
forecast energy prices in all economies. In this paper we have tried to
identify the determinants of energy inflation in Pakistan. Energy
products are a critical component in any economy, serving as a core
input, particularly in manufacturing industries. Moreover, the demand
for energy and fuel comes from households fuelling cars and kitchens for
which other alternatives are not easily available. This renders the
demand inelastic compared to any other good [Edelstein and Kilian
(2009)], making economies vulnerable to supply and price shocks. The
energy price inflation therefore through cost push inflation and
demand-pull inflation has a major impact on core inflation itself,
thereby playing a significant role in macroeconomic health of a country.
As predicted by Ben Bernanke for the US in 2006, “in the long run energy
prices can reduce the productive capacity of US economy if high energy
costs make businesses less willing to invest new capital”. The nature of
the energy market itself creates a major gap between the oil consumers
and oil producers. Whilst demand is inelastic everywhere, supply is
limited and is difficult to increase, and confined to certain regions on
Earth. This is true particularly for two of the most common energy
types: oil and gasoline. The supply of oil is controlled by a few
countries, and supply shocks therefore lead to an immediate surge in
prices.
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