How Do Crude Oil Prices, Exchange Rates, Gold Prices, and Interest Rates Impact Inflation in Pakistan?

Abstract

The purpose of this study is to examine the macroeconomic factors driving inflation in Pakistan from 1990 to 2024, particularly the effects of crude oil prices, exchange rate devaluation, gold prices, and interest rate changes on inflation. The study uses a Structural Equation Model (SEM) to examine the direct and indirect effects of global commodity prices and monetary conditions on domestic prices. To capture large external regime changes, two binary structural dummy variables are included: a COVID-19 shock dummy (2019–2021) and a Russia-Ukraine geopolitical tension dummy (2022–ongoing). Money supply growth and trade openness are among the control variables. Based on annual data from the World Development Indicators (WDI), International Financial Statistics (IFS), and the State Bank of Pakistan (SBP), the SEM path analysis indicates that the two largest direct influences on inflation are the interest rate and the exchange rate. The positive effects of crude oil on the exchange rate and gold prices have a strong indirect impact on inflation. The other significant and negative factor is trade openness, which indicates the import-cost channel. The structural dummies have mixed coefficients, indicating that policy interventions during the crisis period suppress inflationary pressures in both cases. The findings confirm the preeminence of external macroeconomic variables in determining inflation in Pakistan and offer some empirical lessons for policy.