Abstract
Inflation in Pakistan has been an area of great debate and policymakers are striving hard to control it by adopting different fiscal and monetary tools. Inflation in Pakistan is either demand-pull or cost-push, but an unseen factor which plays significant role in a sharp increase in its rate is expectations about future. The present study investigates the role of expectations in determining inflation dynamics for a small open economy of Pakistan. The study analyzes the New Keynesian Phillips Curve (NKPC) in both standard and hybrid forms for the period of 1980–2022. Output gap and labor income share are being used proxies for real economic activity. To check the stationarity of variables, the Dicky–Fuller test has been applied, while generalized method of moments has been employed to estimate the long run parameters of the model. Results of the study show that NKPC explains well inflation dynamics in Pakistan and fits with the data well. The output gap has been observed as an inappropriate proxy for measuring economic activity, while the income shares of labor appeared significantly positive. Results also showed that inflation in Pakistan is dominated by forward-looking behavior rather than backward-looking. Structural estimates of parameters of the model show that the degree of nominal rigidity in Pakistan is very high and prices remain rigid up to nine quarters.