ASIGNMENT NO: 2

Name: Enrollment: Class: Course: Topic:

Mohammad Abdullah 2010-E-037 MBA (4th quarter) Economic Issues & society Causes of Inflation in Pakistan & way forward. Dr. Jan Mohammad 10-01-2012

Submitted To: Submission Date:

INSTITUTE OF MANAGEMENT SCIENCES UNIVERSITY OF BALUSHISTAN QUATT

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10/01/2012

Causes of Inflation in Pakistan:

One of the most important factors influencing poverty in the country is inflation. Inflation is defined as a situation where general price level is persistently moving upward in a country. In Pakistan the general price level is persistently rising since its establishment. The prices remained volatile during the decade of 1990s ranging from 5.7 % to 13 % mainly because of declining economic growth, expansionary prices, output set backs, higher taxes and a depreciation of Pakistan rupee. The inflation rate started declining from 1998 onward due to improved supply position of goods and strict budgetary measures. The inflation rate was 5.7 % in 1998-99. It was brought down to 3.6 % in 1999-2000 and further to 3.1 % in 2002-2003. The inflation rate based on CPI (Consumer Price Index) has averaged 4.6 % during 2003-2004. The slight rise in prices was due to increase in price of wheat. The inflation rate reached as high as 9.3% in the year 2004-2005 mainly due to rise in price of wheat and increase in the international oil price. The causes of general rise in prices are usually grouped under the following two main heads. A. Demand-pull inflation and B. Cost-push-inflation. These two types of inflation are now discussed in the context of Pakistans economy. DEMAND-PULL INFLATION: Demand-pull inflation is generated when aggregate demand for goods for all purposes-consumption, investment and government exceeds the supply of goods at current prices. The main factors which have led to demand induced inflation in Pakistan are as follows. (i) Demand for non-development expenditures: The elected and non-elected governments in Pakistan since 1947 have not been able to curb the non-development expenditures. The lavish expenditures by the elected representatives and the government functionaries have contributed to the inflationary rise in the general prices. (ii) Rapid monetary expansion: During the last three years the growth in monetary assets has outstripped the rise in nominal GDP. The easy monetary policy adopted to kick start the stagnant economy has led to the rise in general price level. (iii) Deficit Financing: Due to lack of resources for economic development, the government has been resorting to deficit financing (bank borrowing, creation of new currency) over the years. The excessive growth in money supply compared to increase in output has resulted in inflation. (iv) Increase in Workers remittances: During the last three years there is a rapid increase in the flow of workers remittances in the country. During the year 2001-02 the workers remittance were $2.389 billion which now in the year 2004-05 have crossed $3.90 billion dollars. The workers remittances no doubt a boon for the country, has also resulted in the expansion in aggregate demand for goods and so a factor in the general rise in prices. (v) Foreign Economic assistance: For rapid economic development, Pakistan has been receiving foreign and since early 50s. The foreign debt outstanding is 36.6 billion dollars by 2005. The tied and untied aid is mostly invested in the projects having long gestation. The output of goods 2

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therefore does not increase correspondingly with the rise in income. Foreign economic assistance is thus also a contributory factor in pulling up the general level of prices in the country. (vi) Consumption habits: Pakistanis living in Urban and rural areas are mostly send thrift. They are proud of spending money on the goods which are used by the people in the advanced countries of the world. The increased expenditure on clothes, foods, cosmetics etc. have added much to the inflationary pressure in the country. (vii) Construction of houses: Since 1970 people are spending their savings mostly on the purchase of land and construction of houses. The unproductive expenditure on the construction of houses, plazas etc. has also contributed to the rising trend in prices. (viii) Excessive speculation and hoarding: The investor class since the nationalization of industries is generally shy of investing money in capital intensive projects. They are mostly spending their resources on speculation and hoarding of goods. The abrupt rise I demand of goods also results in the rise of price level of goods. (ix) Increase in Wages: The rise in wages, salaries, and fringe allowances, bonuses etc. in the annual budget increase the purchasing power of the employees. With the increase in the disposable income of the workers, the prices of the commodities go up. The workers gain press for higher wages. The wages and prices thus chess each other at a very rapid speed and have accelerated the trend of price rise in the country. (x) Population explosion: The population is increasing at the rate of about 1.9% in Pakistan; the pressure of population has increased the aggregate demand for commodities thus pulling up the general level of prices in the country. (xi) Black Money: Black money is the unaccounted money receipts. It is generated through smuggling, tax evasion, price control etc. It is estimated that annual generation of black money is about 25% of GNP of the country. This huge amount pushes up the prices of land, houses, cars, air conditioners and other expensive items. COST-PUSH INFLATION: The rise in the general price level is also caused by the rising costs of the factors of production; it is called cost push inflation. In Pakistan the cost push inflation has occurred in the following ways. (i) Increase in Wages: In Pakistan one of the factors leading to cost-push inflation in the rise in wage not backed by increase in productivity. The compensatory wage increase and the rise in prices are chasing each other at quite a rapid speed causing personal rise in the level of prices. (ii) Rising prices of imported goods: The import prices of POL chemicals, fertilizers, non-electrical machinery etc have gone up in the world market. The cost and so the price of commodities using the imported items has gone up in the country. (iii) Increase in Indirect taxes: For increasing the revenue the Government is heavily relying on indirect taxes. The increase in the indirect taxes every year has given the general price level an

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inflationary push. (iv) Depreciation of Rupee: The Pakistani rupee is depreciating vis--vis the US dollar. The repeated and higher devaluations of Pakistani rupee has increased the cost and prices of imported goods. Depreciation of the currency thus is an important factor for the rise in the average level of prices in Pakistan. (v) Rise in POL, Gas, and Excise Duty: The multiplier effect of the rise in POL, gas prices, and levying of excise duty, sales tax on a number of items has greatly contributed to the cost push effect. (vi) Sick Industrial Units: The increase in number of sick industrial units, fall in industrial production due to strikes, electricity breakdown etc cause decrease in production and lead to higher cost, thus pushing up inflationary pressure. (vii) Increase in Utility Tariffs, excise duty: The governments in the budgets considerably increase the rates of sales tax, excise duty on a large number of items. A rise in utility tariffs has also kicked a new round of inflation in the country. (viii) Rise in support price of agriculture crops: The Government raises the support prices of cotton, wheat, sugar cane to protect the interests of farmers. This also has an inflationary impact on the currency. Reference: http://notesforpakistan.blogspot.com/2009/08/causes-of-inflation.html

Way Out:
The future strategy to control inflation must include coordinated and timely response to changing macroeconomic conditions along with a concerted effort to raise the productive capacity of economy. Any delay in implementing such a strategy would only make the policy trade-offs much more difficult, resulting in continuing uncertainty regarding desirable economic outcomes. Monetary policy has played its part in correcting the macroeconomic imbalances, but other government policies have not been that supportive. The inflation outlook and reserve position of the country would have been much worse. Growth in broad money and thus inflation would have been much higher if the private sector also had continued to borrow unchecked from the banking system along with the public sector. some observers can comment that availability of cheap credit to the private sector would have supplemented productive capacity, helping reduce the output gap but given the deterioration in the law and order conditions and energy sector problems in the last three years, it is highly unlikely that investments in the country, by both local and foreign investors, would have grown rapidly. Thus in any case, rising inflation would have made the businesses uncompetitive by increasing the cost of production. What the dynamics of inflation in Pakistan is that in broad terms, inflationary pressures have been a mix of upward adjustments in administrated prices, a persistence of output gap and inconsistent macroeconomic policies negatively influencing expectations of inflation. Pakistans economy has experienced an inflation of 66 percent between June 2007 and October 2010 in cumulative terms. This is almost twice the level of inflation seen during June 2003 and June 2007, which was 36 percent, 4

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the credit extended for state bank for commodity operations, including both wheat and sugar, grew by 288 percent during the last three years compared to 33 percent in the three years before that. Borrowings of this scale would not have been possible without an upward pressure on market interest rates, the borrowing of government agencies for financing its wheat, urea, and sugar trading operations was Rs 382 billion at just under 3 percentage points above KIBOR, the interest rate regime that the private sector would have to face in competition with the sovereign. Further, this led to an injection of a lot of cash in the rural areas, which was used for higher expenditures on consumer durables and possibly other food items as well, that an initial supply shock turned into a demand shock and adversely affected expectation of inflation remaining high. The heavily subsidized commodity prices including that of petroleum products, electricity and gas has resulted in heavy government borrowing from the central bank, which consequently had a negative impact on inflation. Borrowings of the public sector enterprises is partially explain transfer of subsidies from the governments budgetary expenditures directly to the power sector entities, which grew by 305 percent during June 2007 and October 2010 compared to only 17 percent during 2003 and June 2007. The contribution of this towards growth in money and thus overall inflation should not be discounted, Even if the food and energy group prices were excluded from CPI, there was substantial increase in inflationary pressures. Both non-food-non-energy (NFNE) and trimmed measures of core inflation validate this observation. Reduction in subsidies unfortunately did not help in reducing the fiscal deficit and increasing aggregate demand pressure. In cumulative terms the fiscal deficit grew by 146 percent in nominal terms during June 2007 and June 2010 compared to 113 percent during June 2003 and June 2007. If SBP take out the interest payments, which have been mentioned as a factor adding to the fiscal problems, and look at the primary deficit, the fiscal driven aggregate demand pressures look more pronounced. The stock of outstanding borrowings of the government from the SBP is in excess of Rs 1500 billion compared to only Rs 53 billion at end-June 2003. Imagine the effect on market interest rate, if the government had borrowed this amount from the scheduled banks, the undoubtedly interest rates would have been much higher than they are now. References:
http://www.dailytimes.com.pk/default.asp?