NAME:

HAFIZ MUHAMMAD UMER

CLASS:
SUBJECT :
TOPIC :
ROLL NO.

MCOM (GENERAL)
INTERNAITONAL BANKING
INFLATION & ITS CAUSES
19

INFLATION:
Inflation is the rise in the prices of goods and services in an economy
over a period of time. When the general price level rises, each unit of
the functional currency buys fewer goods and services; consequently,
inflation is a decline in the real value of money a loss of purchasing
power in the internal medium of exchange, which is also the monetary
unit of account in an economy.
Inflation is a key indicator of a country and provides important insight
on the state of the economy and the sound macroeconomic policies
that govern it. A stable inflation not only gives a nurturing environment
for economic growth, but also uplifts the poor and fixed income citizens
who are the most vulnerable in society.

CAUSES OF INFLATION
It has been generally agreed by the economists that high rates of
inflation and hyperinflation are caused by an excessive growth in the
supply of money.
Today, most economists favour a low steady rate of inflation. Low (as
opposed to zero or negative) inflation may reduce the severity of
economic recessions by enabling the labor market to adjust more
quickly in a downturn, and reduce the risk that a liquidity trap prevents
monetary policy from stabilising the economy.
The task of keeping the rate of inflation low and stable is usually given
to monetary authorities. Generally, these monetary authorities are the
central banks that control the size of the money supply through the
setting of interest rates, through open market operations, and through
the setting of banking reserve requirements.
There are many causes for inflation, depending on a number of factors.
For example, inflation can happen when governments print an excess
of money to deal with a crisis. When any extra money is created, it will
increase some societal groups buying power.
As a result, prices end up rising at an extremely high speed to keep up
with the currency surplus. All sectors in the economy try to buy more
than the economy can produce. Shortages are then created and
merchants lose business.

 To compensate, some merchants raise their prices. Others dont offer

discounts or sales. In the end, the price level rises. This is called
demand-pull inflation, in which prices are forced upwards because of a
high demand, and excessive monetary growth.
For inflation to continue, the money supply must grow faster than the
real GDP.
Another common reason of inflation is a rise in production costs, which
leads to an increase in the price of the final product. For example, if
raw materials increase in price, this leads to the cost of production
increasing, this in turn leads to the company increasing prices to
maintain their profits, this kind of inflation is call cost-push inflation.
Furthermore, rising labour costs can also lead to inflation, because
workers demand wage increases, and companies usually chose to pass
on those costs to their customers, this sort of inflation is called wagepush inflation.
Inflation can also be caused by international lending and national
debts.
As nations borrow money, they have to deal with interests, which in
the end cause prices to rise as a way of keeping up with their debts.
A deep drop of the exchange rate can also result in inflation, as
governments will have to deal with differences in the import/export
level.
Finally, inflation can also be caused by federal taxes put on consumer
products. As the taxes rise, suppliers often pass on the burden to the
consumer; the catch, however, is that once prices have increased, they
rarely go back, even if the taxes are later reduced.

EFFECTS AND MEASUREMENT OF INFLATION

The most immediate effects of inflation are the decreased purchasing
power of the rupee and its depreciation. Depreciation is especially hard
on retired people with fixed incomes, as spending power decreases
each month. Those not on fixed incomes are more able to cope,
because they can simply increase their income.

 Another destabilising effect of inflation is that some people choose to

speculate heavily in an attempt to take advantage of the higher price
level. Because some of the purchases are high-risk investments,
spending is diverted from the normal channels and some structural
unemployment may take place.
Finally, inflation alters the distribution of income. Lenders are generally
hurt more than borrowers during long inflationary periods, which mean
that loans made earlier are repaid later in inflated rupees.
Inflation weakens the function of money as storage of value, because
each unit of money is worth less with the passing of time. The
progressive loss of the value of money during a period of inflation
makes the borrowers to be less willing to use the money as standard
differed payments.
To measure the price level, economists select a variety of goods and
construct a price index such as the consumer price index (CPI). This is
one measure of inflation. The CPI measures inflation as experienced by
consumers in their day-to-day living expenses; it is the ratio of the
value of a basket of goods in the current year to the value of that same
basket of goods in an earlier year.
By using the CPI, the inflation rate can be calculated. This is done by
dividing the CPI by the beginning price level and then multiplying the
result by 100. The GDP deflator is another very important measure of
inflation as it measures the price changes in goods that are produced
domestically.
Pakistan publishes four different price indices, namely: the consumer
price index (CPI), the wholesale price index (WPI), the sensitive price
index (SPI) and the GDP deflator. The CPI is the main measure of price
changes at the retail level.
It indicates the cost of purchasing a representative fixed basket of
goods and services consumed by private households. In Pakistan, the
CPI covers the retail prices of 374 items in 35 major cities and reflects
roughly the changes in the cost of living of urban areas. The WPI is
designed for those items which are mostly consumable in daily life on
the primary and secondary level; these prices are collected from
wholesale markets as well as from mills at organised wholesale market
level. It covers the wholesale price of 106 commodities prevailing in 18
major cities of Pakistan.
The SPI shows the weekly change of price of 53 selected items of daily
use consumed by those households whose monthly income in the base
year 2000-01 ranged from Rs3000 to above Rs12000 per month. The

SPI also informs about the actual position of supply: whether the
commodity is available in market or not.
If the commodity is not available, the reason for that is also recorded.
It is based on the prices prevailing in 17 major cities and is computed
for the basket of commodities being consumed by the households
belonging to all income groups combined as in CPI. In most countries,
the main focus for assessing inflationary trends is placed on the CPI,
because it most closely represents the cost of living.
In Pakistan, the main focus is also placed on the CPI as a measure of
inflation as it is more representative with a wider coverage of 374
items in 71 markets of 35 cities around the country.
Inflation has started veering its ugly head in many parts of the world,
including Pakistan. Food inflation has emerged as the main contributor
to inflationary pressures.
The inflation rates based on CPI, SPI and WPI for the year 2008-09
increased by 22.35 per cent, 26.33 per cent and 21.44 per cent
respectively over the corresponding period of 2007-08. It increased by
10.27 per cent, 14.09 per cent and 13.70 per cent respectively in
2007-08 over the corresponding period of 2006-07. In 2006-07, the
rate of inflation increased by 7.89 per cent, 11.13 per cent and 6.92
per cent respectively over the same period of 2005-06. An analysis of
data for last three years for the same period indicates that CPI, SPI &
WPI were higher as compared to last two years.
The government is cautious about inflation and thus has taken various
steps to release demand pressures on the one hand and enhance
supplies of essential commodities on the other.
To ease demand pressures, the State Bank of Pakistan (SBP) has
continuously tightened the monetary policy over the last three years
and more so in the current fiscal year, while to enhance supplies, the
government has relaxed its import regime and allowed imports of
several essential items so that there is a continuous flow in the supply
of those important commodities.
In addition, the government increased the imports of items like wheat,
pulse and sugar to complement the efforts of the private sector.
In order to provide relief to the common man, the government also
increased the scale of operations of the Utility Stores Corporation
(USC) which supplies essential commodities such as wheat flour, sugar,
pulses and cooking oil/ ghee at less than the market prices.

ALL THREE INDICES CPI, SPI AND WPI AT A GLANCE

Average JulyApril over same period of previous year
(Change of indices in %)
Index

2006-07

2007-08

CPI

7.89

10.27

SPI

11.13

14.09

WPI

6.92

13.70

2008-09
22.35
26.33
21.44