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INFLATION

Definitions:

• A persistent and appreciable rise in the general level of prices is called


inflation
OR
• Inflation is the continued upward movement in the general level of
prices.
OR
• Inflation is the process in which there is a continuous increase in the
general price level. If the price level rises persistently, then people
need more and more money to make transactions. But a one time
increase in the price level is not Inflation. But it is an ongoing process.
To illustrate this we have a graph

Inflation v/sOneTime Risein PriceLevel

160
140
120
100
price level

ongoing
80
60 one time change

40
20
0
03

07
02

04

05

06
20

20

20

20

20

20

years

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HISTORY OF INFLATION:
• Inflation originally referred to the debasement of the currency. When
gold was used as currency, gold coins could be collected by the
government, melted down, mixed with other metals such as silver,
copper or lead, and reissued at the same nominal value. By diluting the
gold with other metals, the government could increase the total
number of coins issued without also needing to increase the amount of
gold used to make them. When the cost of each coin is lowered in this
way, the government profits from an increase in seignior age.
• By the nineteenth century, economists categorized three separate
factors that cause a rise or fall in the price of goods: a change in the
value or resource costs of the good, a change in the price of money
which then was usually a fluctuation in metallic content in the
currency, and currency depreciation resulting from an increased supply
of currency relative to the quantity of redeemable metal backing the
currency. Following the proliferation of private bank note currency
printed during the American Civil War, the term "inflation" started to
appear as a direct reference to the currency depreciation that occurred
as the quantity of redeemable bank notes outstripped the quantity of
metal available for their redemption. The term inflation then referred
to the devaluation of the currency, and not to a rise in the price of
goods.

THEORY OF 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.
Inflation means a sustained rise in prices. Inflation can be Creeping, walking
or trotting, running, hyper or gallop, demand pull, cost push, mixed, markup
or stagflation according to velocity and nature. Inflation is caused by some
demand side factors (Increase in nominal money supply, Increase in
disposable income, Expansion of Credit, Deficit Financing Policy, Black
money spending, Repayment of Public Debts, Expansion of the Private
Sector, Increasing Public Expenditures) and some Supply side factors
(Shortage of factors of production or inputs, Industrial Disputes, Natural
Calamities, Artificial Scarcities, Increase in exports (excess exports), Global
factors, Neglecting the production of consumer goods, Application of law of
diminishing returns).

TYPES OF INFLATION:
There are six main types of inflation. The various types of inflation are
briefed below.
1. Demand-pull Inflation
2. Cost-Push Inflation
3. Price Power Inflation
4. Sectoral Inflation
5. Fiscal Inflation
6. Hyper Inflation

1. Demand-pull inflation:
This type of inflation occurs when total demand for goods and services in an
economy exceeds the supply of the goods and services. When the supply is
less, the prices of these goods and services would rise, leading to a situation
called as demand-pull inflation. This type of inflation affects the market
economy adversely during the wartime.

2. Cost-push Inflation:
As the name suggests, if there is increase in the cost of production of goods
and services, there is likely to be a forceful increase in the prices of finished
goods and services. For instance, a rise in the wages of laborers would raise
the unit costs of production and this would lead to rise in prices for the
related end product. This type of inflation may or may not occur in
conjunction with demand-pull inflation.

3. Pricing Power Inflation:


Pricing power inflation is more often called as administered price inflation.
This type of inflation occurs when the business houses and industries decide
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to increase the price of their respective goods and services to increase their
profit margins. A point noteworthy is pricing power inflation does not occur at
the time of financial crises and economic depression, or when there is a
downturn in the economy.
This type of inflation is also called as oligopolistic inflation because
oligopolies have the power of pricing their goods and services.

4. Sectoral Inflation:
This is the fourth major type of inflation. The sectoral inflation takes place
when there is an increase in the price of the goods and services produced by
a certain sector of industries. For instance, an increase in the cost of crude
oil would directly affect all the other sectors, which are directly related to the
oil industry. Thus, the ever-increasing price of fuel has become an important
issue related to the economy all over the world. Take the example of aviation
industry. When the price of oil increases, the ticket fares would also go up.
This would lead to a widespread inflation throughout the economy, even
though it had originated in one basic sector. If this situation occurs when
there is a recession in the economy, there would be layoffs and it would
adversely affect the work force and the economy in turn.

5. Fiscal Inflation:
Fiscal Inflation occurs when there is excess government spending. This
occurs when there is a deficit budget. For instance, Fiscal inflation originated
in the US in 1960s at the time President Lydon Baines Johnson. America is
also facing fiscal type of inflation under the president ship of George W. Bush
due to excess spending in the defense sector.

6. Hyper Inflation:
Hyperinflation is also known as runaway inflation or galloping inflation. This
type of inflation occurs during or soon after a war. This can usually lead to
the complete breakdown of a country’s monetary system. However, this type
of inflation is short-lived. In 1923, in Germany, inflation rate touched
approximately 322 percent per month with October being the month of
highest inflation.

HOW TO MEASURE RATE OF INFLATION:


Inflation is usually estimated by calculating the inflation rate of a price index,
usually the Consumer Price Index. The Consumer Price Index measures
prices of a selection of goods and services purchased by a "typical
consumer”. The inflation rate is the percentage rate of change of a price
index over time.

Other widely used price indices for calculating price


inflation include the following:
* Cost-of-living indices (COLI) are indices similar to the CPI which are
often used to adjust fixed incomes and contractual incomes to maintain the
real value of those incomes.

* Producer price indices (PPIs) which measures average changes in


prices received by domestic producers for their output. This differs from the
CPI in that price subsidization, profits, and taxes may cause the amount
received by the producer to differ from what the consumer paid. There is
also typically a delay between an increase in the PPI and any eventual
increase in the CPI. Producer price index measures the pressure being put on
producers by the costs of their raw materials. This could be "passed on" to
consumers, or it could be absorbed by profits, or offset by increasing
productivity. In India and the United States, an earlier version of the PPI was
called the Wholesale Price Index.

* Commodity Price Indices which measure the price of a selection of


commodities. In the present commodity price indices are weighted by the
relative importance of the components to the "all in" cost of an employee.

* Core Price Indices because food and oil prices can change quickly due
to changes in supply and demand conditions in the food and oil markets, it
can be difficult to detect the long run trend in price levels when those prices
are included. Therefore most statistical agencies also report a measure of
'core inflation', which removes the most volatile components (such as food
and oil) from a broad price index like the CPI. Because core inflation is less
affected by short run supply and demand conditions in specific markets,
central banks rely on it to better measure the inflationary impact of current
monetary policy.

Other common measures of inflation are:


* GDP Deflator is a measure of the price of all the goods and services
included in Gross Domestic Product (GDP). The US Commerce Department
publishes a deflator series for US GDP, defined as its nominal GDP measure
divided by its real GDP measure.
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* Regional Inflation The Bureau of Labor Statistics breaks down CPI-U
calculations down to different regions of the US.

* Historical Inflation before collecting consistent econometric data


became standard for governments, and for the purpose of comparing
absolute, rather than relative standards of living, various economists have
calculated imputed inflation figures. Most inflation data before the early 20th
century is imputed based on the known costs of goods, rather than compiled
at the time. It is also used to adjust for the differences in real standard of
living for the presence of technology.

* Asset Price Inflation is an undue increase in the prices of real or


financial assets, such as stock (equity) and real estate. While there is no
widely-accepted index of this type, some central bankers have suggested
that it would be better to aim at stabilizing a wider general price level
inflation measure that includes some asset prices, instead of stabilizing CPI
or core inflation only. The reason is that by raising interest rates when stock
prices or real estate prices rise, and lowering them when these asset prices
fall, central banks might be more successful in avoiding bubbles and crashes
in asset prices.

Inflation rate is the percentage rate of change of a price index over


time. To measure the inflation rate; we calculate the annual
percentage change in the price level.

Inflation Rate= Current Year Price—Previous Year Price x


100

Previous Year Price

Example:
If this year price level is 126 and the last year price level was 120, then

Inflation rate= 126-120 x 100 = 5%


120
So the 5% is inflation rate of the current year. This equation shows the
connection between the inflation rate and the price level. For a given price
by last year, the higher the price levels in the current year the higher the
inflation rate. If the price level is rising, the inflation rate increases. Also the
higher the new price level, lower is the value of money and the higher is the
inflation rate.

INFLATION IN PAKISTAN:
Pakistan experienced high economic growth over six per cent during 2004-
06. However, prices also started increasing at a rapid pace and the headline
inflation remained above eight per cent during the last two years. The
average Consumer Price Index (CPI) inflation was 9.3 per cent in 2004-2005
and around eight per cent in 2005-06.

Inflation In The Fiscal year 2008-09:


This year the increase in the price level has been extraordinary in Pakistan.
The inflation rate measured through the Consumer Price Index (CPI) has
climbed to 22.3 percent during (July-April) 2008-09 over the corresponding
increase of 10.3 percent. Inflation accelerated at a rapid pace mainly
because of raising food prices; a weaker rupee/dollar exchange rate; the
gradual withdrawal of subsidies on gas, electricity and petroleum; the
imposition of custom duty on the imports of various items; and an upward
revision in the support price of wheat and sugarcane crops. The overall CPI-
base inflation during the first ten months of the current fiscal year 2008-09
(July—
April) averaged at 22.4 percent, much higher than that of the last fiscal year
2007-08 (July—April) when inflation stood at 10.2 percent. The food group
also increased sharply when compared to last year figures, measuring 26.6
percent for the first ten months of fiscal year 2008-09 as compared to 15
percent during the corresponding period last year. The steep rise in food
inflation was largely due to an increase in the prices of a few essential items
such as wheat, rice, edible oil, meat, pulses, tea, milk and fresh vegetables.
Non-food inflation also showed a sharp increase of 19 percent during the
same period as compared to 6.8 percent of last year. Most concerning,
however, is the sharp increase in core inflation, measuring a substantial
17.8 percent during the first ten months of the current fiscal year as
compared to 7.5 percent during the corresponding period last year (See
Table 7.2)
Based on current trends, it is expected that the average inflation for the year
(2008-09) as measured by the CPI will be around 21 percent. These
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developments in the CPI are also reflected in other measures of inflation
used in Pakistan, namely the Wholesale Price Index (WPI) as well as the
Sensitive Price Index (SPI).

Table 01:
Item (2006- (2007-08) (July-
2007) April)
(2007-08) (2008-09)
CPI(Gener 7.8 12.0 10.2 22.4
al)
Food 10.4 17.5 15.0 26.6
Group
Non-food 6.0 7.9 6.8 19.0
Group
Core 5.9 8.3 7.5 17.8
inflation
30
25
20
15
10
5
0
2006-7 2007-08 2007- 2008-
08(July- 09(July-
April) April)
CPI(General)
Food Group
Non-Food Group
Core Inflation

Source: Federal Bureau of Statistics Revenue (FBS)

The food group has been the most significant contributor to the pick up in
inflation during 2008-09 and the food price index is at its highest point since
1980, averaging 26.6 percent over the July – April period. Within the food
group, the inflation of perishable food items is estimated at 23.2 percent
whereas non-perishable food items at 28.6 percent. Their contribution to this
year’s overall
CPI trend is registered at 5.3 percent and 45.1 percent respectively
indicating a larger increase in prices of such items as pulses, sugar, wheat
and tea.
Given the speed at which food prices increased, high food inflation is likely to
persist in the country over the next few months. The higher food prices have
had a devastating effect on the Pakistani people as a major share of

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consumer spending is on food items. Hence, inflation has a direct impact on
the poverty level as people suffer more from the high price of food than they
gain from higher income. The escalation in food inflation began right from
the start of the fiscal year, i.e. July 2008 and continued to persist up until
December 2008 at an average of 31.3 percent for the fiscal year. However,
thereafter it started to slowdown from 29.9 percent in January 2009 to
28.0 percent in March 2009 and further to 26.6 percent in April 2009, staying
in tandem with the trend seen in international food and fuel prices. A
shortfall in the production of some essential commodities in the country in
relation to their demand has also driven up food prices. In fact, there are 13
food items (such as wheat and flour; sugar, poultry, mash pulse, meat, milk,
tea, fresh vegetables etc) that account for almost 23 percent of the total
weight in the Consumer Price Index (CPI). It is from these critical items that
there has been a sharp pick up in food inflation in Pakistan. Food in general
has become more expensive in Pakistan, resulting in a steep rise in the price
of some basic commodities. For instance, the average price of sugar has
risen above 41 percent, wheat prices by 17 percent, chicken prices by 24
percent, beef prices by 13 percent and onion prices by 64 percent since July
2008 over April 2009. With a 23 percent weight in
CPI, the contribution of these few items to the overall CPI inflation is 18
percent. However, prices of certain other food items such as potatoes, rice,
red chilies, edible oil and all the pulses, with the exception of mash pulse,
have declined. Non-food price inflation rose to 19.0 percent for the July-April
period as against 6.8 percent during the same period last year. Both the food
and non-food inflation contributed to the overall CPI inflation but in different
ways as various factors influenced the two CPI components separately. The
increase in food inflation was influenced mainly from a shortfall in the supply
of some essential consumer food items such as wheat, meat, sugar, milk and
poultry whereas the non-food price inflation was mainly driven by the price
of POL products and the resultant rise in transportation costs. In the
international markets, oil prices dropped significantly from a peak of $145
/barrel in July 2008 to around $35 /barrel by December 2008 A similar impact
was witnessed in the prices of food items with a reduction of 21 percent in
the international price of wheat, 40 percent fall in the prices of rice, 38
percent reduction in palm oil prices and a 4 percent decrease in sugar prices.
However, unfortunately for Pakistan, benefits of this reduction in world
commodity prices could not be realized owing to a depreciation of the rupee.
The impact of depreciation along with the imposition of addition duty on
imports has been reflected in both the import costs of commodity and capital
goods. Based on current tendencies, the contribution of food and non-food
inflation to the overall CPI is estimated at 48.0 percent and 50.7 percent
respectively. When we further categorize inflation into different groups, the
higher inflationary trends on an average-over average basis were observed
in the transport group (30%) and fuel group (25%), showing the impact of
rising energy prices. The cleaning and laundry group increased by 19
percent while the medicine group rose 12 percent but their weights in the
CPI basket are small (5.9. percent and 2.1 percent respectively), hence their
contribution to inflation was also minimal. On the other hand, the house rent
index, which has a 23.4 percent weight in the total CPI, has shown a higher
pick in inflation of 16.8 percent (See Table 7.3 and Fig-2).
Other major factors that effected domestic prices, both in the recent past as
well as those currently having an impact, include: Firstly, in order to reduce
the pressure on the country’s fiscal position, the Government started
phasing out subsidies on petroleum products. This led to an increase in the
price of diesel, causing transportation costs to rise which in turn translated to
higher prices of many other goods in the country. Secondly, the Government
revised the support price of wheat in September 2008 by increasing it over
50 percent from Rs 625 /40 Kg to Rs 950 /40 Kg which in turn pushed up the
retail prices of both wheat and wheat flour across the country. Thirdly, the
gradual hike in power and gas tariffs during fiscal year 2008-09 also added
to the domestic inflation rate. Electricity charges carry a significant weight of
4.4 percent in the overall CPI whereas natural gas has a weight of 2.1
percent, thus an increase in their prices would have a noteworthy impact on
the headline inflation rate. Fourthly, the decision to increase the import
duties on various items in tandem with the depreciation of the rupee vis-à-
vis the dollar caused domestic prices to rise. This caused imports to be more
costly than anticipated and hence served as another creeping cause of
inflation. It is worth mentioning that appropriate policy response to tame
inflation also includes monitoring the scarcity of essential items through
timely imports, keeping a close vigilance on the stock and availability of
essential items, the provision of incentives to the commodity producing
sector, and keeping the money supply within the targeted range. Given the
decelerating trend in food price inflation, the CPI headline inflation rate is
likely to come down during the remaining months of the current fiscal year.
Hence the current fiscal year is expected to end with average inflation rate
of 21 percent.
Due to this inflation, prices of the commodities increase very fastly.

Table 02:

Commodity (July- Point


Group April) Contribution
(July-April)
Weigh Percen Percent
t t

(2007-08) (2008- (2007-08) (2008


09) -09)
CPI 100 10.27 22.35 10.27 22.35
Food 40.3 15.02 26.61 59.03 48.03

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1)Perishable 5.14 4.46 23.24 2.23 5.34
2)Non- 35.2 12.94 28.61 44.36 45.06
perishable
Non-Food 59.7 6.82 19.01 39.60 50.75
Core 52.4 7.49 17.83 38.61 47.97
Apparel, 6.1 7.86 14.87 4.67 4.06
Textile
House rent 23.4 8.78 16.78 19.92 17.60
Energy 7.3 3.42 24.98 2.88 9.73
Household 3.3 6.56 13.53 2.10 1.99
Transport 7.3 0.66 29.53 0.34 6.91
Recreation 0.8 0.42 12.71 0.03 0.47
Education 3.5 6.89 16.74 2.32 2.58
Cleaning 5.9 9.76 18.72 5.59 4.92
Medicare 2.1 8.38 12.44 1.69 1.15

Historical Trend in Inflation:


Historically viewed, Pakistan's experience in growth and inflation can be
expressed in five distinct phases. Starting with the fifties there was low
inflation with low growth, whereas in the sixties there was low inflation with
high growth. The seventies entailed high inflation with low growth; the
eighties saw moderate inflation with high growth; and in the nineties
witnessed high inflation with moderate growth. Over the following nine
years, i.e. 2000-01 to 2008-09, inflation saw a low of 3.1 percent in 2002-03
to a high of 22.3 percent during the current year, which is also the highest
level in two decades. The overall annual inflation is expected to average 21
percent while GDP growth to remain at 2.0 percent for the year 2008-09.

Table 03: Trend in GDP Growth Rate and Inflation Rate

Period GDP Growth rate Inflation rate


1950-1960 3.1 2.1
1960-1970 6.8 3.2
1970-1980 4.8 12.3
1980-1990 6.5 7.8
1990-2000 4.6 9.7
2000-2009 5.2 8.4
14

12

10

8
GDP Growth Rate
6 Inflation Rate

0
1950-60 1960-70 1970-80 1980-90 1990-00 2001-09

Is there any need to worry about inflation?


When is inflation bad for the economy?
A reasonable rate of inflation--around 3- 6 per cent—but in our graph which
represent the inflation rate and growth rate of Pakistan, after the period of
1960-70 there is no satisfactory rate of GDP and inflation up till 2009.
When inflation crosses reasonable limits, it has negative effects. It reduces
the value of money, resulting in uncertainty of the value of gains and losses
of borrowers, lenders, and buyers and sellers. The increasing uncertainty
discourages saving and investment.
In case of Pakistan:
Annual inflation was above 11 per cent in the past 32 years. For Pakistan
economy, inflation can be bad if it crosses the threshold of six per cent, and
can be extremely harmful if it crosses the double digit level.

A near History of Inflation in Pakistan with reference to


CPI, SPI and WPI: [1]
Consumer Price Index (CPI) is the main measure of price changes at the
retail level. It measures changes in the cost of buying a representative fixed
basket of goods and services and generally indicates inflation rate in the
country. The Consumer price index was computed for the first time with
1948-49 as a base for industrial workers in the cities of Lahore, Karachi and
Sialkot only. Continuous efforts have been made, since then, to make CPI
more representatives by improving and expanding its scope and coverage in
terms of items, category of employees, cities and markets. Accordingly, the
CPI series were computed with 1959-60, 1969-70, 1975-76, 1980-81 and
1990-91 as base years. At present, the CPI is being computed with 2000-01
as base year. And according to the studies of CPI, the inflation rate during
the fiscal year 2000-2001 was 4.41, during the fiscal year 2001-2002 it
dropped down to 3.54, further dropped to 3.10 during the fiscal year 2002-
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2003, rose again to 4.57 during 2003-2004, increased drastically to 9.28
during 2004-2005 and then dropped to 7.92 during 2005-2006. And by the
mid of October 2006, the CPI is reported to be 8.43.
The Sensitive Price Indicator (SPI) is computed on weekly basis to assess the
price movements of essential commodities at short intervals so as to review
the price situation in the country. The SPI is being presented in the Economic
Coordination Committee of the Cabinet (ECC). Sensitive price indicator was
originally computed with 1969-70 as base which was subsequently switched
over to 1975-76, 1980-81 and 1990-91 as base year. Presently, the SPI is
being computed with base 2000-2001. And Sensitive Price Indicator (SPI)
shows the facts as; 4.84 in 2000-2001, 3.37 in 2001-2002, 3.58 in 2002-
2003, 6.83 in 2003-2004, 11.55 in 2004-2005 and 7.02 in 2005-2006.
Recently (By the mid of October 2006) the SPI is reported as 9.86.
The Wholesale Price Index (WPI) is designed to measure the directional
movements of prices for a set of selected items in the primary and wholesale
markets. Items covered in the series are those which could be precisely
defined and are offered in lots by producers/manufacturers. Prices used are
generally those, which conform to the primary sellers realization at ex-
mandi, ex-factory or at an organized Wholesale level. The WPI initially was
computed with 1959-60 as base. Since then, continuous efforts have been
made to make the WPI more representatives by improving and expending its
scope and coverage in terms of commodities, quotations/markets, etc.
Accordingly, WPI series were computed with 1969-70, 1975-76, 1980-81 and
1990-91 as base years. Presently, the WPI is being computed with 2000-01
as base. The Wholesale Price Index (WPI) tells the story as; 6.21 in 2000-
2001, 2.08 in 2001-2002, 5.57 in 2002-2003, 7.91 in 2003-2004, 6.75 in
2004-2005 and 10.10 in 2005-2006.

CAUSES OF INFLATION IN PAKISTAN:


Now what are the causes of inflation in Pakistan? There are four main causes
that can create inflation at high rate.
1) Demand-pull inflation.
2) Cost- push inflation.
3) Money supply
4) Artificially created

1) Demand -pull inflation:


It is generated when the aggregate demand increases than supply.
Following are the causes of demand pull inflation in Pakistan.

 High monetary expansion:


The supply of money expanding quickly every year but the supply of
goods and services is not increasing according to that ratio. So in this
condition there will be more demand due to excess of money and there
is less supply so in this condition producer have to increase there
prices to meet with the demand.

 Foreign aid:
The volume of foreign aid is increasing with the passage of time.
almost every year we receive million of dollars aid when this aid is
used in the country, it increase the demand because with that aid
people will have more purchasing power so with the more purchasing
power than there will 8me more demand this excessive demand tends
the economy towards inflation.

 Consumptions Habits:
In Pakistan most population usually feel proudness for using those
items (goods and services) which are commonly used in advance
countries.

 Population Explosion:
The population is increasing at 1.9% in Pakistan. So this rate of
increase in population will increase the demand for many commodities
if the demand increases than you know there will be more inflation.

 Increase in wages:
The rise in wages, salaries, and pension has increased the purchasing
power of the people.

 Nationalization of industries:
After the nationalization of industries in Pakistan the investor class is
hesitating to do the investment due to fear of nationalization. So in this
case there will be less industries who fulfills the demand of the goods
and services so there is increase in price level which is the symptoms
of inflation.

 Income from the Foreign:


The Pakistanis who are in abroad .those families who are receiving in
Pakistan there purchasing power increasing day by day .in other words
their demand increases.

2) Cost -push inflation:

 Sale tax:
Government of Pakistan has imposed sale tax on large number of
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goods like oil, gas, electricity, telephone etc. It has also contributed the
rate of inflation.

 Devaluation of rupee:
It is an important factor in increasing the general level of price.
Pakistan has devalued his currency many times in term of dollar.
Devaluation has increase the cost of product and the price of the
imported goods while the value of export has fallen.

 Rising prices of imported goods:


Different commodities are imported whose prices are rising in the
world market. So these commodities are bringing inflation with them.

 Increase in indirect Taxation:


The government of Pakistan is increasing the taxes on the goods every
year. The direct taxes have also increased the rate of inflation.

3) Money supply:
It plays a large role in inflationary pressure as well. Monetarist economists
believe that if the Federal Reserve does not control the money supply
adequately, it may actually grow at a rate faster than that of the potential
output in the economy, or real GDP. The belief is that this will drive up prices
and hence, inflation. Low interest rates correspond with high levels of money
supply and allow for more investment in big business and new ideas which
eventually leads to unsustainable levels of inflation as cheap money is
available. The credit crisis of 2007 is a very good example of this at work.

4) Artificial created:
Inflation can artificially be created through a circular increase in wage
earners demands and then the subsequent increase in producer costs which
will drive up the prices of their goods and services. This will then translate
back into higher prices for the wage earners or consumers. As demands go
higher from each side, inflation will continue to rise.

MEASURES TO REMOVE INFLATION IN


PAKISTAN:
Now the question is how we can overcome to the inflation? What
measures should be adopted to remove the inflation?

• The inflation was well under control from the fiscal year 2000-2004.
However it shoots up to 9.3% in the year 2005 mainly due to the rise in
the support price of wheat and the surge in the international price of
oil. it has been bought down to 7.9% in 2006-2007.However the food
inflation was 10.2% for the fiscal year 2006-2007.The Government of
Pakistan being well aware of the adverse effects of inflation, is taking
following measure to bring down the inflationary pressure in the
economy.

 Increase in the supply of essential goods:


The Government of Pakistan is regularly monitoring the domestic
stock of essential goods and their price in the market. The supply of
essential goods is being improved through the import of these
commodities.

 Supply of essential items through utility store:


The Government of Pakistan is expanding the supply of the
essential items such as sugar, wheat, pulses at subsidized rates
through the utility stores in the country which are likely to increase to
5000 in 2007-2008.

 Restriction on the import of luxury items:


The import of luxury items must be restricted. It will protect s from
international inflation and it will be favorable for the balance of
payment as well as for price level of goods.

 Denationalization:
Nationalized industries should be denationalized and private sector
should be allowed to play its role more effectively. In denationalized
system foreign investor will invest there money in Pakistan and made
more industries. So if the industries increase than there will be more
production and less inflation.

 Change in taxation system:


The taxation system should be revised in order to encourage the
private sector. Tax holidays must be given to expand the industrial
sector.

 Sick industries problem:


Sick industries should be handed over to private sector and their
production and profit can be restored to stabilize the economy.

 Check on unplanned cities:


The unplanned and unregulated growth of cities should be checked.

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 Effective Administration:
The administration should be made effective and clear to increase the
output of the country.

 Discipline:
Discipline should be restored in factories and office to improve the
output of the country.

 Co-ordination between Monetary and Fiscal Policy:


Govt. should coordinate the monetary and fiscal policy in such a
manner that it should check the rate of inflation.

 Special Bazaars:
Govt. has established the Friday and Sunday bazaars in every city to
provide the basic necessities of life at lower prices. These can be
improved further in small towns and villages.

 Reduction in Interest Rate:


To increase the credit facility to private sector govt. should reduce the
bank rate. It will reduce the cost and price of production. Due to the
fall in price aggregate demand will also increase.

 Increase in the supply of essential goods:


The govt. is regulatory monitoring the domestic stock of essential
goods and their prices in the market. The supply of essential goods is
being improved through the import of these commodities.

 Supply of Essential items through Utility Stores:


The govt. is expanding the supply of essential items such as sugar,
wheat, pulses at subsidized rates through the utility stores in the
country which are likely to increase to 5000 in 2007-08.

 Cash Reserve Ratio and Discount Ratio:


The SBP has increased the cash reserve ratio from commercial banks from 5%
to 7% and discount ratio to 9.5% to 9% for controlling the money supply.

A variety of methods have been used in attempts to


control inflation.

 Monetary policy:
Today the primary tool for controlling inflation is monetary policy. Most
central banks are tasked with keeping the federal funds lending rate at
a low level; normally to a target rate around 2% to 3% per annum, and
within a targeted low inflation range, somewhere from about 2% to 6%
per annum. A low positive inflation is usually targeted, as deflationary
conditions are seen as dangerous for the health of the economy.

There are a number of methods that have been suggested to control


inflation. Central banks such as the U.S. Federal Reserve can affect
inflation to a significant extent through setting interest rates and
through other operations. High interest rates and slow growth of the
money supply are the traditional ways through which central banks
fight or prevent inflation, though they have different approaches. For
instance, some follow a symmetrical inflation target while others only
control inflation when it rises above a target, whether express or
implied.

Monetarists emphasize keeping the growth rate of money steady, and


using monetary policy to control inflation (increasing interest rates,
slowing the rise in the money supply). Keynesians emphasize reducing
aggregate demand during economic expansions and increasing
demand during recessions to keep inflation stable. Control of
aggregate demand can be achieved using both monetary policy and
fiscal policy (increased taxation or reduced government spending to
reduce demand)

 Fixed exchange rates:


Under a fixed exchange rate currency regime, a country's currency is
tied in value to another single currency or to a basket of other
currencies (or sometimes to another measure of value, such as gold). A
fixed exchange rate is usually used to stabilize the value of a currency,
vis-a-vis the currency it is pegged to. It can also be used as a means to
control inflation. However, as the value of the reference currency rises
and falls, so does the currency pegged to it. This essentially means
that the inflation rate in the fixed exchange rate country is determined
by the inflation rate of the country the currency is pegged to. In
addition, a fixed exchange rate prevents a government from using
domestic monetary policy in order to achieve macroeconomic stability.

Under the Bretton Woods agreement, most countries around the world
had currencies that were fixed to the US dollar. This limited inflation in
those countries, but also exposed them to the danger of speculative
attacks. After the Bretton Woods agreement broke down in the early
1970s, countries gradually turned to floating exchange rates. However,
in the later part of the 20th century, some countries reverted to a fixed
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exchange rate as part of an attempt to control inflation. This policy of
using a fixed exchange rate to control inflation was used in many
countries in South America in the later part of the 20th century (e.g.
Argentina (1991-2002), Bolivia, Brazil, and Chile).

 Gold Standard:
Under a gold standard, paper notes are convertible into pre-set, fixed
quantities of gold.

The gold standard is a monetary system in which a region's common


media of exchange are paper notes that are normally freely
convertible into pre-set, fixed quantities of gold. The standard specifies
how the gold backing would be implemented, including the amount of
specie per currency unit. The currency itself has no innate value, but is
accepted by traders because it can be redeemed for the equivalent
specie. A U.S. silver certificate, for example, could be redeemed for an
actual piece of silver.

Gold was a common form of representative money due to its rarity,


durability, divisibility, fungibility, and ease of identification.[43]
Representative money and the gold standard were used to protect
citizens from hyperinflation and other abuses of monetary policy, as
were seen in some countries during the Great Depression. However,
they were not without their problems and critics, and so were partially
abandoned via the international adoption of the Bretton Woods
System. Under this system all other major currencies were tied at fixed
rates to the dollar, which itself was tied to gold at the rate of $35 per
ounce. The Bretton Woods system broke down in 1971, causing most
countries to switch to fiat money – money backed only by the laws of
the country. Austrian economists strongly favor a return to a 100
percent gold standard

 Wage and Price Controls:

Another method attempted in the past has been wage and price
controls ("incomes policies"). Wage and price controls have been
successful in wartime environments in combination with rationing.
However, their use in other contexts is far more mixed. Notable
failures of their use include the 1972 imposition of wage and price
controls by Richard Nixon. More successful examples include the Prices
and Incomes Accord in Australia and the Wassenaar Agreement in the
Netherlands.
In general wage and price controls are regarded as a temporary and
exceptional measure, only effective when coupled with policies
designed to reduce the underlying causes of inflation during the wage
and price control regime, for example, winning the war being fought.
They often have perverse effects, due to the distorted signals they
send to the market. Artificially low prices often cause rationing and
shortages and discourage future investment, resulting in yet further
shortages. The usual economic analysis is that any product or service
that is under-priced is over consumed. For example, if the official price
of bread is too low, there will be too little bread at official prices, and
too little investment in bread making by the market to satisfy future
needs, thereby exacerbating the problem in the long term.

Temporary controls may complement a recession as a way to fight


inflation: the controls make the recession more efficient as a way to
fight inflation (reducing the need to increase unemployment), while the
recession prevents the kinds of distortions that controls cause when
demand is high. However, in general the advice of economists is not to
impose price controls but to liberalize prices by assuming that the
economy will adjust and abandon unprofitable economic activity. The
lower activity will place fewer demands on whatever commodities were
driving inflation, whether labor or resources, and inflation will fall with
total economic output. This often produces a severe recession, as
productive capacity is reallocated and is thus often very unpopular
with the people whose livelihoods are destroyed (see creative
destruction).

 Cost-of-living Allowance:

The real purchasing-power of fixed payments is eroded by inflation


unless they are inflation-adjusted to keep their real values constant. In
many countries, employment contracts, pension benefits, and
government entitlements (such as social security) are tied to a cost-of-
living index, typically to the consumer price index.[49] A cost-of-living
allowance (COLA) adjusts salaries based on changes in a cost-of-living
index. Salaries are typically adjusted annually.[49] They may also be
tied to a cost-of-living index that varies by geographic location if the
employee moves.

Annual escalation clauses in employment contracts can specify


retroactive or future percentage increases in worker pay which are not
tied to any index. These negotiated increases in pay are colloquially
referred to as cost-of-living adjustments or cost-of-living increases
because of their similarity to increases tied to externally-determined
indexes. Many economists and compensation analysts consider the
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idea of predetermined future "cost of living increases" to be misleading
for two reasons: (1) For most recent periods in the industrialized world,
average wages have increased faster than most calculated cost-of-
living indexes, reflecting the influence of rising productivity and worker
bargaining power rather than simply living costs, and (2) most cost-of-
living indexes are not forward-looking, but instead compare current or
historical data.

EFFECTS OF INFLATION ON ECENOMY IN PAKISTAN:


The following are the effects of inflation in Pakistan.

Negative Effects:
 An increase in the general level of prices implies a decrease in the
purchasing power of the currency. That is, when the general level of
prices rises, each monetary unit buys fewer goods and services, so in
Pakistan due to high rate of inflation people have low purchasing
power and they cannot get luxury goods and services as well as
necessary goods and services.

Unpredictable rates of Inflation discourage investments and savings.


Because there is no convenient plans for the price level of goods and
services, so the investor does not make long term plan for their
companies. As in Pakistan there is high and unpredictable inflation
rate. So in those types of countries, investor does not predict about the
long term planning for their organization.

The effects of inflation can be brutal for the elderly who are looking to
retire on a fixed income. The rupees that they expect to retire with will
be worth less and less as time goes on and inflation goes higher.

 Hoarding:

People buy consumer durables as stores of wealth in the absence of


viable alternatives as a means of getting rid of excess cash before it is
devalued, creating shortages of the hoarded objects.

 Hyperinflation:

If inflation gets totally out of control (in the upward direction), it can
grossly interfere with the normal workings of the economy, it hurting
its ability to supply.

 Allocative Efficiency:

A change in the supply or demand for a good will normally cause its
price to change, signaling to buyers and sellers that they should re-
allocate resources in response to the new market conditions. But when
prices are constantly changing due to inflation, genuine price signals
get lost in the noise, so agents are slow to respond to them. The result
is a loss of Allocative efficiency.

 Shoe Leather Cost:

High inflation increases the opportunity cost of holding cash balances


and can induce people to hold a greater portion of their assets in
interest paying accounts. However, since cash is still needed in order
to carry out transactions this means that more "trips to the bank" are
necessary in order to make withdrawals, proverbially wearing out the
"shoe leather" with each trip.

 Menu Costs:

With high inflation, firms must change their prices often in order to
keep up with economy wide changes. But often changing prices is itself
a costly activity whether explicitly, as with the need to print new
menus, or implicitly.

 Business Cycles:

According to the Austrian Business Cycle Theory, inflation sets off the
business cycle. Austrian economists hold this to be the most damaging
effect of inflation. According to Austrian theory, artificially low interest
rates and the associated increase in the money supply lead to reckless,
speculative borrowing, resulting in clusters of mal investments, which
eventually have to be liquidated as they become unsustainable.
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Positive Effects:

 Labor-Market Adjustments:

Keynesians believe that nominal wages are slow to adjust downwards.


This can lead to prolonged disequilibrium and high unemployment in
the labor market. Since inflation would lower the real wage if nominal
wages are kept constant, Keynesians argue that some inflation is good
for the economy, as it would allow labor markets to reach equilibrium
faster.

 Debt relief:

Debtors who have debts with a fixed nominal rate of interest will see a
reduction in the "real" interest rate as the inflation rate rises. The
“real” interest on a loan is the nominal rate minus the inflation rate.
[dubious – discuss] (R=n-i) For example if you take a loan where the
stated interest rate is 6% and the inflation rate is at 3%, the real
interest rate that you are paying for the loan is 3%. It would also hold
true that if you had a loan at a fixed interest rate of 6% and the
inflation rate jumped to 20% you would have a real interest rate of
-14%. Banks and other lenders adjust for this inflation risk either by
including an inflation premium in the costs of lending the money by
creating a higher initial stated interest rate or by setting the interest at
a variable rate.

 Room to maneuver:

The primary tools for controlling the money supply are the ability to set
the discount rate, the rate at which banks can borrow from the central
bank, and open market operations which are the central bank's
interventions into the bonds market with the aim of affecting the
nominal interest rate. If an economy finds itself in a recession with
already low, or even zero, nominal interest rates, then the bank cannot
cut these rates further (since negative nominal interest rates are
impossible) in order to stimulate the economy - this situation is known
as a liquidity trap. A moderate level of inflation tends to ensure that
nominal interest rates stay sufficiently above zero so that if the need
arises the bank can cut the nominal interest rate.
 Tobin Effect:

The Nobel Prize winning economist James Tobin at one point had
argued that a moderate level of inflation can increase investment in an
economy leading to faster growth or at least higher steady state level
of income. This is due to the fact that inflation lowers the return on
monetary assets relative to real assets, such as physical capital. To
avoid inflation, investors would switch from holding their assets as
money (or a similar, susceptible to inflation, form) to investing in real
capital projects. See Tobin monetary model.

Indicators:

 Gross Domestic Product (GDP):

The most important indicator is the GDP report. Basically, the GDP is
the widest measure of the state of the economy. The figure is released
at 8:30 am EST on the last day of each quarter and reflects the
previous quarter. The GDP is the aggregated monetary value of all the
goods and services produced by the entire economy during the quarter
(with the exception of international activity). The key number to look
for is the growth rate of GDP. Generally, the U.S. economy grows at
around 2.5-3% per year and deviations from this range can have a
significant impact. Growth above this level is often thought to be
unsustainable and a precursor to high inflation, and the Fed usually
responds by trying to slow down the "overheated" economy. Growth
below this range (and especially negative growth) means that the
economy is running slowly, which can lead to increased unemployment
and lower spending. It is worth noting that each initial GDP report will
be revised twice before the final figure is settled upon: the "advance"
report is followed by the "preliminary" report about a month later and
a final report a month after that. Significant revisions to the advance
number can cause additional ripples through the markets. The GDP
numbers are reported in two forms: current dollar and constant dollar.
Current dollar GDP is calculated using today's dollars and makes
comparisons between time periods difficult because of the effects of
inflation. Constant dollar GDP solves this problem by converting the
current information into some standard era dollar, such as 1997
dollars. This process factors out the effects of inflation and allows easy
comparisons between periods. Don't confuse Gross Domestic Product
with Gross National Product (GNP). GDP includes only goods and
services produced within the geographic boundaries of the U.S.,
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regardless of the producer's nationality. GNP doesn't include goods and
services produced by foreign producers, but does include goods and
services produced by U.S. firms operating in foreign countries. For
example, if a U.S. firm was operating a chain of stores in France, the
goods and services produced by those stores would not be included in
the GDP, but would be included in the GNP. As the global economy
grows, the difference in GDP and GNP is falling for developed countries
like the U.S. But for smaller, developing countries, the difference can
be substantial.

 Consumer Price Index (CPI):

The CPI is the most widely used measure of inflation. The report is
released at 8:30 am EST around the 15th of each month and reflects
the previous month's data. The CPI measures the change in the cost of
a bundle of consumer goods and services. The bundle includes about
200 types of goods and thousands of actual products, ranging from
foods and energy to expensive consumer goods. The prices are
measured by taking a sample of prices at different stores. In addition
to the overall CPI number, it is important to also look at the "core rate."
The core rate excludes volatile goods like food and energy and gives a
closer measure of real inflation. Most reports of the CPI numbers will
include both the overall and the core numbers. The CPI is also
important because it is used to adjust the annual changes to Social
Security payments. There has been much debate about how well the
CPI measures inflation and some feel that it is an imperfect way to
track rising prices

 The Producer Price Index (PPI):

As mentioned above, the PPI is one of the two most important ways to
measure inflation (along with the CPI). The PPI is released at 8:30 am
EST during the second full week of each month and reflects the
previous month's data. The index measures the price of goods at the
wholesale level. So, while the CPI tracks the cost paid by consumers for
goods, the PPI tracks how much the producers are receiving for the
goods. There are three types of goods measured by the PPI: crude,
intermediate, and finished. Crude goods are raw materials used in
production of something else, intermediate goods are components of a
larger product, and finished goods are what is actually sold to a
reseller. The finished goods data are the most closely watched because
they are the best measure of what consumers will actually have to pay.

 Employment Cost Index (ECI):

The ECI is another important measure of inflation. Released at 8:30 am


EST on the last Thursday of January, April, July, and November, the ECI
measures the cost of labor including wages, benefits, and bonuses. The
reason the ECI is thought to be an indicator of inflation is that as wages
increase, the added cost is often passed to consumers shortly
thereafter in the form of higher prices (inflation). In combination with
the productivity report (see below) the ECI can reveal whether the
increased cost of labor is justified or not.

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