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Inflation

In economics, inflation is a rise in the general level of prices of goods and services in an
economy over a period of time. When the general price level rises, each unit of currency
buys fewer goods and services; consequently, inflation is also a decline in the real value
of money—a loss of purchasing power in the medium of exchange which is also the
monetary unit of account in the economy. A chief measure of general price-level inflation
is the general inflation rate, which is the percentage change in a general price index
(normally the Consumer Price Index) over time.

Inflation can have adverse effects on an economy. For example, uncertainty about future
inflation may discourage investment and saving. High inflation may lead to shortages of
goods if consumers begin hoarding out of concern that prices will increase in the future.

Economists generally agree that high rates of inflation and hyperinflation are caused by
an excessive growth of the money supply. Views on which factors determine low to
moderate rates of inflation are more varied. Low or moderate inflation may be attributed
to fluctuations in real demand for goods and services, or changes in available supplies
such as during scarcities, as well as to growth in the money supply. However, the
consensus view is that a long sustained period of inflation is caused by money supply
growing faster than the rate of economic growth.

Graph (a)

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Today, most economists favor 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 stabilizing 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.

Yearly Inflation Rates of Pakistan

Period SPI CPI WPI


1991-1992 10.54 10.58 9.84
1992-1993 10.71 9.83 7.36
1993-1994 11.79 11.27 11.40
1994-1995 15.01 13.02 16.00
1995-1996 10.71 10.79 11.10
1996-1997 12.45 11.80 13.01
1997-1998 7.35 7.81 6.58
1998-1999 6.44 5.74 6.35
1999-2000 1.83 3.58 1.77
2000-2001 4.84 4.41 6.21
2001-2002 3.37 3.54 2.08
2002-2003 3.58 3.10 5.57
2003-2004 6.83 4.57 7.91
2004-2005 11.55 9.28 6.75
2005-2006 7.02 7.92 10.10
2006-2007 10.82 7.77 6.94

Table (I)

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Graph (b)

Year Inflation rate Form 2001-2008:

Table (II)

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Graph (c)

Causes of Inflation in Pakistan:

The causes of inflation are generally grouped under two main heads

• Demand Pull Inflation

• Cost Push Inflation.

Demand Pull Inflation in Pakistan:

Demand pull inflation occurs when aggregate demand for goods exceeds
aggregate supply of goods at current prices, thus leading to an increase in the price level.
The factors of which bring about increase in aggregate demand for goods or rise in the
general level of prices are grouped under two separate heads;

• Factors operating on demand side

• Factors operating on the supply side.

Factors operating on the demand side:

These are the factors which bring continuous rise in the general price level.

• Increase in money supply: An increase in money supply leads to an increase in


money income. The increase in money income raises the aggregate demand for
goods and services in the country. The supply of money increases when the govt.
resorts to deficit financing or the commercial banks expand credit. When too
much money chases too few goods, the result is an increase in general price level.

• Increase in Government expenditure: If there is increase in govt. expenditure due


to adoption of development and welfare activities of the country has to flight a
war, it causes as increase in govt. expenditure which leads to increase in
aggregate demand for goods and services and hence the price level goes up.

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• Increase in private expenditure: A continuous increase in consumption and
investment expenditure in the private sector raises the demand for goods and
services and leads to inflationary rise in prices.

• Increase in population: The rapid rising population exerts pressure on the demand
for goods and services. If the supply of goods and services fail to match with the
demand, the general price level moves upward.

• Black money: The money generated through smuggling, tax evasion etc. raises
the demand for luxury and other goods. Hence black money is also one of the
causes in raising the aggregate demand for goods and a rise in general price level.

Factors causing decrease in supply of goods:

If the increase in aggregate demand for goods and services is matched by an increase in
the supply of goods, it will not cause inflationary situation. When the aggregate supply of
goods is at a slower pace than the growth in aggregate demand, it then causes inflationary
rise in prices. The following factors are identified for relatively slower growth in the
supply of goods.

• Lagging agricultural & industrial production: The increase in population,


incomes, employment and urbanization exert pressure on the demand for goods
and services. However, the agricultural and industrial production grows at a
slower pace, due to shortage of essential inputs like fertilizers, water, cement, iron
etc. When aggregate demand for goods and services exceeds the aggregate
supply of it, it causes a rise in the prices of agricultural and industrial goods.

• Inadequate infrastructure facilities: If, in a country there is shortage of power,


transport and communication facilities are slow and inefficient, it results in the
slowing down of overall production of goods. When the supply of goods falls
short of demand, the prices go up in the country.

• Long gestation period: If the time lag between investment and the production of
goods is long, the shortage of goods will arise. This will also contribute to
inflationary pressure in the economy.

Cost Push Inflation in Pakistan:

Cost push inflation occurs when there is an increase in the cost of production of goods
and is not associated with excess demand. The main causes of cost push inflation are:

(1) Increase in money wage rate: The wage push inflation occurs when strong labor
unions manage to press for wage increases in excess of labor productivity. Unit
cost of production is thereby raised. The rise in cost of production exerts pressure
on sellers to increase prices of goods so as to get profit margin.

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(2) Profit push inflation: If the producers of certain commodities have monopoly or
near monopoly power in the market, they fix up higher profit margins arbitrarily
without any increase in other elements of cost. When a few powerful firms
increase the profit margins, the smaller firms also tend to mark up their profit
margins. The higher profit margins, thus, inflate the price level.

(3) Material push inflation: If there is increase in the prices of some basic materials
such as gas, steel, chemicals, oil etc which are used directly or indirectly in
almost all industries, it causes an increase in the cost of production and hence in
the general price level.

(4) Higher taxes: If the government levies new taxes and raises the rates of old taxes
the producers generally shift the burden of taxes on to the consumers. The
increases in the selling prices of the commodities push up the inflationary trend
in the economy.

(5) Import prices: If prices of imported goods increase, it also results in the
contribution of inflation.

Kinds of inflation in Pakistan:

Inflation is of different types. It is generally classified on the following basis.

• On the Basis of Rate of Inflation:

Creeping Inflation:

It is a situation in which the rise in general price level is at a very slow rate over a period
of time. Under creeping inflation, the price level raises upto a rate of 2% per annum. A
mild inflation is generally considered a necessary condition of economic growth.

Walking Inflation:

Walking inflation is a marked increase in the rate of inflation as compared to creeping


inflation. The price rise is around 5% annually.

Running Inflation:

Under running inflation, the price increases is about 8% to 10% per annum.

Galloping or Hyper Inflation:

Galloping inflation is a full inflation. Keynes calls it as the final stage of inflation. It is a
stage of inflation which starts after the level of full employment is reached. Here price
level rises very rapidly within a short period.

• On the Basis of Degree of Control:

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Open Inflation:

It is a stage when the rise in price level gets out of control. Milton Friedman describes it
as “inflationary process in which prices are permitted to rise without being suppressed by
government price control or similar measures.

Suppressed Inflation:

Under this type of inflation, the government makes efforts to check and control the rise in
price level through price and rationing. When price level is suppressed by the above short
term measures, it results in many evils such black marketing, hoarding, corruption &
profiteering.

Demand Pull Inflation:

Inflation caused by increase in aggregate demand, not matched by aggregate supply of


goods, resulting in rise of general price level is called demand pull inflation. Demand pull
inflation to be simpler, occurs when the demand for goods and services in the country is
more than their supply. The effective demand for goods increases due to many factors
such as increase in money supply, increase in the demand for goods by the government,
increase in the income of various factors of production etc. In short, the excessive
increase in the money supply causes inflationary conditions. Demand pull inflation is
generally characterized by shortage of goods and shortage of workers.

Cost Push Inflation:

Cost push inflation occurs when the increasing cost of production pushes up the general
price level. Cost pull inflation occurs when the economy is below full employment with
prices rising even though there is no shortage of goods. Cost push inflation is the result of
increase in wage costs unaccompanied by corresponding increase in productivity, rise in
import prices of goods, depreciation in the external value of the currency, higher mark up
etc, etc.

Profit Induced Inflation in Pakistan:

Profit inflation is in fact categorized under cost push inflation. When entrepreneur, due to
their monopoly position raise the profit margin on goods. It may cause profit push
inflation.

Budgetary Inflation in Pakistan:

When the government of a country occurs the deficits in the budgets through bank
borrowing and creating new money (Deficit Financing), the purchasing power of
commodity increases without a simultaneous increase in the production of goods. This
leads to rise in the general price level.

Monetary Inflation in Pakistan:

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Milton Friedman is of the firm view that inflation is always and anywhere a monetary
phenomenon. According to him, inflation is caused by a too rapid increase in the money
supply and by nothing else.

Multi Casual Inflation in Pakistan:

Inflation has a number of causes. It may be caused by increase in money supply,


excessive wage demands, excess aggregate demand for goods, shortage of goods etc. The
chief cause of inflation in one year may not be in the next year. Since inflation is multi
causal, therefore a variety of policy measures are needed to deal with it.

• On the Basis of Employment:

Partial Inflation:

According to J.M. Keynes, takes place when the general price level rises partly due to an
increase in the cost of production of goods and partly due to rise in supply of money
before the full employment stage is reached.

Full Inflation:

Full inflation prevails when the economy has reached the level of full employment. Any
increase in money supply beyond full employment. It is also called as real inflation.

Anticipated versus Unanticipated Inflation:

• Anticipated inflation is the rate of inflation which majority of the individual


believes will occur. When the rate of inflation (say 6%) turns out to be same (6%)
we are then in a situation of fully anticipated inflation.

• Unanticipated inflation is that which comes as a surprise to majority of


individuals. It can be higher or lower than the rate of anticipated inflation.

Price of Oil and National Income Accounting:

Examination of the analytical model as mentioned above very similar results as to what
actually happened in Pakistan during the period when oil prices rose exponentially. To do
this, I am going to use the numbers from the following tables showing the GDP (Y) of
Pakistan, the total Consumption Expenditure I, Investment (I) & Government Spending
(G), and the net Exports (x-m).

GDP at Current Prices (2008)

USD $ (BILLION) 2003 2004 2005 2006 2007 (est.)2008

Consumption( C ) 66.10 78.00 91.85 107.30 120.00 129.78

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Investment &
Government
Spending ( I + G ) 13.60 15.58 20.67 27.10 32.35 35.46

Exports ( x ) 10.65 11.25 13.78 15.63 16.05 16.85

Imports ( m ) 11.52 14.29 19.48 27.66 29.50 37.44

Balance of Trade
(x–m) (.87) (3.04) (5.70) (11.97) (13.45) (20.59)
GDP ( Y )
= C+I+G+(x-m) 78.83 90.54 106.82 122.43 138.9 144.65
GDP Percent
Change(YoY)% - +11.71 +17.9 +14.6 +13.5 +4.1%

Table (III)

Rising Value of Imports:

As you can see, the numbers tell us nothing other than the GDP, at current prices has
been steadily growing. The issue arises when we look at the change from one year to the
next. For example comparing the balance of trade between 2007 and 2008 shows that the
rate at which the trade deficit increased was (20.59-13.45)/13.45 = 53%. Taking any year
for example 2007, if we examine the numbers it is:
Y=C+I+G+(x-m), so Y= 120+32.35+ (16.05-29.5) = 138.9 ($BILLION)
>>**(I+G)=32.35**<<
In 2008 the value of m increased, leading to a negative effect on the growth of Y.
Unexpectedly the value of imports rises to 40($BILLION). The GDP rose but a
decreasing rate

Y=129.78+35.46+ (16.05-40) = 140.65 ($BILLION)


>>** (I+G) =35.46 **<<

GDP growth rate fell from 17.9% (YoY) in 2005, to 4.1% (YoY) in 2008:

Meaning a rise in the value of imports at any given time will result in a fall in the growth
rate of Gross Domestic Product, in nominal terms. Assuming oil is predominantly
imported in Pakistan, the rise in the price of oil, will increase the value of imports (m)
leading to a negative impact on the growth rate of national income(Y).
The other impact of rising prices of imported oil translate into a growing trade deficit
which depicted earlier shows the growth of imports much higher than the growth of
exports. Examining the table above, exports have grown by 7.8% between 2006 and
2008, while imports have grown by 35.3%.

Oil Prices, Inflation, and lower GDP growth:

Increased imported oil prices cause inflation, as the costs of production, storage, and
distribution rise (assuming oil is a major source of energy in the economy). Increased
inflation lowers the buying power of consumers in addition to lowering discretionary

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income left (after buying more expensive energy) with households to spend on other
goods and services. This leads to lower growth in consumption spending, further
weakening the economic outlook of the nation. The following table shows that although
total consumption spending has been growing, the (YoY) change in percentage terms is
declining in Pakistan. Proving that higher oil prices are leading to lower economic
growth, as lower growth in consumption (C) means lower growth in GDP (Y). In addition
to lower consumption growth, higher growth in imports (m) is further deteriorating the
situation as shown earlier.

Consumption Spending Growth (2005-2008)

Consumption( C ) US$ in Billions Percent Change


2005 91.85 -
2006 107.30 +16.8%
2007 120.00 +11.8%
2008 125.78 +4.8%

Table (IV)

The CPI data which follows shows the rapid increase in the Consumer Price Index as a
direct result of the rising price of oil.

Consumer Price Index (2004-2008)

Consumer Price Percentage Percentage Change


Index(YoY)
2004 4.57 -
2005 9.28 +103%
2006 7.92 -14.6%
2007 7.77 -1.8%
2008 18.29 +135%

Table (V)

Real Negative Affect of Rising Oil Prices on Pakistan:

So the rising price of oil has had 2 major affects on the economy of Pakistan.

Increased value of imports (m), have led to decreased GDP growth rate.

Increased prices of imported oil have also brought Inflation which has decreased buying
power of money, and increased the energy costs of consumers and producers resulting in
lower discretionary spending.

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Effects of inflation in Pakistan:

Lower discretionary spending has contributed to the declining rate of consumption


growth (C) lowering GDP growth rate further:

Illustration of Effect 1 & Effect 2.

Effect 1

Increased Imports have led to a decreased trade balance or an increased trade deficit as
follows. I

Grapa (d)

Effect 2

Increased imported energy prices have led to increased prices at home leading to
increased inflation. Increased inflation has decreased the discretionary income of
households, leading to decreased discretionary spending. Decreased discretionary
spending has resulted in slower consumption growth.

Graph (e)

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Higher Inflation = Lower Consumption Growth as follows:

Graph (f)

Lower Consumption growth, and higher trade balance result in decreasing economic
growth depicted as follows.

Graph (g)

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Natural Gas as a Solution

The advantages of Natural Gas as a substitute for Oil are quite apparent in the Pakistani
economic framework. The government is offering simple price incentives for the use of
Natural Gas as opposed to oil for consumers in the transport industry; mainly private and
commercial vehicles. The other incentive is for Independent power producers (IPP) to
switch their power production methods from oil powered pants to gas powered plants.
IPP’s contribute to about 35% of the nations’ total power production, and about 59% of
total non hydroelectric power.

Remedies of inflation
The first panacea for a mismanagement nation is inflation of the currency. The second is
war. Both bring a permanent ruin. They both are the refuge of political and economic
opportunities. (Ernest Hemingway). To avoid political unrest and harmful, social and
economic effects on the economy, it is the main objective of every government to take
appropriate measures to control inflation. The main measures which are used to control
inflation are

• MONETARY POLICY
• FISCAL POLICY

Monetary Policy
Monetary policy is a policy that influences the economy through changes in the money
supply and available credit. Monetary policy is adopted by central bank of a country. The
various monetary measures which are used to control inflation are grouped under two
heads
• Quantitative controls
• Qualitative controls.

They are

• Open market operations


• Variation in bank rates
• Credit rationing
• Varying reserve requirements
• Varying margin requirements
• Consumer credit regulations.

Fiscal Policy
Fiscal policy is the deliberate change in either government spending or taxes to stimulate
or slow down the economy. It is the budgetary policy of the government relating to taxes
public expenditure, public borrowing and deficit financing. Fiscal policy is based upon
demand management i.e, raising or lowering the level of aggregate demand by

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controlling various expenditures, government expenditure, consumption expenditure and
investment expenditure. The main fiscal measures are:

Changes in taxation
If the Govt: of a country brings about changes in tax rates, it can help stabilization of
prices in the country. For example. A decrease in taxes relates increases disposable
income in relation to national income hence, consumption rises at every level of national
income. With the increase in aggregate demand for goods, the employment goes up in the
country. A rise in tax rates has the opposite effect. A rise in taxes causes a decrease in
disposable income, creates a larger budget deficit and brings relief from inflation.

Changes in Govt. Expenditure


If inflation is at or above the level of full employment in the country, the government can
bring down price level by curtailing its own unproductive expenditure.

Public borrowing
Public borrowing is another effective method of controlling inflation. Public borrowing
reduces the aggregate demand for goods and hence price level.

Balanced budget Changes


A balanced budget decrease has a mild contractionary effect on national income and
hence on bringing down the price level.

Control of deficit financing


For financing the budget deficit, the govt. often resorts to deficit financing. The bank
borrowing and printing of new notes increases the money supply in the country and
pushes up the price level. Deficit financing therefore, should be avoided to control
inflation.

Others Measures:
Apart from fiscal and monetary measures, the other measures which are helpful in
controlling inflation are;

• Price support programme.


• Provision subsidies.
• Arrangements of easy availability of goods on hire purchase to stimulate
demand.
• Imposing direct control on prices of essential items.
• Rationing of essential consumer goods in case of acute emergency holding of
Friday and Sunday markets.

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Since 1950’s the control of inflation has become the chief objective of both developing
and developed countries of the world. The government therefore takes monetary, fiscal
and other measures to combat inflation.

CONCLUSION
This paper evaluates the role of different factors such as government sector borrowing,
demand relative to supply, private sector credit, imported inflation, exchange rate, total
tax revenue of the government, adaptive inflation expectations and wheat support price in
explaining inflation.
The quantitative analysis reveals that the most significant factors which explain 8 percent
inflation in 2005-06 were inflation expectations, private sector credit (a significant part of
asset side of money supply) and imported inflation. Overall impact of fiscal policies on
inflation was not significant and rather the direct part of taxes was dominant in putting
downward pressure on prices. Government sector borrowing also did not contribute in the
rise in prices in 2005-06, though it did contribute in 2004-05. The policy of keeping
stability in the exchange rate was successful in holding the exchange rate from putting
further pressure on prices. The role of wheat support/procurement price and the other
unexplained factors were also insignificant.
It can be safely stated, on the basis of our analysis, that while the expansionary monetary
policy did contribute in promising GDP growth, it also led to the rise in consumer prices.
The phenomenal growth in the flow of ‘loose credit’ to the private sector had a
significant role to play in disturbing the price mechanism. The availability of money at
virtually no cost encouraged speculators and hoarders. The role of adaptive expectations
then became prominent when people started expecting higher prices in future as land
prices, house rents and food prices seemed to have no limits.
The main concern that emerges out of this scenario is whether it is possible for the
economy to come out of this price spiral in the presence of high expectations for inflation
in future and a rising trade deficit? Would the policy makers be able to control the flow
of credit to nonproductive sectors and to profit seeking activities? Would the policy of
subsidizing food items through the government-run Utility Stores be successful or would
it be another episode of mismanagement?

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REFRENCES:

• Federal Bureau of Statistics


• Economic Survey of Pakistan (2005-2006)_
• Economic Theory by (K.K. Dewett, P. A. Samuelson, Parkin)
• Journals of the Chief Economist by WB (The Writer)
• Daily Dawn, 28/4/2008

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