Introduction to Economics
Instructor: Miss Isma Khatoon
• Inflation is defined as continuous increase in
general price level.
• “When the general level of prices for goods
and services is rising and subsequently
purchasing power is falling.”
• “Inflation can be thought of as a decrease in
the value of the unit of currency.”
• As inflation rises, every dollar will buy a
smaller percentage of goods. ( purchasing
power of each unit of currency falls, as you
can buy less now than before)
• Most of the country’s central bank tries to
sustain an inflation rate of 2-3%.
There are several variations in Inflation
• Stagflation is the combination of high inflation
and low growth rate in the economy.
• Deflation is when the general level of prices is
falling. This is the opposite of inflation.
• Hyperinflation is unusually rapid inflation. In
extreme case this can lead to the broke down
of nation’s monetary system.
Types of inflation
• There are two types of inflation
1) Demand pull inflation
This theory can be summarized as “ too much
money chasing too few goods”. In other
words, if demand is growing faster than
supply, price will increase. This usually occur
in growing economies.
AD>AS→ increase in prices → demand is
pulling Prices upward
Cost push inflation
• When companies costs go up, they need to
increase prices to maintain their profit margin.
Increased costs can include things such as
wages, taxes or increased cost of imports.
• Inflation at the cost/ supply side of the
• Increase in the cost of raw material/energy inputs→
increase in per unit production cost → increase in
• Per unit production cost
Average cost of a particular level of output
per unit production cost = total input cost
units of output
Rising per unit production costs → profit decrease
→ output decrease at the existing price level→
Main price indexes measure inflation
1. Consumer price index (CPI)
CPI measures the variation in cost of buying
(prices) of representative market basket of
goods and services. The CPI measures price
change from the perspective of the purchaser.
• It covers 374 items in 35 major cities. It
computes on monthly basis.
• CPI is calculated at the base year of 2000-01.
2. Producer Price Index (PPI)
A family indexes that measure the average change
overtime in selling prices by domestic producers of
goods and services. PPI measure price change from
the perspective of seller, an earlier version of PPI
was called the Wholesale Price Index.
3. Core Inflation
Core inflation is a measure of inflation which
excludes certain items that face volatile price
movements such as Food and fuel prices.
4. GDP deflator
GDP deflator is measure of the prices of all goods
and services included in Gross Domestic Product.
GDP deflator = Nominal GDP
5. Sensitive price index
it computes on weekly basis to assess the price
movements of essential commodities at short
intervals so as to review the price situation in the
economy. It is computed from 17 major cities.
• The CPI is calculated by taking price changes
for each item in the predetermined basket of
goods and averaging them: the goods are
weighted according to their importance.
• CPI = Price of the most recent market basket
in the particular year
price estimate of the same market
basket in the recent year X100
Rate of Inflation
• Rate of inflation for a certain year is found by
comparing, in percentage terms, that year’s
index (CPI) with the index in previous year.
• Rate of inflation = CPI2 -CPI1
Causes of inflation in Pakistan
1. International inflation
2. Increase in wages
3. Population pressure
4. Increase in money supply
5. Fall in production
6. Foreign aid
7. No limits to growth
8. Improper economic policies
9. Persistent deficit in BOP
10. Defective social structure
(1 )International inflation
• Globalization→ world is global village now
• Each country is interconnected and affected
by world prices
• As Pakistan importer of edible oil, machinery,
oil, chemicals etc.
• So world prices affect inflation in the country
(2) Increase in wages
• Price increases→ demand for increase in
wages → cost of production of producer will
increase, ultimately increase prices.
(3) population pressure
population of Pakistan
population growth rate
Pop increase→ demand increase → prices inc
(4) Increase in Money supply
Reason of this increase
i. Decrease in the rate of interest
ii. Increase in remittances
iii. Increased non productive expenses of Gov
iv. Decreased saving and investment
v. Decrease in taxable capacity
(5) Fall in production
• Agriculture sector problems
• Water logging
• Agricultural diseases
• Pests and insects
• Floods and droughts
• Results decrease in production, AS<AD→ P↑
• Same as industrial production
(6) Foreign Aid
• Non- Productive loans increased
• Productive loans decreased
• No increase in output
• Demand and expenses increase→ prices↑
(7) International demonstration affect
demand for luxury items increased
(8) Improper economic policies
• Political instability
• Unlimited power with bureaucracy
(9) Persistent deficit in BOP
imports > exports
Demand for $ > Supply of $
Depreciation and devaluation of currency →
increased import prices
Measures to control inflation
• Fiscal measures
• Monetary measures
• Structural measures
1. Fiscal measures
• Decrease in non-developmental expenditures by
• Increase in taxes
2. Monetary Measures
• increase in discount rate by SBP
• Selling government securities by SBP
• Increase in reserve ratio by SBP
3. Structural Measures
• Increase in industrial and agricultural
• Exploration of mineral resources
• Population control
• Price controls
• Link between productivity and wages
• Change in life style
Remedies of Inflation
1. Reduce Demand Pressure
if inflation is caused by high demand then:
i. Increase interest rate to reduce consumers
ii. Raise interest rate to discourage borrowing
iii. Raise taxes to reduce disposable income and
2. Reduce Cost Push Pressure
• If inflation is caused by high costs
i. Limit wage increases if possible e.g. public
ii. Force electricity and gas companies to hold
iii. Increase the value of currency in order to
reduce the cost of importing
3. Reduce Money Supply Pressure
• If inflation is caused by too much money in
• Print less money
• Withdraw some money from circulation
Whereas each of the above mention methods
have some advantages and disadvantages.
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