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Inflation
Inflation
Inflation
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Inflation
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Inflation
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Inflation
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  • 1. INFLATIONReport for Course: Micro EconomicsSubmitted to: Mr. Riaz Hussain SoomroSubmitted by: M. Assad Fahim Khan (313001)Class: MBA-IDate of Submission: May 06, 2013
  • 2. ACKNOWLEDGEMENTSFirstly I would thank Allah for giving me the opportunity and theresources to be able to do something productive with our lives. WithoutHis blessings I would not have been able to come as far as i have.I wish to express my sincere thanks to Sir, Riaz Hussain Soomro forhelping us throughout this report. His guidelines have been very usefulfor me in preparing this report. He helped me find new ways of beinginnovative and creative.This report would not have been possible without his cooperationand continuous direction.Last but not the least I would like to thank my family and all my classfellows for their incessant support and approval.
  • 3. Introduction of InflationIn economics, inflation is a rise in the general level of prices of goods and services inan economy over a period of time. When the general price level rises, each unit ofcurrency buys fewer goods and services. Consequently, inflation reflects a reduction inthe purchasing power per unit of money – a loss of real value in the medium ofexchange and unit of account within the economy.Inflations effects on an economy are various and can be simultaneously positive andnegative. Negative effects of inflation include an increase in the opportunity cost ofholding money, uncertainty over future inflation which may discourage investmentand savings, and if inflation is rapid enough, shortages of goods as consumers beginhoarding out of concern that prices will increase in the future. Positive effects includeensuring that central banks can adjust real interest rates (intended to mitigaterecessions),and encouraging investment in non-monetary capital projectsEconomists generally agree that high rates of inflation and hyperinflation are causedby an excessive growth of the money supply. Views on which factors determine low tomoderate rates of inflation are more varied. Low or moderate inflation may beattributed to fluctuations in real demand for goods and services, or changes inavailable supplies such as during scarcities, as well as to changes in the velocity ofmoney supply measures; in particular the MZM ("Money Zero Maturity") supplyvelocity. However, the consensus view is that a long sustained period of inflation iscaused by money supply growing faster than the rate of economic growth.History of InflationIncreases in the quantity of money or in the overall money supply (or debasement ofthe means of exchange) have occurred in many different societies throughout history,changing with different forms of money used. For instance, when gold was used ascurrency, the government could collect gold coins, melt them down, mix them withother metals such as silver, copper or lead, and reissue them at the same nominalvalue. By diluting the gold with other metals, the government could issue more coinswithout also needing to increase the amount of gold used to make them. When the costof each coin is lowered in this way, the government profits from an increase inseigniorage. This practice would increase the money supply but at the same time therelative value of each coin would be lowered. As the relative value of the coinsbecomes lower, consumers would need to give more coins in exchange for the samegoods and services as before. These goods and services would experience a priceincrease as the value of each coin is reduced.
  • 4. . Types of Inflation in Economics1. Types of Inflation on CoverageTypes of inflation on the basis of coverage and scope point of view:-1. Comprehensive Inflation : When the prices of all commodities risethroughout the economy it is known as Comprehensive Inflation. Anothername for comprehensive inflation is Economy Wide Inflation.2. Sporadic Inflation : When prices of only few commodities in few regions (areas)rise, it is known as Sporadic Inflation. It is sectional in nature. For example, risein food prices due to bad monsoon (winds bringing seasonal rains in India).2. Types of Inflation on Time of OccurrenceTypes of inflation on the basis of time (period) of occurrence:-1. War-Time Inflation : Inflation that takes place during the period of a war-likesituation is known as War-Time inflation. During a war, scare productiveresources are all diverted and prioritized to produce military goods andequipments. This overall result in very limited supply or extreme shortage (lowavailability) of resources (raw materials) to produce essential commodities.Production and supply of basic goods slow down and can no longer meet thesoaring demand from people. Consequently, prices of essential goods keep onrising in the market resulting in War-Time Inflation.2. Post-War Inflation : Inflation that takes place soon after a war is known as Post-War Inflation. After the war, government controls are relaxed, resulting in a fasterhike in prices than what experienced during the war.3. Peace-Time Inflation : When prices rise during a normal period of peace, it isknown as Peace-Time Inflation. It is due to huge government expenditure orspending on capital projects of a long gestation (development) period.
  • 5. 3. Types of Inflation on Government ReactionTypes of inflation on basis of Governments reaction or its degree of control:-1. Open Inflation : When government does not attempt to restrict inflation, it isknown as Open Inflation. In a free market economy, where prices are allowed totake its own course, open inflation occurs.2. Suppressed Inflation : When government prevents price rise through pricecontrols, rationing, etc., it is known as Suppressed Inflation. It is also referred asRepressed Inflation. However, when government controls are removed,Suppressed inflation becomes Open Inflation. Suppressed Inflation leads tocorruption, black marketing, artificial scarcity, etc.4. Types of Inflation on Rising PricesTypes of inflation on the basis of rising prices or rate of inflation:-1. Creeping Inflation : When prices are gently rising, it is referred as CreepingInflation. It is the mildest form of inflation and also known as a Mild Inflation orLow Inflation. According to R.P. Kent, when prices rise by not more than (up to)3% per annum (year), it is called Creeping Inflation.2. Chronic Inflation : If creeping inflation persist (continues to increase) for alonger period of time then it is often called as Chronic or Secular Inflation.Chronic Creeping Inflation can be either Continuous (which remains consistentwithout any downward movement) or Intermittent (which occurs at regularintervals). It is called chronic because if an inflation rate continues to grow for alonger period without any downturn, then it possibly leads to Hyperinflation.3. Walking Inflation : When the rate of rising prices is more than the CreepingInflation, it is known as Walking Inflation. When prices rise by more than 3% butless than 10% per annum (i.e between 3% and 10% per annum), it is called asWalking Inflation. According to some economists, walking inflation must betaken seriously as it gives a cautionary signal for the occurrence of Runninginflation. Furthermore, if walking inflation is not checked in due time it caneventually result in Galloping inflation.
  • 6. 4. Moderate Inflation : Prof. Samuelson clubbed together concept of Crepping andWalking inflation into Moderate Inflation. When prices rise by less than 10% perannum (single digit inflation rate), it is known as Moderate Inflation. Accordingto Prof. Samuelson, it is a stable inflation and not a serious economic problem.5. Running Inflation : A rapid acceleration in the rate of rising prices is referred asRunning Inflation. When prices rise by more than 10% per annum, runninginflation occurs. Though economists have not suggested a fixed range formeasuring running inflation, we may consider price rise between 10% to 20% perannum (double digit inflation rate) as a running inflation.6. Galloping Inflation : According to Prof. Samuelson, if prices rise by double ortriple digit inflation rates like 30% or 400% or 999% per annum, then thesituation can be termed as Galloping Inflation. When prices rise by more than20% but less than 1000% per annum (i.e. between 20% to 1000% per annum),galloping inflation occurs. It is also referred as Jumping inflation. India has beenwitnessing galloping inflation since the second five year plan period.7. Hyperinflation : Hyperinflation refers to a situation where the prices rise at analarming high rate. The prices rise so fast that it becomes very difficult to measureits magnitude. However, in quantitative terms, when prices rise above 1000% perannum (quadruple or four digit inflation rate), it is termed as Hyperinflation.During a worst case scenario of hyperinflation, value of national currency(money) of an affected country reduces almost to zero. Paper money becomesworthless and people start trading either in gold and silver or sometimes even usethe old barter system of commerce. Two worst examples of hyperinflationrecorded in world history are of those experienced by Hungary in year 1946 andZimbabwe during 2004-2009 under Robert Mugabes regime.5. Types of Inflation on CausesTypes of inflation on the basis of different causes:-1. Deficit Inflation : Deficit inflation takes place due to deficit financing.
  • 7. 2. Credit Inflation : Credit inflation takes place due to excessive bank credit ormoney supply in the economy.3. Scarcity Inflation : Scarcity inflation occurs due to hoarding. Hoarding is anexcess accumulation of basic commodities by unscrupulous traders and blackmarketers. It is practised to create an artificial shortage of essential goods likefood grains, kerosene, etc. with an intension to sell them only at higher prices tomake huge profits during scarcity inflation. Though hoarding is an unfair tradepractice and a punishable criminal offence still some crooked merchants often getthemselves engaged in it.4. Profit Inflation : When entrepreneurs are interested in boosting their profitmargins, prices rise.5. Pricing Power Inflation : It is often referred as Administered Price inflation. Itoccurs when industries and business houses increase the price of their goods andservices with an objective to boost their profit margins. It does not occur during afinancial crisis and economic depression, and is not seen when there is a downturnin the economy. As Oligopolies have the ability to set prices of their goods andservices it is also called as Oligopolistic Inflation.6. Tax Inflation : Due to rise in indirect taxes, sellers charge high price to theconsumers.7. Wage Inflation : If the rise in wages in not accompanied by a rise in output,prices rise.8. Build-In Inflation : Vicious cycle of Build-in inflation is induced by adaptiveexpectations of workers or employees who try to keep their wages or salaries highin anticipation of inflation. Employers and Organizations raise the prices of theirrespective goods and services in anticipation of the workers or employeesdemands. This overall builds a vicious cycle of rising wages followed by anincrease in general prices of commodities. This cycle, if continues, keeps on
  • 8. accumulating inflation at each round turn and thereby results into what is called asBuild-in inflation.9. Development Inflation : During the process of development of economy,incomes increases, causing an increase in demand and rise in prices.10. Fiscal Inflation : It occurs due to excess government expenditure or spendingwhen there is a budget deficit.11. Population Inflation : Prices rise due to a rapid increase in population.12. Foreign Trade Induced Inflation : It is divided into two categories, viz., (a)Export-Boom Inflation, and (b) Import Price-Hike Inflation.13. Export-Boom Inflation : Considerable increase in exports may cause a shortageat home (within exporting country) and results in price rise (within exportingcountry). This is known as Export-Boom Inflation.14. Import Price-Hike Inflation : If a country imports goods from a foreign country,and the prices of imported goods increases due to inflation abroad, then the pricesof domestic products using imported goods also rises. This is known as ImportPrice-Hike Inflation. For e.g. India imports oil from Iran at $100 per barrel. Oilprices in the international market suddenly increases to $150 per barrel. NowIndia to continue its oil imports from Iran has to pay $50 more per barrel to getthe same amount of crude oil. When the imported expensive oil reaches India, theIndian consumers also have to pay more and bear the economic burden.Manufacturing and transportation costs also increase due to hike in oil prices.This, consequently, results in a rise in the prices of domestic goods beingmanufactured and transported. It is the end-consumer in India, who finally paysand experiences the ultimate pinch of Import Price-Hike Inflation. If the oil pricesin the international market fall down then the import price-hike inflation alsoslows down, and vice-versa.
  • 9. 15. Sectoral Inflation : It occurs when there is a rise in the prices of goods andservices produced by certain sector of the industries. For instance, if prices ofcrude oil increases then it will also affect all other sectors (like aviation, roadtransportation, etc.) which are directly related to the oil industry. For e.g. If oilprices are hiked, air ticket fares and road transportation cost will increase.16. Demand-Pull Inflation : Inflation which arises due to various factors like risingincome, exploding population, etc., leads to aggregate demand and exceedsaggregate supply, and tends to raise prices of goods and services. This is knownas Demand-Pull or Excess Demand Inflation.17. Cost-Push Inflation : When prices rise due to growing cost of production ofgoods and services, it is known as Cost-Push (Supply-side) Inflation. For e.g. Ifwages of workers are raised then the unit cost of production also increases. As aresult, the prices of end-products or end-services being produced and supplied areconsequently hiked..
  • 10. 6. Types of Inflation on ExpectationTypes of inflation on the basis of expectation or predictability:-1. Anticipated Inflation : If the rate of inflation corresponds to what the majority ofpeople are expecting or predicting, then is called Anticipated Inflation. It is alsoreferred as Expected Inflation.2. Unanticipated Inflation : If the rate of inflation corresponds to what the majorityof people are not expecting or predicting, then is called Unanticipated Inflation. Itis also referred as Unexpected Inflation.Effects of Inflation - The Positives and the NegativesThere are both “positive and negative” effects of Inflation on economy.Positive EffectProbably the most significant effect of inflation is its effect on the revenues of thegovernment. When inflation is higher than previously thought and planned with, therevenues of the government increases, which is good as the budget balance of thegovernment improves. The reason why revenues of the government increases wheninflation increases is because the government has higher tax revenues. For example acompany sells its products and services at higher prices, which increases the total incomeof the company, which in turn increases the gross (before tax) profits of the company(provided that all other factors influencing profits remain constant). Greater before taxprofits result in greater taxes paid to the government.Negative EffectHigh or unpredictable inflation rates are regarded as bad:1) Uncertainty about future inflation may discourage investment and saving.2) International trade: Where fixed exchange rates are imposed, higher inflation thanin trading partners economies will make exports more expensive and tend towarda weakening balance of trade.3) Menu costs: Firms must change their prices more frequently, which imposescosts, for example with restaurants having to reprint menus.
  • 11. 4) Rising inflation can prompt trade unions to demand higher wages, to keep up withconsumer prices. Rising wages in turn can help fuel inflation. In the case ofcollective bargaining, wages will be set as a factor of price expectations, whichwill be higher when inflation has an upward trend. This can cause a wagespiral.[citation needed] In a sense, inflation begets further inflationaryexpectations.5) Hyperinflation: if inflation gets totally out of control (in the upward direction), itcan grossly interfere with the normal workings of the economy, hurting its abilityto supply.CONTROLLING OF INFLATIONInflation needs to be controlled in the very beginning, otherwise it completely ruins theeconomy, once it acquires the hyper inflation form. Various anti-inflationary measuresare suggested to avoid or overcome disastrous consequences of inflation. Most of thesemeasures aim at reducing aggregate demand for goods and services. These measures canbe explained in three categories, namely, monetary measures, fiscal measures and othermeasures.1. Monetary MeasuresGrowth of inflation during the post Second War period revived the confidence in thepotency of monetary policy, though it proved to be ineffective by Keynes to controldepression. Monetary policy is the policy of the central bank of the country, which is thesupreme monetary authority. Monetary measures attempt to regulate the money supply inan economy. To check inflation, increase in the volume of currency should be avoided. Ifthere is abundant black money, currency of higher denominations should be demonetized.New currency notes can also be issued in exchange of old currency notes.Bank deposits which enable credit creation form large share of money supply. Thus, themain concern of monetary measures should be to regulate the bank credit. Central bankuses various quantitative and qualitative (selective) control measures for this purpose.Quantitative control measures such as bank rate policy, open market operations andvariable reserve requirements influence the cost and availability of credit.The central bank by raising the bank rate can easily push up the market) rates of interestand makes investment less attractive. Inflationary rise in prices is arrested by choking offthe excess demand. The bank rate policy is effective, if banks do not have an easy accessto other sources of funds. Under open market operations, through sale of governmentsecurities, money supply is reduced. This measure is superior to the bank rate policy, as itdirectly affects the money supply. However, its success to control credit and henceinflation depends upon the attractiveness of these securities and the existence oforganized money market. Variable reserve requirements is the most effective measure tocheck inflation, but it is not very often used due to its harsh effects. By raising the cashreserve ratio, central bank can reduce the amount of credit which banks can create.
  • 12. Among selective control measures, the regulation of consumer credit has become verycommon with the rise of consumerism. During inflation, consumer credit facilities arecurtailed by raising the down payments and reducing the payment period on selectivebasis. Central bank may also fix higher margin requirements for loans according to thepurposes. Higher are the margin requirements, lower will be the amounts of loans that theborrowers can obtain from the bank. These selective control measures, besides directives,moral suasion, publicity, direct action, etc., may be used to limit the undue monetaryexpansion.The effectiveness of the monetary measures depends upon the degree of control exercisedby the central bank and the extent of cooperation extended by the commercial banks andother constituents of the money market. In a developing country like India, most of thesefactors are lacking. Hence monetary policy will be of little value here. Further, wheninflation is due to expansion of printed currency (to finance war or development plans),fiscal measures will be more useful to which we now turn.2. Fiscal MeasuresAs government expenditure has become an important portion of the aggregateexpenditure in almost every economy of the world, the government can significantlyaffect the money supply and hence inflation. Monetary policy, when supplemented byfiscal policy will become more effective. The following anti-inflationary fiscal measurescan be used to mop up the excessive purchasing power in the economy.(a) Public ExpenditureTo control price rise, the government can reduce its expenditure. This will reduce publicmoney from the market and hence the demand for goods and services. Reduction ingovernment expenditure as an anti-inflationary weapon should be used with care. It isalmost suicidal to curtail defence or development expenditure of the government. Further,it is of no use to give up the schemes under various plans, that the government hasalready taken up. Thus, the government must keep the non-essential expenditure to theminimum. This will also put a check on private expending, which depend upongovernment expenditure.(b) TaxationTaxes determine the volume of disposable income in the hands of the people. Impositionof new taxes and raising the rates of taxes, on one hand reduces the purchasing power ofthe people. On the other hand, it generates resources to the government for combatinginflation. Anti-inflationary taxation should, thus, aim at reducing the disposable income,that otherwise would be spent on consumption. Tax revenue realized by the governmentshould be used to maintain essential expenditure. However, the rates of taxes should notbe so high as to discourage saving, investment and production. Rather, the tax systemshould provide larger incentives to those who save, invest and produce. Further, to bringmore tax revenue, the government should penalize the tax evaders by imposing heavyfines.The government should give up deficit financing and instead have surplus budgets by
  • 13. collecting more tax revenues by a fine combination of direct and indirect taxes. Directtaxes like income tax, wealth tax, expenditures tax, etc., decline the disposable incomeand exert pressure on demand. Indirect taxes may also produce similar effects with anextra advantage of wide coverage. However, indirect taxes fall heavily on fixed incomeearners, who are already hit by the inflation. This discriminating effects can be correctedby imposing heavy excise duties and other similar taxes on luxury commodities, whichare consumed by imposing heavy by the high income groups in the economy. However,indirect taxes are not suitable as these add to the cost push inflation by raising the pricesof goods.(c) Public Borrowing and DebtThe main purpose of public borrowing, like tax is to take away from public, excessivepurchasing power, which if left free, would exert an upward pressure on the demand. Ifvoluntary borrowing does not yield the desired results, the government may resort tocompulsory borrowing. Forced loans, a variant of compulsory savings have been tried inNorway, Belgium and Holland. Compulsory provident fund cum-pension schemes, etc.,may be introduced compulsorily. The government can also float public loans carryinghigh rates of interest, start saving scheme for long periods with prize money or lottery.The government should avoid paying back any of its previous loans during inflation toprevent an increase in the circulation of money. Further, if possible, the payment of partof the salary to the employees he deferred to reduce current purchasing power of people.Deferred purchasing power can be released, when inflation comes to an end or there is anexpectation of recession in the economy. Similarly, pay revision arrears may betransferred to the provident fund accounts, rather making cash payments of the sameduring inflation. Compulsory savings and deferred payments are normally avoided duringpeace time.Measuring of InflationThe inflation rate is widely calculated by calculating the movement or change in a priceindex, usually the consumer price index.[33]The consumer price index measuresmovements in prices of a fixed basket of goods and services purchased by a "typicalconsumer". The inflation rate is the percentage rate of change of a price index over time.The Retail Prices Index is also a measure of inflation that is commonly used in the UnitedKingdom. It is broader than the CPI and contains a larger basket of goods and services.Example:To illustrate the method of calculation, in January 2007, the U.S. Consumer Price Indexwas 202.416, and in January 2008 it was 211.080. The formula for calculating the annualpercentage rate inflation in the CPI over the course of 2007 is
  • 14. The resulting inflation rate for the CPI in this one year period is 4.28%, meaning thegeneral level of prices for typical U.S. consumers rose by approximately four percent in2007.Important terms for calculating priceProducer price indices:(PPIs) which measures average changes in prices received by domestic producers fortheir output. This differs from the CPI in that price subsidization, profits, and taxes maycause the amount received by the producer to differ from what the consumer paid. Thereis also typically a delay between an increase in the PPI and any eventual increase in theCPI. Producer price index measures the pressure being put on producers by the costs oftheir raw materials. This could be "passed on" to consumers, or it could be absorbed byprofits, or offset by increasing productivity. In India and the United States, an earlierversion of the PPI was called theConsumer price indices:A consumer price index (CPI) measures changes in the price level of aconsumer goods and servicesdefined by the Bureau of Labor Statisticsin the prices paid by urban consumers for aservices."The resulting inflation rate for the CPI in this one year period is 4.28%, meaning thegeneral level of prices for typical U.S. consumers rose by approximately four percent inImportant terms for calculating price inflation include the following::(PPIs) which measures average changes in prices received by domestic producers fors from the CPI in that price subsidization, profits, and taxes maycause the amount received by the producer to differ from what the consumer paid. Thereis also typically a delay between an increase in the PPI and any eventual increase in ther price index measures the pressure being put on producers by the costs oftheir raw materials. This could be "passed on" to consumers, or it could be absorbed byprofits, or offset by increasing productivity. In India and the United States, an earliersion of the PPI was called the “Wholesale Price Index”.Consumer price indices:(CPI) measures changes in the price level of a market basketservices purchased by households. The CPI in the United States isBureau of Labor Statistics as "a measure of the average changein the prices paid by urban consumers for a market basket of consumer goods andThe resulting inflation rate for the CPI in this one year period is 4.28%, meaning thegeneral level of prices for typical U.S. consumers rose by approximately four percent in(PPIs) which measures average changes in prices received by domestic producers fors from the CPI in that price subsidization, profits, and taxes maycause the amount received by the producer to differ from what the consumer paid. Thereis also typically a delay between an increase in the PPI and any eventual increase in ther price index measures the pressure being put on producers by the costs oftheir raw materials. This could be "passed on" to consumers, or it could be absorbed byprofits, or offset by increasing productivity. In India and the United States, an earliermarket basket ofpurchased by households. The CPI in the United States isas "a measure of the average change over timeof consumer goods and
  • 15. Pakistan Inflation RateThe inflation rate in Pakistan was recorded at 6.57 percent in March of 2013. InflationRate in Pakistan is reported by the Pakistan Bureau of Statistics. Historically, from 1957until 2013, Pakistan Inflation Rate averaged 8.04 Percent reaching an all tim37.81 Percent in December of 1973 and a record low of1959. In Pakistan, most important categories in the consumer price index are food andnon-alcoholic beverages (35 percent of total weight); housing, water, electrfuels (29 percent); clothing and footwear (8 percent) and transport (7 percent). The indexalso includes furnishings and household equipment (4 percent), education (4 percent),communication (3 percent) and health (2 percent). The remainingby: recreation and culture, restaurants and hotels, alcoholic beverages and tobacco andother goods and services. This page includes a chart with historical data for PakistanPakistan Inflation RateThe inflation rate in Pakistan was recorded at 6.57 percent in March of 2013. InflationRate in Pakistan is reported by the Pakistan Bureau of Statistics. Historically, from 1957until 2013, Pakistan Inflation Rate averaged 8.04 Percent reaching an all tim37.81 Percent in December of 1973 and a record low of -10.32 Percent in February of1959. In Pakistan, most important categories in the consumer price index are food andalcoholic beverages (35 percent of total weight); housing, water, electricity, gas andfuels (29 percent); clothing and footwear (8 percent) and transport (7 percent). The indexalso includes furnishings and household equipment (4 percent), education (4 percent),communication (3 percent) and health (2 percent). The remaining 8 percent is composedby: recreation and culture, restaurants and hotels, alcoholic beverages and tobacco andother goods and services. This page includes a chart with historical data for PakistanInflation Rate.The inflation rate in Pakistan was recorded at 6.57 percent in March of 2013. InflationRate in Pakistan is reported by the Pakistan Bureau of Statistics. Historically, from 1957until 2013, Pakistan Inflation Rate averaged 8.04 Percent reaching an all time high of10.32 Percent in February of1959. In Pakistan, most important categories in the consumer price index are food andicity, gas andfuels (29 percent); clothing and footwear (8 percent) and transport (7 percent). The indexalso includes furnishings and household equipment (4 percent), education (4 percent),8 percent is composedby: recreation and culture, restaurants and hotels, alcoholic beverages and tobacco andother goods and services. This page includes a chart with historical data for Pakistan
  • 16. What are the main Causes of inflation in Pakistanin recent time?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 aboveeight 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.Is there any need to worry about inflation? When is inflation bad for the economy? Areasonable rate of inflation--around 3- 6 per cent-- is often viewed to have positive effectson the national economy as it encourages investment and production and allows growthin wages.When inflation crosses reasonable limits, it has negative effects. It reduces the value ofmoney, resulting in uncertainty of the value of gains and losses of borrowers, lenders, andbuyers and sellers. The increasing uncertainty discourages saving and investment.Not only can high inflation erode the gains from growth, it also makes the poor worse offand widens the gap between the rich and the poor. If much of the inflation comes fromincrease in food prices, it hurts poor more since over half of family budget of the lowwage earners goes for food. Second, it redistributes income from fixed income earners(for instance pensioners) to owners of assets and earners of large and variable income,such as profits.In case of Pakistan, annual inflation was above 11 per cent in the 11 of the past 32 years.Not surprisingly, average real per capita income growth was 2.8 per cent in years havingless than 11 per cent inflation as compared to the years of high inflation with an averageof 1.5 per cent.For Pakistan economy, inflation can be bad if it crosses the threshold of six per cent, andcan be extremely harmful if it crosses the double digit level.Several supply and demand factors could be responsible for this surge in inflation.Supply-side shocks can cause large fluctuations in food and oil prices, effects of whichon overall inflation, at times, can be so excessive that these cannot be countered throughdemand management, including monetary policy.First, increased domestic demand created an output gap, putting upward pressure onprices. Growth in private consumption on the average remained over 10 per cent betweenFY04 and FY06, depicting signs of demand side pressures on price level.The relationship between growth and inflation depends on the state of the economy. Highgrowth, without an increase in inflation, is possible if the productive capacity or potentialoutput of the economy is growing enough to keep pace with demand. This is also possibleif the actual output is below the potential output and there is sufficient spare capacity
  • 17. available to cope up with the demand pressures.When the actual output catches up with the potential output, there remains no sparecapacity and the economy is working at full employment level, any further gain in growthcomes at the cost of rising inflation. If demand continues to grow at this stage, and theproductive capacity does not expand, there is a serious threat of rapid inflation in the longrun without any additional growth in the output. A prolonged phase of rising inflation insuch a case can have severe consequences for the economy.Second, the growing gap between domestic demand and production was filled by a sharpincrease in net imports, which grew by above 40 per cent in FY05 and by 24 per cent inFY06. As compared to imports, exports increased by only around 10 per cent in FY05and by 13 per cent in FY06. This resulted in a record trade deficit.Rising trade deficit can be a cause of expectations of high inflation in future.The expectations effect is very important since there is a danger that the current high rateof inflation can get locked into expectations of inflation.People expect higher salaries to compensate for expected increase in prices, speculationin asset prices increases, credit meant for manufacturing sector diverts to real estate andstock markets, and hoarders, profit and rent seekers become active in expectation of highprice in the future. All this can have devastating effect for the prices.Third, fiscal policy has remained expansionary in the last few years. Expansionary fiscalpolicy fuels domestic demand and puts pressure on the current account deficit. It widensthe investment-saving gap, which has to be financed externally. Financing of fiscal deficitthrough money creation adds to inflationary pressures. Increased government borrowingfrom central bank can have serious consequences for general price level.Fourth, the expansionary monetary policy- high growth in money supply and loose creditpolicy- was believed to be contributing to high inflation. Although expansion of credit isusual in expanding economies, excessive credit growth can have adverse effects on realvariables.Rising import prices are also considered an important factor for inflation. Exchange rate,if depreciating can also put upward pressure on price level. Increase in prices of goods,such as petrol, raw material etc makes our imports costlier, impacting on cost ofproduction.Similarly, indirect taxes are also blamed as the main cause of inflation. The indirecttaxes, such as sales tax and excise duties raise the prices of consumer goods. This createsinflationary pressure. On the other hand, direct taxes reduce the take-home income andhave anti-inflationary effect. A substantial increase in support price of wheat is estimatedto have an inflationary effect on consumer prices, particularly food prices. This effect isdue to the fact that wheat and wheat-related products account for 5.1 per cent of the CPI
  • 18. basket.The question arises as to what were the factors that stimulated the recent inflation inPakistan?During the first four years of the new millennium inflation remained under five per centand then suddenly increased to 9.3 per cent in 2004-05 and settled to eight per cent in2005-06. The growth in wheat prices and exchange rate was low in some years and highin others. However, it seems that excessive money flows towards public and privatesector, along with the import price hike in 2003-04 and 2005-06 and wheat price rise in2003-04 and 2004-05 created inflationary pressure at an alarming level. Taxes as apercentage of manufacturing sector value-added did not show any rise.Inflation: ConclusionSome points to remember: Inflation is a sustained increase in the general level of prices for goods andservices. When inflation goes up, there is a decline in the purchasing power of money. Variations on inflation include deflation, hyperinflation and stagflation. Two theories as to the cause of inflation are demand-pull inflation and cost-pushinflation. When there is unanticipated inflation, creditors lose, people on a fixed-incomelose, "menu costs" go up, uncertainty reduces spending and exporters arent ascompetitive. Lack of inflation (or deflation) is not necessarily a good thing. Inflation is measured with a price index. The two main groups of price indexes that measure inflation are the ConsumerPrice Index and the Producer Price Indexes. Inflation plays a large role in the Feds decisions regarding interest rates. In the long term, stocks are good protection against inflation. Inflation is a serious problem for fixed income investors. Its important tounderstand the difference between nominal interest rates and real interest rates. Inflation-indexed securities offer protection against inflation but offer low returns.

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