1. INFLATION
Report for Course: Micro Economics
Submitted to: Mr. Riaz Hussain Soomro
Submitted by: M. Assad Fahim Khan (313001)
Class: MBA-I
Date of Submission: May 06, 2013

2. ACKNOWLEDGEMENTS
Firstly I would thank Allah for giving me the opportunity and the
resources to be able to do something productive with our lives. Without
His 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 for
helping us throughout this report. His guidelines have been very useful
for me in preparing this report. He helped me find new ways of being
innovative and creative.
This report would not have been possible without his cooperation
and continuous direction.
Last but not the least I would like to thank my family and all my class
fellows for their incessant support and approval.

3. Introduction of 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 reflects a reduction in
the purchasing power per unit of money – a loss of real value in the medium of
exchange and unit of account within the economy.
Inflation's effects on an economy are various and can be simultaneously positive and
negative. Negative effects of inflation include an increase in the opportunity cost of
holding money, uncertainty over future inflation which may discourage investment
and savings, and if inflation is rapid enough, shortages of goods as consumers begin
hoarding out of concern that prices will increase in the future. Positive effects include
ensuring that central banks can adjust real interest rates (intended to mitigate
recessions),and encouraging investment in non-monetary capital projects
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 changes in the velocity of
money supply measures; in particular the MZM ("Money Zero Maturity") supply
velocity. 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.
History of Inflation
Increases in the quantity of money or in the overall money supply (or debasement of
the means of exchange) have occurred in many different societies throughout history,
changing with different forms of money used. For instance, when gold was used as
currency, the government could collect gold coins, melt them down, mix them with
other metals such as silver, copper or lead, and reissue them at the same nominal
value. By diluting the gold with other metals, the government could issue more coins
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
seigniorage. This practice would increase the money supply but at the same time the
relative value of each coin would be lowered. As the relative value of the coins
becomes lower, consumers would need to give more coins in exchange for the same
goods and services as before. These goods and services would experience a price
increase as the value of each coin is reduced.

4. . Types of Inflation in Economics
1. Types of Inflation on Coverage
Types of inflation on the basis of coverage and scope point of view:-
1. Comprehensive Inflation : When the prices of all commodities rise
throughout the economy it is known as Comprehensive Inflation. Another
name 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, rise
in food prices due to bad monsoon (winds bringing seasonal rains in India).
2. Types of Inflation on Time of Occurrence
Types of inflation on the basis of time (period) of occurrence:-
1. War-Time Inflation : Inflation that takes place during the period of a war-like
situation is known as War-Time inflation. During a war, scare productive
resources are all diverted and prioritized to produce military goods and
equipments. This overall result in very limited supply or extreme shortage (low
availability) of resources (raw materials) to produce essential commodities.
Production and supply of basic goods slow down and can no longer meet the
soaring demand from people. Consequently, prices of essential goods keep on
rising 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 faster
hike in prices than what experienced during the war.
3. Peace-Time Inflation : When prices rise during a normal period of peace, it is
known as Peace-Time Inflation. It is due to huge government expenditure or
spending on capital projects of a long gestation (development) period.

5. 3. Types of Inflation on Government Reaction
Types of inflation on basis of Government's reaction or its degree of control:-
1. Open Inflation : When government does not attempt to restrict inflation, it is
known as Open Inflation. In a free market economy, where prices are allowed to
take its own course, open inflation occurs.
2. Suppressed Inflation : When government prevents price rise through price
controls, rationing, etc., it is known as Suppressed Inflation. It is also referred as
Repressed Inflation. However, when government controls are removed,
Suppressed inflation becomes Open Inflation. Suppressed Inflation leads to
corruption, black marketing, artificial scarcity, etc.
4. Types of Inflation on Rising Prices
Types of inflation on the basis of rising prices or rate of inflation:-
1. Creeping Inflation : When prices are gently rising, it is referred as Creeping
Inflation. It is the mildest form of inflation and also known as a Mild Inflation or
Low 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 a
longer period of time then it is often called as Chronic or Secular Inflation.
Chronic Creeping Inflation can be either Continuous (which remains consistent
without any downward movement) or Intermittent (which occurs at regular
intervals). It is called chronic because if an inflation rate continues to grow for a
longer period without any downturn, then it possibly leads to Hyperinflation.
3. Walking Inflation : When the rate of rising prices is more than the Creeping
Inflation, it is known as Walking Inflation. When prices rise by more than 3% but
less than 10% per annum (i.e between 3% and 10% per annum), it is called as
Walking Inflation. According to some economists, walking inflation must be
taken seriously as it gives a cautionary signal for the occurrence of Running
inflation. Furthermore, if walking inflation is not checked in due time it can
eventually result in Galloping inflation.

6. 4. Moderate Inflation : Prof. Samuelson clubbed together concept of Crepping and
Walking inflation into Moderate Inflation. When prices rise by less than 10% per
annum (single digit inflation rate), it is known as Moderate Inflation. According
to 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 as
Running Inflation. When prices rise by more than 10% per annum, running
inflation occurs. Though economists have not suggested a fixed range for
measuring running inflation, we may consider price rise between 10% to 20% per
annum (double digit inflation rate) as a running inflation.
6. Galloping Inflation : According to Prof. Samuelson, if prices rise by double or
triple digit inflation rates like 30% or 400% or 999% per annum, then the
situation can be termed as Galloping Inflation. When prices rise by more than
20% 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 been
witnessing galloping inflation since the second five year plan period.
7. Hyperinflation : Hyperinflation refers to a situation where the prices rise at an
alarming high rate. The prices rise so fast that it becomes very difficult to measure
its magnitude. However, in quantitative terms, when prices rise above 1000% per
annum (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 becomes
worthless and people start trading either in gold and silver or sometimes even use
the old barter system of commerce. Two worst examples of hyperinflation
recorded in world history are of those experienced by Hungary in year 1946 and
Zimbabwe during 2004-2009 under Robert Mugabe's regime.
5. Types of Inflation on Causes
Types 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 or
money supply in the economy.
3. Scarcity Inflation : Scarcity inflation occurs due to hoarding. Hoarding is an
excess accumulation of basic commodities by unscrupulous traders and black
marketers. It is practised to create an artificial shortage of essential goods like
food grains, kerosene, etc. with an intension to sell them only at higher prices to
make huge profits during scarcity inflation. Though hoarding is an unfair trade
practice and a punishable criminal offence still some crooked merchants often get
themselves engaged in it.
4. Profit Inflation : When entrepreneurs are interested in boosting their profit
margins, prices rise.
5. Pricing Power Inflation : It is often referred as Administered Price inflation. It
occurs when industries and business houses increase the price of their goods and
services with an objective to boost their profit margins. It does not occur during a
financial crisis and economic depression, and is not seen when there is a downturn
in the economy. As Oligopolies have the ability to set prices of their goods and
services it is also called as Oligopolistic Inflation.
6. Tax Inflation : Due to rise in indirect taxes, sellers charge high price to the
consumers.
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 adaptive
expectations of workers or employees who try to keep their wages or salaries high
in anticipation of inflation. Employers and Organizations raise the prices of their
respective goods and services in anticipation of the workers or employees'
demands. This overall builds a vicious cycle of rising wages followed by an
increase 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 as
Build-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 spending
when 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 shortage
at home (within exporting country) and results in price rise (within exporting
country). 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 prices
of domestic products using imported goods also rises. This is known as Import
Price-Hike Inflation. For e.g. India imports oil from Iran at $100 per barrel. Oil
prices in the international market suddenly increases to $150 per barrel. Now
India to continue its oil imports from Iran has to pay $50 more per barrel to get
the same amount of crude oil. When the imported expensive oil reaches India, the
Indian 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 being
manufactured and transported. It is the end-consumer in India, who finally pays
and experiences the ultimate pinch of Import Price-Hike Inflation. If the oil prices
in the international market fall down then the import price-hike inflation also
slows down, and vice-versa.

9. 15. Sectoral Inflation : It occurs when there is a rise in the prices of goods and
services produced by certain sector of the industries. For instance, if prices of
crude oil increases then it will also affect all other sectors (like aviation, road
transportation, etc.) which are directly related to the oil industry. For e.g. If oil
prices are hiked, air ticket fares and road transportation cost will increase.
16. Demand-Pull Inflation : Inflation which arises due to various factors like rising
income, exploding population, etc., leads to aggregate demand and exceeds
aggregate supply, and tends to raise prices of goods and services. This is known
as Demand-Pull or Excess Demand Inflation.
17. Cost-Push Inflation : When prices rise due to growing cost of production of
goods and services, it is known as Cost-Push (Supply-side) Inflation. For e.g. If
wages of workers are raised then the unit cost of production also increases. As a
result, the prices of end-products or end-services being produced and supplied are
consequently hiked.
.

10. 6. Types of Inflation on Expectation
Types of inflation on the basis of expectation or predictability:-
1. Anticipated Inflation : If the rate of inflation corresponds to what the majority of
people are expecting or predicting, then is called Anticipated Inflation. It is also
referred as Expected Inflation.
2. Unanticipated Inflation : If the rate of inflation corresponds to what the majority
of people are not expecting or predicting, then is called Unanticipated Inflation. It
is also referred as Unexpected Inflation.
Effects of Inflation - The Positives and the Negatives
There are both “positive and negative” effects of Inflation on economy.
Positive Effect
Probably the most significant effect of inflation is its effect on the revenues of the
government. When inflation is higher than previously thought and planned with, the
revenues of the government increases, which is good as the budget balance of the
government improves. The reason why revenues of the government increases when
inflation increases is because the government has higher tax revenues. For example a
company sells its products and services at higher prices, which increases the total income
of 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 tax
profits result in greater taxes paid to the government.
Negative Effect
High 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 than
in trading partners' economies will make exports more expensive and tend toward
a weakening balance of trade.
3) Menu costs: Firms must change their prices more frequently, which imposes
costs, for example with restaurants having to reprint menus.

11. 4) Rising inflation can prompt trade unions to demand higher wages, to keep up with
consumer prices. Rising wages in turn can help fuel inflation. In the case of
collective bargaining, wages will be set as a factor of price expectations, which
will be higher when inflation has an upward trend. This can cause a wage
spiral.[citation needed] In a sense, inflation begets further inflationary
expectations.
5) Hyperinflation: if inflation gets totally out of control (in the upward direction), it
can grossly interfere with the normal workings of the economy, hurting its ability
to supply.
CONTROLLING OF INFLATION
Inflation needs to be controlled in the very beginning, otherwise it completely ruins the
economy, once it acquires the hyper inflation form. Various anti-inflationary measures
are suggested to avoid or overcome disastrous consequences of inflation. Most of these
measures aim at reducing aggregate demand for goods and services. These measures can
be explained in three categories, namely, monetary measures, fiscal measures and other
measures.
1. Monetary Measures
Growth of inflation during the post Second War period revived the confidence in the
potency of monetary policy, though it proved to be ineffective by Keynes to control
depression. Monetary policy is the policy of the central bank of the country, which is the
supreme monetary authority. Monetary measures attempt to regulate the money supply in
an economy. To check inflation, increase in the volume of currency should be avoided. If
there 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, the
main concern of monetary measures should be to regulate the bank credit. Central bank
uses various quantitative and qualitative (selective) control measures for this purpose.
Quantitative control measures such as bank rate policy, open market operations and
variable 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 interest
and makes investment less attractive. Inflationary rise in prices is arrested by choking off
the excess demand. The bank rate policy is effective, if banks do not have an easy access
to other sources of funds. Under open market operations, through sale of government
securities, money supply is reduced. This measure is superior to the bank rate policy, as it
directly affects the money supply. However, its success to control credit and hence
inflation depends upon the attractiveness of these securities and the existence of
organized money market. Variable reserve requirements is the most effective measure to
check inflation, but it is not very often used due to its harsh effects. By raising the cash
reserve 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 very
common with the rise of consumerism. During inflation, consumer credit facilities are
curtailed by raising the down payments and reducing the payment period on selective
basis. Central bank may also fix higher margin requirements for loans according to the
purposes. Higher are the margin requirements, lower will be the amounts of loans that the
borrowers can obtain from the bank. These selective control measures, besides directives,
moral suasion, publicity, direct action, etc., may be used to limit the undue monetary
expansion.
The effectiveness of the monetary measures depends upon the degree of control exercised
by the central bank and the extent of cooperation extended by the commercial banks and
other constituents of the money market. In a developing country like India, most of these
factors are lacking. Hence monetary policy will be of little value here. Further, when
inflation 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 Measures
As government expenditure has become an important portion of the aggregate
expenditure in almost every economy of the world, the government can significantly
affect the money supply and hence inflation. Monetary policy, when supplemented by
fiscal policy will become more effective. The following anti-inflationary fiscal measures
can be used to mop up the excessive purchasing power in the economy.
(a) Public Expenditure
To control price rise, the government can reduce its expenditure. This will reduce public
money from the market and hence the demand for goods and services. Reduction in
government expenditure as an anti-inflationary weapon should be used with care. It is
almost 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 has
already taken up. Thus, the government must keep the non-essential expenditure to the
minimum. This will also put a check on private expending, which depend upon
government expenditure.
(b) Taxation
Taxes determine the volume of disposable income in the hands of the people. Imposition
of new taxes and raising the rates of taxes, on one hand reduces the purchasing power of
the people. On the other hand, it generates resources to the government for combating
inflation. Anti-inflationary taxation should, thus, aim at reducing the disposable income,
that otherwise would be spent on consumption. Tax revenue realized by the government
should be used to maintain essential expenditure. However, the rates of taxes should not
be so high as to discourage saving, investment and production. Rather, the tax system
should provide larger incentives to those who save, invest and produce. Further, to bring
more tax revenue, the government should penalize the tax evaders by imposing heavy
fines.
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. Direct
taxes like income tax, wealth tax, expenditures tax, etc., decline the disposable income
and exert pressure on demand. Indirect taxes may also produce similar effects with an
extra advantage of wide coverage. However, indirect taxes fall heavily on fixed income
earners, who are already hit by the inflation. This discriminating effects can be corrected
by imposing heavy excise duties and other similar taxes on luxury commodities, which
are 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 prices
of goods.
(c) Public Borrowing and Debt
The main purpose of public borrowing, like tax is to take away from public, excessive
purchasing power, which if left free, would exert an upward pressure on the demand. If
voluntary borrowing does not yield the desired results, the government may resort to
compulsory borrowing. Forced loans, a variant of compulsory savings have been tried in
Norway, Belgium and Holland. Compulsory provident fund cum-pension schemes, etc.,
may be introduced compulsorily. The government can also float public loans carrying
high 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 to
prevent an increase in the circulation of money. Further, if possible, the payment of part
of 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 an
expectation of recession in the economy. Similarly, pay revision arrears may be
transferred to the provident fund accounts, rather making cash payments of the same
during inflation. Compulsory savings and deferred payments are normally avoided during
peace time.
Measuring of Inflation
The inflation rate is widely calculated by calculating the movement or change in a price
index, usually the consumer price index.[33]
The consumer price index measures
movements in prices of a fixed basket of goods and services purchased by a "typical
consumer". 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 United
Kingdom. 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 Index
was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual
percentage 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 the
general level of prices for typical U.S. consumers rose by approximately four percent in
2007.
Important terms for calculating price
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
Consumer price indices:
A consumer price index (CPI) measures changes in the price level of a
consumer goods and services
defined by the Bureau of Labor Statistics
in the prices paid by urban consumers for a
services."
The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the
general level of prices for typical U.S. consumers rose by approximately four percent in
Important terms for calculating price inflation include the following:
:
(PPIs) which measures average changes in prices received by domestic producers for
s 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
r 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
sion of the PPI was called the “Wholesale Price Index”.
Consumer price indices:
(CPI) measures changes in the price level of a market basket
services purchased by households. The CPI in the United States is
Bureau of Labor Statistics as "a measure of the average change
in the prices paid by urban consumers for a market basket of consumer goods and
The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the
general 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 for
s 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
r 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
market basket of
purchased by households. The CPI in the United States is
as "a measure of the average change over time
of consumer goods and

15. Pakistan Inflation Rate
The inflation rate in Pakistan was recorded at 6.57 percent in March of 2013. Inflation
Rate in Pakistan is reported by the Pakistan Bureau of Statistics. Historically, from 1957
until 2013, Pakistan Inflation Rate averaged 8.04 Percent reaching an all tim
37.81 Percent in December of 1973 and a record low of
1959. In Pakistan, most important categories in the consumer price index are food and
non-alcoholic beverages (35 percent of total weight); housing, water, electr
fuels (29 percent); clothing and footwear (8 percent) and transport (7 percent). The index
also includes furnishings and household equipment (4 percent), education (4 percent),
communication (3 percent) and health (2 percent). The remaining
by: recreation and culture, restaurants and hotels, alcoholic beverages and tobacco and
other goods and services. This page includes a chart with historical data for Pakistan
Pakistan Inflation Rate
The inflation rate in Pakistan was recorded at 6.57 percent in March of 2013. Inflation
Rate in Pakistan is reported by the Pakistan Bureau of Statistics. Historically, from 1957
until 2013, Pakistan Inflation Rate averaged 8.04 Percent reaching an all tim
37.81 Percent in December of 1973 and a record low of -10.32 Percent in February of
1959. In Pakistan, most important categories in the consumer price index are food and
alcoholic beverages (35 percent of total weight); housing, water, electricity, gas and
fuels (29 percent); clothing and footwear (8 percent) and transport (7 percent). The index
also includes furnishings and household equipment (4 percent), education (4 percent),
communication (3 percent) and health (2 percent). The remaining 8 percent is composed
by: recreation and culture, restaurants and hotels, alcoholic beverages and tobacco and
other goods and services. This page includes a chart with historical data for Pakistan
Inflation Rate.
The inflation rate in Pakistan was recorded at 6.57 percent in March of 2013. Inflation
Rate in Pakistan is reported by the Pakistan Bureau of Statistics. Historically, from 1957
until 2013, Pakistan Inflation Rate averaged 8.04 Percent reaching an all time high of
10.32 Percent in February of
1959. In Pakistan, most important categories in the consumer price index are food and
icity, gas and
fuels (29 percent); clothing and footwear (8 percent) and transport (7 percent). The index
also includes furnishings and household equipment (4 percent), education (4 percent),
8 percent is composed
by: recreation and culture, restaurants and hotels, alcoholic beverages and tobacco and
other goods and services. This page includes a chart with historical data for Pakistan

16. What are the main Causes of inflation in Pakistan
in 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 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.
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-- is often viewed to have positive effects
on the national economy as it encourages investment and production and allows growth
in wages.
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.
Not only can high inflation erode the gains from growth, it also makes the poor worse off
and widens the gap between the rich and the poor. If much of the inflation comes from
increase in food prices, it hurts poor more since over half of family budget of the low
wage 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 having
less than 11 per cent inflation as compared to the years of high inflation with an average
of 1.5 per cent.
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.
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 which
on overall inflation, at times, can be so excessive that these cannot be countered through
demand management, including monetary policy.
First, increased domestic demand created an output gap, putting upward pressure on
prices. Growth in private consumption on the average remained over 10 per cent between
FY04 and FY06, depicting signs of demand side pressures on price level.
The relationship between growth and inflation depends on the state of the economy. High
growth, without an increase in inflation, is possible if the productive capacity or potential
output of the economy is growing enough to keep pace with demand. This is also possible
if 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 spare
capacity and the economy is working at full employment level, any further gain in growth
comes at the cost of rising inflation. If demand continues to grow at this stage, and the
productive capacity does not expand, there is a serious threat of rapid inflation in the long
run without any additional growth in the output. A prolonged phase of rising inflation in
such a case can have severe consequences for the economy.
Second, the growing gap between domestic demand and production was filled by a sharp
increase in net imports, which grew by above 40 per cent in FY05 and by 24 per cent in
FY06. As compared to imports, exports increased by only around 10 per cent in FY05
and 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 rate
of inflation can get locked into expectations of inflation.
People expect higher salaries to compensate for expected increase in prices, speculation
in asset prices increases, credit meant for manufacturing sector diverts to real estate and
stock markets, and hoarders, profit and rent seekers become active in expectation of high
price in the future. All this can have devastating effect for the prices.
Third, fiscal policy has remained expansionary in the last few years. Expansionary fiscal
policy fuels domestic demand and puts pressure on the current account deficit. It widens
the investment-saving gap, which has to be financed externally. Financing of fiscal deficit
through money creation adds to inflationary pressures. Increased government borrowing
from central bank can have serious consequences for general price level.
Fourth, the expansionary monetary policy- high growth in money supply and loose credit
policy- was believed to be contributing to high inflation. Although expansion of credit is
usual in expanding economies, excessive credit growth can have adverse effects on real
variables.
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 of
production.
Similarly, indirect taxes are also blamed as the main cause of inflation. The indirect
taxes, such as sales tax and excise duties raise the prices of consumer goods. This creates
inflationary pressure. On the other hand, direct taxes reduce the take-home income and
have anti-inflationary effect. A substantial increase in support price of wheat is estimated
to have an inflationary effect on consumer prices, particularly food prices. This effect is
due 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 in
Pakistan?
During the first four years of the new millennium inflation remained under five per cent
and then suddenly increased to 9.3 per cent in 2004-05 and settled to eight per cent in
2005-06. The growth in wheat prices and exchange rate was low in some years and high
in others. However, it seems that excessive money flows towards public and private
sector, along with the import price hike in 2003-04 and 2005-06 and wheat price rise in
2003-04 and 2004-05 created inflationary pressure at an alarming level. Taxes as a
percentage of manufacturing sector value-added did not show any rise.
Inflation: Conclusion
Some points to remember:
 Inflation is a sustained increase in the general level of prices for goods and
services.
 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-push
inflation.
 When there is unanticipated inflation, creditors lose, people on a fixed-income
lose, "menu costs" go up, uncertainty reduces spending and exporters aren't as
competitive.
 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 Consumer
Price Index and the Producer Price Indexes.
 Inflation plays a large role in the Fed's decisions regarding interest rates.
 In the long term, stocks are good protection against inflation.
 Inflation is a serious problem for fixed income investors. It's important to
understand the difference between nominal interest rates and real interest rates.
 Inflation-indexed securities offer protection against inflation but offer low returns.