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8/8/2019 Inflation Umer

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Inflation

In economics, inflation is a rise in the general level of prices of goods and services in aneconomy over a period of time. When the general price level rises, each unit of currencybuys fewer goods and services; consequently, inflation is also a decline in the real value

of moneya loss of purchasing powerin the medium of exchange which is also themonetary unit of account in the economy. A chief measure of general price-level inflationis 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 futureinflation may discourage investment and saving. High inflation may lead to shortages ofgoods 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 byan 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 attributedto fluctuations in real demand for goods and services, or changes in available suppliessuch as during scarcities, as well as to growth in the money supply. However, theconsensus view is that a long sustained period of inflation is caused by money supplygrowing faster than the rate ofeconomic growth.

Graph (a)

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Today, most economists favor a low steady rate of inflation. Low (as opposed to zero ornegative) inflation may reduce the severity of economic recessions by enabling the labormarket to adjust more quickly in a downturn, and reduce the risk that a liquidity trapprevents monetary policy from stabilizing the economy. The task of keeping the rate ofinflation low and stable is usually given to monetary authorities. Generally, these

monetary authorities are the central banks that control the size of the money supplythrough the setting of interest rates, through open market operations, and through thesetting 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 16.001995-1996 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 7.912004-2005 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 exceedsaggregate 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 thegeneral 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 inmoney 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 toomuch 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 dueto adoption of development and welfare activities of the country has to flight awar, it causes as increase in govt. expenditure which leads to increase inaggregate 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 andinvestment expenditure in the private sector raises the demand for goods andservices 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 thedemand, the general price level moves upward.

Black money: The money generated through smuggling, tax evasion etc. raisesthe demand for luxury and other goods. Hence black money is also one of thecauses 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 inthe supply of goods, it will not cause inflationary situation. When the aggregate supply ofgoods is at a slower pace than the growth in aggregate demand, it then causes inflationaryrise in prices. The following factors are identified for relatively slower growth in thesupply of goods.

Lagging agricultural & industrial production: The increase in population,incomes, employment and urbanization exert pressure on the demand for goodsand services. However, the agricultural and industrial production grows at aslower pace, due to shortage of essential inputs like fertilizers, water, cement, ironetc. When aggregate demand for goods and services exceeds the aggregatesupply 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 theslowing down of overall production of goods. When the supply of goods fallsshort of demand, the prices go up in the country.

Long gestation period: If the time lag between investment and the production ofgoods is long, the shortage of goods will arise. This will also contribute toinflationary 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 laborunions manage to press for wage increases in excess of labor productivity. Unitcost of production is thereby raised. The rise in cost of production exerts pressureon 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 ornear monopoly power in the market, they fix up higher profit margins arbitrarilywithout any increase in other elements of cost. When a few powerful firmsincrease the profit margins, the smaller firms also tend to mark up their profitmargins. The higher profit margins, thus, inflate the price level.

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

(4) Higher taxes: If the government levies new taxes and raises the rates of old taxesthe producers generally shift the burden of taxes on to the consumers. Theincreases in the selling prices of the commodities push up the inflationary trendin 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. Amild 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 creepinginflation. 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 astage of inflation which starts after the level of full employment is reached. Here pricelevel rises very rapidly within a short period.

On the Basis of Degree of Control:

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Milton Friedman is of the firm view that inflation is always and anywhere a monetaryphenomenon. According to him, inflation is caused by a too rapid increase in the moneysupply 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. Thechief cause of inflation in one year may not be in the next year. Since inflation is multicausal, 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 anincrease 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. Anyincrease 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 individualbelieves 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 ofindividuals. 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 whatactually happened in Pakistan during the period when oil prices rose exponentially. To dothis, I am going to use the numbers from the following tables showing the GDP (Y) ofPakistan, 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 90.54 106.82 122.43 138.9 144.65GDP 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 hasbeen steadily growing. The issue arises when we look at the change from one year to thenext. For example comparing the balance of trade between 2007 and 2008 shows that therate at which the trade deficit increased was (20.59-13.45)/13.45 = 53%. Taking any yearfor 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**>** (I+G) =35.46 **


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income left (after buying more expensive energy) with households to spend on othergoods and services. This leads to lower growth in consumption spending, furtherweakening the economic outlook of the nation. The following table shows that althoughtotal consumption spending has been growing, the (YoY) change in percentage terms isdeclining 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 additionto lower consumption growth, higher growth in imports (m) is further deteriorating thesituation 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 adirect result of the rising price of oil.

Consumer Price Index (2004-2008)

Consumer Price

Index(YoY)

Percentage Percentage Change

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 buyingpower of money, and increased the energy costs of consumers and producers resulting inlower discretionary spending.

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Effects of inflation in Pakistan:

Lower discretionary spending has contributed to the declining rate of consumptiongrowth (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 asfollows. I

Grapa (d)

Effect 2

Increased imported energy prices have led to increased prices at home leading toincreased inflation. Increased inflation has decreased the discretionary income ofhouseholds, leading to decreased discretionary spending. Decreased discretionaryspending 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 economicgrowth 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 Pakistanieconomic framework. The government is offering simple price incentives for the use ofNatural 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) toswitch their power production methods from oil powered pants to gas powered plants.IPPs contribute to about 35% of the nations total power production, and about 59% oftotal non hydroelectric power.

Remedies of inflation

The first panacea for a mismanagement nation is inflation of the currency. The second iswar. Both bring a permanent ruin. They both are the refuge of political and economicopportunities. (Ernest Hemingway). To avoid political unrest and harmful, social andeconomic effects on the economy, it is the main objective of every government to takeappropriate 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 moneysupply and available credit. Monetary policy is adopted by central bank of a country. Thevarious monetary measures which are used to control inflation are grouped under twoheads

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 stimulateor slow down the economy. It is the budgetary policy of the government relating to taxespublic expenditure, public borrowing and deficit financing. Fiscal policy is based upondemand management i.e, raising or lowering the level of aggregate demand by

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controlling various expenditures, government expenditure, consumption expenditure andinvestment 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 disposableincome in relation to national income hence, consumption rises at every level of nationalincome. With the increase in aggregate demand for goods, the employment goes up in thecountry. A rise in tax rates has the opposite effect. A rise in taxes causes a decrease indisposable 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 canbring down price level by curtailing its own unproductive expenditure.

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

Balanced budget Changes

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

Control of deficit financing

For financing the budget deficit, the govt. often resorts to deficit financing. The bankborrowing and printing of new notes increases the money supply in the country andpushes up the price level. Deficit financing therefore, should be avoided to controlinflation.

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 stimulatedemand.

Imposing direct control on prices of essential items.

Rationing of essential consumer goods in case of acute emergency holding ofFriday and Sunday markets.

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Since 1950s the control of inflation has become the chief objective of both developingand developed countries of the world. The government therefore takes monetary, fiscaland 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 puttingdownward 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 Economistby WB (The Writer) Daily Dawn, 28/4/2008

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