MACRO ECONOMICS

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INFLATION Trends in Pakistan

Macro Economics

Final Project

GROUP E

MACRO ECONOMICS

TRENDS in INFLATION in

PAKISTAN

Inflation

“An increase in the price you pay or a decline in the purchasing power of money”

Inflation is a sustained rise in overall price levels. Moderate inflation is associated with

economic growth, while high inflation can signal an overheated economy.

Introduction to Inflation

As an economy grows, businesses and consumers spend more money on goods and services.

In the growth stage of an economic cycle, demand typically outstrips the supply of goods and

producers can raise their prices. As a result, the rate of inflation increases. If economic

growth accelerates very rapidly, demand grows even faster and producers raise prices

continually. An upward price spiral, sometimes called “runaway inflation” or

“hyperinflation” can result.

The inflation syndrome is sometimes described as “too many dollars chasing too few goods”.

In other words, as spending outpaces the production of goods and services, the supply of

money in an economy exceeds the amount needed for financial transactions. The result is that

the purchasing power (value) of money declines.

In general, when economic growth begins to slow, demand eases and the supply of goods

increases relative to demand. At this point the rate of inflation usually drops. Such a period

of falling inflation is known as “disinflation”. Disinflation can also result from a concerted

effort by government and policy makers to control inflation. Although it is used to describe

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periods of slowing inflation, disinflation should not be confused with “deflation”, which is a

general decline in prices often caused by a reduction in the supply of money.

Reasons for Selection

Pakistan has undergone a significant economic growth during the last few years, but the core

problems of the economy are still unsolved. Inflation remains the biggest of all these

problems. Inflation is one of the obstacles on the way of development. In Pakistan, it has

squeezed the major part of population. The poor people living below the poverty line have

been affected the most. The poverty level is continuously increasing in the country and the

difference between rich and poor is raised. This can create a serious problem for country’s

economy in future.

Measuring Inflation

Inflation is measured by comparing two sets of goods at two points in time, and computing

the increase in cost not reflected by an increase in quality. There are, therefore, many

measures of inflation depending on the specific circumstances. The most well known are the

CPI which measures consumer prices, and the GDP deflator, which measures inflation in the

whole economy.

The main challenge, in measuring inflation as the change in level of prices is establishing, is

deciding of which prices to use for the calculation. National statistics agencies usually

measure various inflation rates:

the "raw materials price index" (RPI), or so-called "crude goods" price index, which

measures commodity price inflation;

the "industrial product price index" (IPPI), which measures changes in the wholesale

price of goods at 'the factory door'; and

The "consumer price index" (CPI), which measures the change in retail prices.

Since economists, market strategists, and politicians are usually concerned with changes in

consumer prices, the CPI is the most frequently used measure of price change. Across a

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country, however, prices vary with market conditions, availability, transportation costs and

other factors.

Types of Inflation

There are four different types of inflation on the basis of its different causes. They are as

follows

The most important type of inflation is the “demand pull inflation”. It occurs when

the total demand for goods and services in an economy exceeds the available supply,

so the prices for them rise in a market economy. Historically this has been the most

common type and at times the most serious. The effective demand for goods increases

due to many factors such as increase in the money supply, increase in the demand of

goods by the government, increase in the income etc. In short the excessive increase

in the money supply causes inflationary conditions. Every war produces this type of

inflation because demand for war materials and manpower grows rapidly without

comparable shrinkage elsewhere. Demand pull inflation is generally characterized by

shortage of goods and shortage of workers. Other types of inflation occur more

readily in conjunction with demand pull inflation.

Another type of inflation is called “cost-push inflation”. The name suggests the

cause--costs of production rise for one reason or another, and force up the prices of

finished goods and services. Cost pull inflation occurs when the economy is below full

employment with prices rising even though there is no shortage of goods. An increase

in wage costs unaccompanied by corresponding increase in productivity, rise in

import prices of goods, and depreciation in the external value of the currency usually

result in cost push inflation. Profit inflation is in fact categorized under cost push

inflation. This is less common than demand-pull, but can occur independently as well

as in conjunction with it.

The third type of inflation is called “pricing power inflation”, but is more frequently

called “administered price inflation”. It occurs whenever businesses in general

decide to boost their prices to increase their profit margins. This does not occur

normally in recessions but when the economy is booming and sales are strong. It

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might be called “oligopolistic inflation”, because it is oligopolies that have the power

to set their own prices and raise them when they decide the time is ripe. An

oligopolistic firm often realizes that if it raises its prices, the other major firms in the

industry will likely see that as a good time to widen their profit margins too without

suffering much from price competition from the few other firms in the industry.

The fourth type is called “sectoral inflation”. The term applies whenever any of the

other three factors hits a basic industry causing inflation there. Since the industry hit

is a major supplier of many other industries, as for example steel is, or oil is, that

raises costs of the industries using say steel or oil, and forces up prices there as well.

So, inflation becomes more widespread throughout the economy, although it

originated in just one basic sector.

Inflation and Unemployment

Unemployment and inflation are two intricately linked economic concepts. Over the years

there have been a number of economists trying to interpret the relationship between the

concepts of inflation and unemployment. There are two possible explanations of this

relationship – one in the short term and another in the long term.

The Phillips Curve: When economists look at inflation and unemployment in the short term,

they see a rough inverse correlation between the two. When unemployment is high, inflation

is low and when inflation is high, unemployment is low. This has presented a problem to

regulators who want to limit both. This relationship between inflation and unemployment is

the Phillips curve. The short term Phillips curve is a declining one.

Figure 1: Philips Curve in Short Run

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This is a rough estimation of a short-term Phillips curve. As you can see, inflation is inversely

related to unemployment. The long-term Phillips curve, however, is different from that of the

short-term curve. Economists have noted that in the long run, there seems to be no

correlation between inflation and unemployment.

Classical View of Inflation

According to the classical view of inflation, inflation is caused by the alterations in the supply

of money. When the money supply goes up the price level of various commodities goes up as

well. The increase in the level of prices is known as inflation. According to the classical

economists there is a natural rate of unemployment, which may also be called the equilibrium

level of unemployment in a particular economy. This is known as the long term Phillips

curve. The long term Phillips curve is basically vertical as inflation is not meant to have any

relationship with unemployment in the long term. It is therefore assumed that unemployment

would stay at a fixed point irrespective of the status of inflation. In the classical view, the

point where the short-term Phillips curve intersects the long-term Phillips curve is the

expected inflation. To the left side of that point, actual inflation is higher than expected and

to the right, actual inflation is lower than expected. Basically, unemployment below natural

unemployment leads to inflation higher than expected and unemployment higher than natural

unemployment leads to inflation lower than expected.

Keynesian View of Inflation

As opposed to the Classics, who view inflation as a problem of ever-increasing money supply,

Keynesians concentrate on the institutional problems of people increasing their price levels.

Keynesians argue that firms raise wages to keep their workers happy. Firms then have to pay

for that and keep making a profit by subsequently raising the prices. This causes an increase

in both wages and prices and demands an increase of money supply to keep the economy

running. So, the government then issues more and more money to keep up with inflation. This

differs from the classical model. Classics view changing money supply as affecting inflation

while Keynesians view inflation as the cause of changing money supply.

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LITERARTURE REVIEW

Literature 1

Abdul Aleem Khan, Syed Kalim Hyder Bukhari and Qazi Masood Ahmed in their research report “determinants of recent inflation in Pakistan” are of the opinion that the expansionary economic policies of the government and the SBP over the last few years resulted in improvement in various macroeconomic indicators including Gross Domestic Product (GDP) growth, which remained above 6 percent during 2004-06. However, on the other hand, they also caused inflation which remained above 8 percent during the last two years. In 2004-05, average CPI inflation was 9.3 percent and on the basis of 12 month changes, inflation was recorded at 11 percent in April 2005.

The 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. 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.

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 Fiscal year 2004 and 2006, depicting signs of demand side pressures on price level. The relationship between growth and inflation depends on the state of the economy. 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. A prolonged phase of rising inflation in such a case can have severe consequences for the economy.

Increase in net exports is another inflationary factor in Pakistan. 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 Fiscal Year 2005 and by 24 per cent in Fiscal Year 2006. As compared to imports, exports increased by only around 10 per cent in Fiscal Year 2005 and by 13 per cent in Fiscal Year 2006. This resulted in a record trade deficit.

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.

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Rising import prices are also considered an important factor for inflation. Exchange rate, if depreciating can also put upward pressure on price level. 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.

The quantitative analysis reveals that the most significant factors which explain 8 percent inflation in 2005-06 were inflation expectations, private sector credit and imported inflation. Overall impact of fiscal policies on inflation was not significant and rather the direct part of taxes was dominant in putting downward pressure on prices. Government sector borrowing also did not contribute in the rise in prices in 2005-06, though it did contribute in 2004-05. The policy of keeping stability in the exchange rate was successful in holding the exchange rate from putting further pressure on prices. The role of wheat support/procurement price and the other unexplained factors were also insignificant.

Literature 2

Khalid Mehmood

Demonstrated in one of his articles the “inflation in Pakistan” According to him inflation means a persistent rise in the general price level in a country over a number of years. Thus different types of inflation exist at different places, depending upon the reason, which generates inflation.

In Pakistan, Inflation is one of the major problems with almost more than 11% inflation rate per anum this is the hardest in the world. According to Mr. Khalid Mehmood an inflation rate of 2 – 3% is required for the development of the economy and proper growth of the economy, but if it exceeds from this limit, then it becomes a problem.

Major causes of increase in the price level are an increase in currency or credit money. Increase in the supply of money results in such a case that people start to demand more and more of goods and services. The policy of deficit financing has led to increase the quantity of money in Pakistan after 1972. And as a result the economy suffered from demand pull inflation.

In January 1993 the total currency in circulation was about 166 billion which has increased to 834 billion in June, 2007. And at the end of fiscal year 2007-08 money in circulation had boosted to 1050 billion.

Literature 3

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Tariq Khattak

A survey conducted by Pakistan Institute of Development Economics (PIDE) says that Inflation rate during the current year will remain higher than target rate of nine per cent. According to the finding released here today, 89 per cent of the respondents believe that inflation rate during current year will be higher than target rate. Whereas, 5 per cent are of the view that it will be lower and 6 per cent say that it will remain the same.The respondents indicate that on average 14.39 per cent is the expected rate of inflation for the next month, 15.79 per cent for the next six months and 14.58 per cent for the current year.During March 2009 to March 2010 expectations about inflation show declining trend consistently. The current year expectations about inflation are 14.58 per cent as compared to 22 per cent last year according to the majority of the respondents. In response to question related to the nature of current inflation, 28.4 percent of respondents believe that it is cost push inflation, while 10.6 percent say it is demand pull. However, 53.2 percent believe that demand pull, cost push and structural factors are the main sources of current price hike. According to 28.4 percent of respondents, oil prices are the main contributing factor of high inflation, followed by food prices (26.3 per cent). In addition to oil and food prices, other factors contributing to inflation are utility prices, money supply and global financial crisis. Majority of the respondents (63.6 per cent) suggest that coordination between monetary and fiscal policy is necessary to control inflation rather than solely rely on monetary or fiscal policy. However, 34 per cent of the respondents consider that monetary policy is an effective tool to control inflation, and only 19 per cent suggest that fiscal policy is the most important tool for price stability. These findings are consistent with the findings of previous two surveys which reflect the strong opinion of the experts about coordination of fiscal and monetary policies to control inflation. As far as question regarding the consumer prices in the next year is concerned, 55.6 per cent of respondents think that consumer prices will rise more rapidly, 23.9 per cent are of the view that it will increase at the same rate, while 2.1 per cent of the respondents think that consumer prices will remain the same for the year 2010-2011.In view of 89.4 per cent of respondents, law and order situation affects inflation expectations, while 7.7 per cent are of the view that law and order has no impact on inflation expectation. To control inflation, State Bank of Pakistan is pursuing high interest rate policy. When question asked, what is best for the economy i.e. high or low interest rate, in view of 67 per cent respondents, low interest rate is better for the economy, whereas only 14.8 per cent respondents say that in current inflationary situation high interest rate is better for the economy.In response to question regarding expectations about exchange rate for the next month and the next six months, large group (49.3 per cent) of respondents expect that domestic currency will depreciate in the coming month, while 30.3 per cent of respondents think that value of domestic currency will remains the same.

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For the next six months, 28.4 per cent of the respondents expect that the exchange rate will appreciate, whereas 60.4 per cent predict that it will depreciate and the remaining is of the view that there will be no change. These observations show that majority of the respondents believe that exchange rate will depreciate in the future.As far as unemployment is concerned, 58.7 per cent of respondents think that unemployment will increase in the next six months. According to 63 per cent of the respondents, unemployment will increase in next 12 months. Majority of the respondents (43.4per cent) are of the view that growth rate will increase as compare to the current growth rate, 26.2 per cent says that it will decrease, while others say that it will remain the same. About 50 per cent of the respondents are of the view that current government policies are not sufficient to enhance growth, 10.4 per cent says that these policies are useful, while remaining are not clear about the government policies.

Literature 4

Abdul Qayyum

According to Mr. Abdul Qayyum inflation is a cause of excess money supply growth in Pakistan in MPRA PAPER He says that inflation adversely effects the growth.

The State Bank of Pakistan has the explicit mandate to ensure price stability and promote growth. In order to contain inflation within the targeted level set by the Government, the SBP used money supply as an instrument/intermediate target. The statistics reveal that money supply growth exceeded its target levels for four consecutive fiscal years 2002-2005 due to easy monetary policy stance to support the growth process. However, the expansionary monetary policy resulted in rapid inflation reaching double digit in 2005. Since inflation is a tax on money holdings. Inflation tax for the year 2005 is estimated at 61928 million or 0.98 percent of GDP. Before 2005 monetary policy was biased towards supporting growth because inflation was at low level. With the rising inflation from 2005 monetary policy stance has tilted towards the containing of inflation [State Bank of Pakistan (2006)].

He concludes that money supply has been the main determinant of inflation in Pakistan. For this purpose, he estimated the relationship between the rate of inflation, money growth, growth in real income, and growth in velocity in Pakistan in the 1960–2005 period.

The results from the correlation analysis indicate that there is strong relationship between the money growth and inflation and the important conclusion that emerged from the analysis is that the money supply growth has been an important contributor to the rise in inflation in

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Pakistan during the study period. This is to conclude that inflation is Pakistan is a monetary phenomenon. This may be due loose monetary policy adopted by the State Bank of Pakistan to boast the high priority of the growth objective. It is argued that the policies to boast output growth through money supply only have short run effect on real output but generate inflation. Indeed the recent act of tightening the monetary policy by the State Bank of Pakistan, supports the monetarist argument that the inflation in Pakistan is a monetary phenomenon. The important policy implication is that inflation in Pakistan can be cured by sufficiently tight monetary policy. The formulation of monetary policy must consider development in the real and financial sector and treat them as constraints on the policy [Gordon (1985)].

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DATA

Fiscal Year ConsumerPrice Index

Wholesale price Index

Sensitive Price

Indicator

Annual GDP

Deflator1990-1991 12.66 11.73 12.59 --

1991-1992 10.58 9.84 10.57 10.07

1992-1993 9.83 7.36 10.71 8.89

1993-1994 11.27 16.4 11.79 12.47

1994-1995 13.02 16 15.01 13.78

1995-1996 10.79 11.1 10.71 8.28

1996-1997 11.8 13.01 12.45 14.63

1997-1998 7.81 6.58 7.35 6.55

1998-1999 5.74 6.35 6.44 5.85

1999-2000 3.58 1.77 1.84 2.78

2000-2001 4.41 6.21 4.84 6.72

2001-2002 3.54 2.08 3.37 2.49

2002-2003 3.1 5.57 3.58 4.42

2003-2004 4.57 7.91 6.83 7.74

2004-2005 9.28 6.75 11.55 7.02

2005-2006 7.92 10.1 7.02 10.49

2006-2007 7.77 6.94 10.82 7.7

2007-2008 10.27 13.7 14.09 16.21

2008-2009 22.35 21.44 26.33 22.63

(Source of data is Federal bureau of Statistics)

WPI, CPI & SPI Base Year = 1990-91 series have been converted into Base Year 2000-01.3. GDP Deflator Base Year 1980-81=100 has been changed with 1999-2000 = 100 as new base year.

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PRICE INDICES IN PAKISTAN

Four different price indices are used in Pakistan over the course of fiscal year, namely: the Consumer Price Index (CPI), the Wholesale Price Index (WPI), the Sensitive Price Index (SPI) and the GDP deflator.

Consumer Price Index

The CPI is the main measure of price changes at the retail level. It covers the retail prices of 374 items in 35 major cities and reflects roughly the changes in the cost of living of urban areas.

1991-1992

1992-1993

1993-1994

1994-1995

1995-1996

1996-1997

1997-1998

1998-1999

1999-2000

2000-2001

2001-2002

2002-2003

2003-2004

2004-2005

2005-2006

2006-2007

2007-2008

2008-20090

5

10

15

20

25

Consumer Price Index

Fiscal Years

Con

sum

er P

rice

In

dex

Whole sale Price Index

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The WPI is designed for those items which are mostly consumable in daily life on the primary and secondary level; these prices are collected from wholesale markets as well as from mills at organized wholesale market level. The WPI covers the wholesale price of 106 commodities prevailing in 18 major cities of Pakistan.

1990-1991

1991-1992

1992-1993

1993-1994

1994-1995

1995-1996

1996-1997

1997-1998

1998-1999

1999-2000

2000-2001

2001-2002

2002-2003

2003-2004

2004-2005

2005-2006

2006-2007

2007-2008

2008-20090

5

10

15

20

25

Wholesale Price Index

Fiscal Year

Wh

ole

Sal

e P

rice

In

dex

Sensitive Price Indicator

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The SPI shows the weekly change of price of 53 selected items of daily use consumed by those households The SPI is based on the prices prevailing in 17 major cities and is computed for the basket of commodities being consumed by the households belonging to all income groups combined.

1990-1991

1991-1992

1992-1993

1993-1994

1994-1995

1995-1996

1996-1997

1997-1998

1998-1999

1999-2000

2000-2001

2001-2002

2002-2003

2003-2004

2004-2005

2005-2006

2006-2007

2007-2008

2008-20090

5

10

15

20

25

30

Sensitive Price Indicator

Fiscal Year

Sen

siti

ve P

rice

In

dex

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Annual GDP Deflator

1991-1992

1992-1993

1993-1994

1994-1995

1995-1996

1996-1997

1997-1998

1998-1999

1999-2000

2000-2001

2001-2002

2002-2003

2003-2004

2004-2005

2005-2006

2006-2007

2007-2008

2008-20090

5

10

15

20

25

GDP Deflator

Fiscal Year

Annu

al G

DP D

eflat

or

Inflation Trends in Pakistan

Inflation in Pakistan over the last 18 years had been fluctuating between 3.1 percent and 13 percent. Both the food and non-food inflation contributed to the persistence of double-digit inflation during the period from 1990-1997, averaging 12.2 and 10.7 percent, respectively against the overall CPI inflation of 11.4. This was because of

o Loose monetary policies

o Higher duties and taxes

o Decrease in Price of Pakistani Currency

o Frequent changes in prices of gas, electricity and petrol.

o Political instability

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The pressure on prices in 1994-95, when inflation was 13%, is because of high food inflation of 16.5%. Nevertheless, the price pressure started to moderate from 1997-98 onwards as an improved supply position, strict budgetary measures and depressed international market prices kept domestic prices in check.

The inflation rate, which was at 5.7 percent in 1998-99, was further reduced to 3.1 percent by 2002-03. This low level of inflation was supported by strict fiscal discipline, the lower monetization of the budget deficit, an output recovery, a reduction in duties and taxes, and appreciation of exchange rate. During this time period, the country had very low levels of food inflation, as domestic supply was plentiful as were international stockpiles. Inflation began to pick up after the first quarter of 2003-04, reaching as high as 9.3 percent in June 2005. It had a variety of reasons including a rise in the support price of wheat, shortages of wheat, and a rise in international prices including the oil prices.

The inflation rate had come down to 7.8 percent at the end 2006-07 but has since steadily risen to 10.3 percent over the period July- April 2007-08. Inflation had been contained during the period of 2000-07 despite tremendous growth through a combination of tight monetary policy and the resolving of several supply bottlenecks. Despite these measures taken by the government over the last couple of years, inflation has steadily increased this past fiscal year due to soaring international food and energy prices.

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HISTORICAL INFLATION TRENDS IN PAKISTAN

Year CPI Food Non-Food Core WPI SPI

1990-91 12.7 12.9 12.4 12.6 11.7 12.61991-92 10.6 10.6 10.5 7.5 9.8 10.51992-93 9.8 11.9 7.8 7.5 7.4 10.71993-94 11.3 11.3 11.2 10.9 16.4 11.11994-95 13.0 16.5 10.2 10.7 16.0 15.01995-96 10.8 10.1 11.3 10.9 11.1 10.71996-97 11.8 11.9 11.7 11.4 13.0 12.51997-98 7.8 7.7 8.0 7.5 6.6 7.41998-99 5.7 5.9 5.6 4.5 6.4 6.41999-00 3.6 2.2 4.7 3.5 1.8 1.82000-01 4.4 3.6 5.1 4.2 6.2 4.82001-02 3.5 2.5 4.3 2.0 2.1 3.42002-03 3.1 2.9 3.2 2.1 5.9 3.62003-04 4.6 6.0 3.6 3.0 7.9 6.82004-05 9.3 12.5 7.1 7.2 6.8 11.62005-06 7.9 6.9 8.6 7.5 10.1 7.0

2006-07(July-April) 7.9 10.2 6.2 6.0 6.9 11.1

Average of 1990s 9.7 10.1 9.3 8.9 10.0 9.9Average of 1990-97 11.4 12.2 10.7 10.7 12.2 12.0

Average of 1998-2000 5.7 5.3 6.1 5.2 4.9 5.2

Average of 2000-2007 5.8 6.4 5.5 4.6 6.6 6.9(Source of data is Federal bureau of Statistics)

Period GDP Growth Rate Inflation Rate1950-60 3.1 2.11960-70 6.8 3.21970-80 4.8 12.31980-90 6.5 7.81990-00 4.6 9.72001-09 5.2 8.4

(Source of data is Federal bureau of Statistics)

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CONCLUSIONInflation is one of the obstacles on the way of development. In Pakistan, it has squeezed the major part of the population. It needs to be controlled by strategic planning. Domestic production should be encouraged instead of imports; investment should be given preference in consumer goods instead of luxuries, Agriculture sector should be given subsidies, foreign investment should be attracted, and developed countries should be requested for financial and managerial assistance. And lastly a strong monitoring system should be established on different levels in order to have a sound evaluation of the process at every stage.

REMEDIESOur proposals to control the inflation rate in Pakistan are mentioned as under

o To Achieve Macro Economic Balance

o Develop Agricultural Sector

o Improve coordination of Monetary and Fiscal Policy

o Strengthen regulatory bodies to break down monopoly

o Promote Industries in Pakistan

o To take control over distribution of wealth

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REFERENCES1. http://www.articlestudy.com/2010/04/20/inflation-in-pakistan2. http://en.wikipedia.org/wiki/Economy_of_Pakistan3. http://en.wikipedia.org/wiki/Inflation4. Federal Bureau of Statistics

http://www.finance.gov.pk/admin/images/survey/chapters/07-inflation09.pdf (11/03/10)

5. http://www.imf.org/external/pubs/ft/wp/2006/wp0660.pdf.6. Khalid Mehmood, 20-11-2008 “Inflation in Pakistan”7. http://www.pide.org.pk/pdf/reports/InflationReport_2009.pdf

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