Research Proposal

On
Inflation its causes, effects and its control in Pakistan

By

Shoaib

Submitted to

Institute Of Business Studies

Affiliated with university of Peshawar

Advisor: Hafiz javed ur Rehman

Contents P/No

Introduction…………………………………………. 03

Statement of the problem…………………………… 04

Literature review…………………………………… 05

Causes …………….………………………………… 06

Effects of inflation………………………………….. 07

Analysis…………………………………………… 08

Control…………………………………………... 08

Conclusion………………………………………… 10

State bank Role……………………………………. 11

Bibliography…………………………………………. 14
INTRODUCTION:
DEFINITION:
Inflation has been different in different dictionaries over the ages. Dictionaries have given different versions of
definition regarding inflation. Inflation is an economic condition wherein the price of the goods and services
increase steadily measured against standard level of purchasing power, whereas the supply of the goods and
services decline along with the devaluation of money.

When the economy of a country faces inflation it brings bad news for the people because the supply of goods
decreases and this scarcity causes a predicament for the people. The definition of inflation has undergone lot of
changes since 1983 when it appeared in the dictionary for the first time. At that time inflation was thought of as a
cause but as time passed by the definition and its significance changed. Economists from different schools differ in
their opinion regarding the genesis of inflation. However, it is agreed that inflation occurs due to an unexpected rise
in the supply of money which causes devaluation or a decrease in the supply of goods and services.

Again, the inflation rate decreases with the increase in the production of goods and with the decrease in the supply
of money in the market.

The purview of inflation has narrowed in the present day since only the phenomenon of increase in the price level is
termed as inflation these days. Previously, the devaluation of money was also considered to be a condition of
inflation. In the present day this phenomenon is known as a monetary inflation.

Inflation is a continuous rise in the price of goods and services. It is important to note that a rise in the price of just
one or two items does not constitute inflation; nor does a one-time rise in all prices mark an inflationary period. To
count as inflation, the price increases must be general throughout the economy and must continue over time. The
hallmark of inflation is that money buys less than it once did. A cup of coffee that may have cost a dime at mid-
twentieth century may cost a dollar some 50 years later.

The government can fight inflation by restricting demand for goods and services, usually by raising interest rates or
imposing new taxes. Such measures tend to lead to higher unemployment, which dampens demands for goods and
services and, in turn, brings down prices. Economists debate whether the cost of fighting inflation, e.g., higher
unemployment and less growth, is worth the pain. Certainly a moderate amount of inflationary price increases, in
the range of one to two percent per year, is viewed by many economists as not worth worrying about.

Inflation is measured by the government's cost of living index. The opposite of inflation is deflation, a steady
decline in the level of prices over time.

 a general and progressive increase in prices; "in inflation everything gets more valuable except money"

 (cosmology) a brief exponential expansion of the universe (faster than the speed of light) postulated to have
occurred shortly after the big bang

 ostentation: lack of elegance as a consequence of being pompous and puffed up with vanity
 the act of filling something with air

In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of
time.
In physical cosmology, cosmic inflation, cosmological inflation or just inflation is the theorized exponential
expansion of the universe at the end of the grand unification epoch, 10−36 seconds after the Big Bang, driven by a
negative-pressure vacuum energy density. ...

An act, instance of, or state of expansion or increase in size, especially by injection of a gas; An increase in the
general level of prices or in the cost of living; A decline in the value of money; An increase in the quantity of
money, leading to a devaluation of existing money; Undue ...

1. The act of inflating or the state of being inflated.

2. A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of
money, caused by an increase in available currency and credit beyond the proportion of available goods and
services.

Statement of the Problem

Inflation, can our economy grow without it? What is inflation? The definition of inflation is “an abnormal increase in
available currency and credit beyond the proportion of available goods.” Although, Webster’s is considered by most to
be the overall best dictionary, WordNet states the meaning of inflation a lot clearer by saying, “it’s a general and
progressive increase in prices.” It occurs when the value of goods rises faster than the value of money. The usual
approximate measure of this is the Consumer Price Index, which weigh the prices of different goods according to
importance in a typical budget and then shows how much the prices of these goods have increased. This immediately
raises some problems; for example, the weight of the goods must change over time. The importance of computers was
not measured in the price index 100 years ago. Another problem is the failure of the price index to capture changes in
quality. The quality of a good may have improved by 20%, while the price has only risen by 10%. The consumer price
index doesn’t feel this should be a factor, but many would disagree. Hence, inflation is not easy to define in practice.
This should be kept in mind when discussing how to defeat inflation.

There have been numerous theories on how to defeat inflation and even some theories on whether, or not, it should be
defeated at all. Some say that inflation is not only expected, but also often, needed. Economists believe that in order for
the economy to expand and grow, there has to be some level of inflation. Therefore, the opposite holds true as well. If
you want to lower inflation, you have to accept a semi-standard economy. They call this tradeoff the Phillips Curve. The
Phillips Curve is thought to be the “proper” way of balancing economic growth and inflation. For this reason the Federal
Reserve is always looking for the perfect equilibrium at which we can maximize our economic growth while keeping
inflation as minimal as possible. They do this by increasing and decreasing interest rates. Although, Economists and the
Federal Reserve abide by the Phillips Curve as a general rule for not letting inflation get out of hand, it has been proven
many times in the past that it is possible to have a very healthy and prosperous economy without raising inflation at all.
There are even examples of inflation declining while the economy booms. As Steve Forbes, of Forbes magazine, said,
“Prosperity is not the fueler of inflation.” For example, in the 1980's, when the economy was at a major high, inflation
fell from 13% all the way to 4%. That’s an incredible drop for such a short period of time.
A near History of Inflation in Pakistan with reference to CPI, SPI and
WPI: [1]
Consumer Price Index (CPI) is the main measure of price changes at the retail level. It measures changes in the cost
of buying a representative fixed basket of goods and services and generally indicates inflation rate in the country.
The Consumer price index was computed for the first time with 1948-49 as a base for industrial workers in the
cities of Lahore, Karachi and Sialkot only. Continuous efforts have been made, since then, to make CPI more
representatives by improving and expanding its scope and coverage in terms of items, category of employees, cities
and markets. Accordingly, the CPI series were computed with 1959-60, 1969-70, 1975-76, 1980-81 and 1990-91 as
base years. At present, the CPI is being computed with 2000-01 as base year. And according to the studies of CPI,
the inflation rate during the fiscal year 2000-2001 was 4.41, during the fiscal year 2001-2002 it dropped down to
3.54, further dropped to 3.10 during the fiscal year 2002-2003, rose again to 4.57 during 2003-2004, increased
drastically to 9.28 during 2004-2005 and then dropped to 7.92 during 2005-2006. And by the mid of October 2006,
the CPI is reported to be 8.43.

The Sensitive Price Indicator (SPI) is computed on weekly basis to assess the price movements of essential
commodities at short intervals so as to review the price situation in the country. The SPI is being presented in the
Economic Coordination Committee of the Cabinet (ECC). Sensitive price indicator was originally computed with
1969-70 as base which was subsequently switched over to 1975-76, 1980-81 and 1990-91 as base year. Presently,
the SPI is being computed with base 2000-2001. And Sensitive Price Indicator (SPI) shows the facts as; 4.84 in
2000-2001, 3.37 in 2001-2002, 3.58 in 2002-2003, 6.83 in 2003-2004, 11.55 in 2004-2005 and 7.02 in 2005-2006.
Recently (By the mid of October 2006) the SPI is reported as 9.86.

The Wholesale Price Index (WPI) is designed to measure the directional movements of prices for a set of selected
items in the primary and wholesale markets. Items covered in the series are those which could be precisely defined
and are offered in lots by producers/manufacturers. Prices used are generally those, which conform to the primary
sellers realization at ex-mandi, ex-factory or at an organized Wholesale level. The WPI initially was computed with
1959-60 as base. Since then, continuous efforts have been made to make the WPI more representatives by
improving and expending its scope and coverage in terms of commodities, quotations/markets, etc. Accordingly,
WPI series were computed with 1969-70, 1975-76,1980-81 and 1990-91 as base years. Presently, the WPI is being
computed with 2000-01 as base. The Wholesale Price Index (WPI) tells the story as; 6.21 in 2000-2001, 2.08 in
2001-2002, 5.57 in 2002-2003, 7.91 in 2003-2004, 6.75 in 2004-2005 and 10.10 in 2005-2006.

Evaluation of the year 2005-2006 (Government’s View):[2]

Inflation Among the most appreciated developments, during fiscal year 2005-06, was the significant abatement of
price pressure over the course of the year. For the first ten months of the fiscal year July–April 2005-06, all
important barometers of price pressure in the economy indicated a steady deceleration in inflation. Inflation during
the first ten months July-April of the current fiscal year is estimated at 8.0 percent as against 9.3 percent in the same
period last year. Food inflation is estimated at 7.0 percent as against 12.8 percent in the same period last year. Non-
food inflation at 8.8 percent is on higher side compared with 6.9 percent in the same period last year. The core
inflation which excludes food and energy costs from the headline CPI, moved up and estimated at 7.7 percent as
against 7.0 percent in the same period last year. House rent index also played an important role in building
inflationary pressure this year. With second largest weight in the CPI (23.4%) after food (40.3%), the house rent
component of the CPI registered a marginal decline to 10.3 percent as against 11.1 percent in the same period last
year. When viewed in the context of year-on- year performance of inflation, the current fiscal year exhibits
significant abatement of price pressure and declaration in overall inflation as well as its sub-indices. The current
fiscal year, started with an inflation rate of 9.0 percent in July 2005, but continued to decelerate, reaching at 23
months low at 6.2 percent in April 2006. Food inflation was closed to 9.7 percent at the beginning of the current
fiscal year but decelerated sharply to 3.6 percent in April 2006- the lowest in the last 31 months. The measures
taken by the Government, particularly since April 2005, when overall inflation reached 93 months high at 11.1
percent (the last time inflation was at this level in July 1997) and food inflation peaked at 15.7 percent in April
2005 (last-time it was at 15.7 percent in May 1994), yielded handsome dividend in the shape of overall inflation
decelerating to 6.2 percent and food inflation to 3.6 percent in April 2006. Notwithstanding a steady deceleration in
inflation, the prices of some of the essential food items (out of the basket of 370 items in CPI) registered sharp
increases, particularly during the second half of the fiscal year and therefore adversely affected the low and fixed
income groups. The expenditure on food items constitutes bulk of the monthly expenditure of the poor segment of
the society. Sharp increases in the prices of some of the strategic food items put pressure on the poor. The higher
inflationary trend in Pakistan over the last two years has been the outcome of pressure that emanated from demand
and supply sides. Four years of strong economic growth has given rise to the income levels of various segments of
the society. The rising level of income have strengthened domestic demand and put upward pressure on prices of
essential commodities. Supply side pressure emanated from a variety of factors, prominent among those are:
increase in support price of wheat for three years in a row, shortage of wheat owing to less than the targeted
production, mismanagement in wheat operation in one of the wheat deficit province, inter-provincial ban on the
movement of wheat resulting in sharp increases in prices of wheat and wheat flour. The prices of other food item
such as beef, mutton, chicken, milk etc also registered sharp increases owing to “sympathy effect” on the one hand
and demand pressure on the other. Lower production of sugar due to a relatively lower production of sugarcane and
a sharp increase in the international prices of sugar brought about by a significant diversion of sugarcane into
ethanol (petroleum substitute), by the largest producer, Brazil, also contributed in building inflationary pressure in
Pakistan. Prices of various kinds of pulses also registered sharp increases owing to a significant decline in domestic
production as well as shortages in international markets. This inadvertently kept the prices of pulses at record high
level. An unprecedented rise in international oil prices also contributed to the build up in inflationary pressure in
Pakistan.

Description of Information Gathered Causes and effects

Causes OF Inflation

There are a few different reasons that can account for the inflation in our goods and services; let's review a few of
them.

• Demand-pull inflation refers to the idea that the economy actual demands more goods and services than
available. This shortage of supply enables sellers to raise prices until an equilibrium is put in place between
supply and demand.
• The cost-push theory , also known as "supply shock inflation", suggests that shortages or shocks to the
available supply of a certain good or product will cause a ripple effect through the economy by raising
prices through the supply chain from the producer to the consumer. You can readily see this in oil markets.
When OPEC reduces oil supply, prices are artificially driven up and result in higher prices at the pump.
• Money supply plays a large role in inflationary pressure as well. Monetarist economists believe that if the
Federal Reserve does not control the money supply adequately, it may actually grow at a rate faster than that
of the potential output in the economy, or real GDP. The belief is that this will drive up prices and hence,
inflation. Low interest rates correspond with a high levels of money supply and allow for more investment
in big business and new ideas which eventually leads to unsustainable levels of inflation as cheap money is
available. The credit crisis of 2007 is a very good example of this at work.
Inflation refers to a rise in prices that causes the purchasing power of a nation to fall. Inflation is a normal economic
development as long as the annual percentage remains low; once the percentage rises over a pre-determined level, it
is considered an inflation crisis.

There are many causes for inflation, depending on a number of factors. For example, inflation can happen when
governments print an excess of money to deal with a crisis. As a result, prices end up rising at an extremely high
speed to keep up with the currency surplus. This is called the demand-pull, in which prices are forced upwards
because of a high demand.

Another common cause of inflation is a rise in production costs, which leads to an increase in the price of the final
product. For example, if raw materials increase in price, this leads to the cost of production increasing, which in
turn leads to the company increasing prices to maintain steady profits. Rising labor costs can also lead to inflation.
As workers demand wage increases, companies usually chose to pass on those costs to their customers.

Inflation can also be caused by international lending and national debts. As nations borrow money, they have to
deal with interests, which in the end cause prices to rise as a way of keeping up with their debts. A deep drop of the
exchange rate can also result in inflation, as governments will have to deal with differences in the import/export
level.

Finally, inflation can be caused by federal taxes put on consumer products such as cigarettes or fuel. As the taxes
rise, suppliers often pass on the burden to the consumer; the catch, however, is that once prices have increased, they
rarely go back, even if the taxes are later reduced. Wars are often cause for inflation, as governments must both
recoup the money spent and repay the funds borrowed from the central bank. War often affects everything from
international trading to labor costs to product demand, so in the end it always produces a rise in prices.

Effects OF Inflation
The effects of inflation can be brutal for the elderly who are looking to retire on a fixed income. The dollars that
they expect to retire with will be worth less and less as time goes on and inflation goes higher.

When the balance between supply and demand spirals out of control, buyers will change their spending habits as
they meet their purchasing thresholds and producers will suffer and be forced to cut output. This can be readily tied
to higher unemployment rates. When extremes arise in the supply/demand structure, imbalances are created.

The mortgage crisis of 2007 is a great example of this. Home prices were increasing at a very rapid rate from 2002
to 2005 and got to the point where the prices became too high, forcing buyers to step aside. This lack of demand
forced sellers to drop prices back to a point where there is demand. As I write this article, this equilibrium has still
not come into the real estate market. This is due to many factors, as you will read in our mortgage crisis article, but
the extreme acceleration of inflation in home prices is directly correlated to the pullback we are seeing.

A similar example can be seen in the internet euphoria in the stock market back in 1998 to 2000. This rapid
acceleration in stock prices eventually became unsustainable and led to a disastrous fall.

The point that is being made is that if inflation is not contained and rises at an unsustainable rate; the stronger the
impact on the other side. There is a saying; "the bigger they are, the harder they fall".
Analysis:
Pakistan, with a population of about 16 million people has undergone a remarkable macro economic growth during
last few years, but the core problems of the economy are still unsolved. Inflation is one of these core problems.
Government claims that in order to keep the prices of essential commodities under control, it has been taking
various measures throughout the year. These measures include: a liberal import regime for food items including
zero rating of the imports of these commodities. In order to provide relief to the low and fixed income groups, the
government has been selling wheat flour and sugar through the outlets of the Utility Stores Corporation (USC) at
much lower prices than the market. In order to augment supplies of essential commodities in shortest possible time
and at lower freight charges, the government has also allowed the import of various items through land routes from
neighboring countries. But, all these are secondary measures. Problems like ‘inflation’ and ‘poverty’ etc can’t be
resolved by applying the secondary measures directly, these need strategic planning. Unfortunately, in Pakistan,
these core problems have never undergone such planning process. Government has never invited foreign
investment for the production of basic goods. Agriculture sector, on which the major industries rely for the raw
material has not been given sufficient subsidies. The major rise in the prices is because of the increasing prices of
oil (as increased prices of oil increase the cost of production), but no such steps have been taken to control the oil
prices, or at least lessen the effect. Selling basic food items at USC is not an achievement. Did this step have the
effective distribution of goods? No, privileged group has taken the major part of goods from these USCs, and the
poor couldn’t have access over these basic goods even then. Government further claims that the role of the Trading
Corporation of Pakistan (TCP) has been enhanced. The TCP is active in importing sugar from around the world to
build up strategic reserves with a view to continue selling sugar at less than the market price through the USC. The
TCP has also been asked to import various kinds of pulses to meet the domestic consumption requirements and
stabilize their prices in the country. In my opinion, TCP should plan the process by which we can have the
maximum production at lower cost at home, instead of formulating plans to import the items. Domestic productions
at less cost of production will not only make the availability of goods much easier but Aggregate Supply will also
increase, and domestic industry will get developed.

Controlling Inflation forms a significant part of the economic activities of a nation. Inflation is an
economic condition characterized by a general rise in the prices. Thus, controlling Inflation is important as
unrestrained increase of the prices may culminate in Hyperinflation, and an excessive fall in the prices may lead to
Deflation. Both the situations are not healthy and sound for the overall growth and development of a country's
economy.

In fact, keeping a strong control over Inflation has turned out to be one of the primary objectives of the
governments of different countries across the globe. To this effect, efficacious economic policies are being
formulated, which mainly concentrate on the fundamental causes of Inflation in an economy, and try to improvise
methods to keep the inflationary conditions under control.

For instance, if the primary reason for inflation in a nation is the excessive demand for goods and services, then the
economic policy on governmental level should find out the causes of such unnecessary rise and undertake measures
to decrease the overall level of collective demand. Sometimes, if it is seen that Cost-Push Inflation is responsible
for the rise in the demand for goods and services, then the cost of production must be checked, to handle the
inflation-related problems.
Mentioned below are some methods, which have proved to be highly effective in controlling inflation to large
extents:

Fiscal Policies:
Fiscal policies are effective in increasing the leakage rates from the circular income flow, thereby rejecting all
further additions into this particular flow of income. This brings about a reduction in the Demand-Pull Inflation, in
terms of increasing unemployment and slackening the economic growths. Following are a few types of fiscal
policies commonly employed:

• Lowering the expenses on governmental level

• A fall in the borrowing amounts in the government sectors, on an annual basis
• High direct taxes, for reducing the disposable income

Monetary Policies:
Monetary Policies have a great role to play in controlling Inflation. These are policies which can actually control
the rise in demand, by increasing the rates of interest and reducing the supply of real money. An escalation in the
interest rates brings about a reduction in collective demands, in the following three ways:

• A rise in the interest rate discourages borrowing from both companies and households. When interest rates
increase, it simultaneously encourages the savings rate, owing to an escalation in the opportunity cost of
expenditure.

• Rise in the interest rates is a very useful tool for restricting monetary inflation. Increase in the real rates of
interest decreases the demand for loans, thereby limiting the growth of broad money.

• There may also be a fall in the commercial investments, due to a rise in the costs of borrowing money. This
exerts a direct influence on a handful of planned investment-related projects, which turn out to be
unprofitable . This leads to a fall in the collective demand.

• An increase in the payment of mortgage interests automatically decreases the real 'effective' disposable
income of the house owners, as well as their spending capacities. Escalation in the mortgage costs also
decreases the demand generated in the housing markets.

Exchange Rates:
An escalation in the exchange rate is possible by increasing the rates of interest or buying money through the
central bank interferences in the foreign exchange markets. Mentioned below, is a short-term mean by which
inflation can be controlled through exchange rates:

• Income policies or direct wage controls: Setting restrictions on the growth rate of wages may decrease cost
push inflation. On governmental level, an attempt to influence the growth of wage leads to limit the rise in
the pay in public sectors, as well as initiates cash restrictions for making payments to the employees of
public sectors.

As far as the private sector is concerned, the government attempts to convince the commercial firms and its
employees to implement self-controls at the time of negotiating wages. Generally, there is a fall in the wage
inflation when there is an economic depression, leading to a rise in the unemployment rates.

The long-term means of controlling Inflation are as follows:

 • Supply-side Reform Policy: According to this policy, if more output is produced at a low per unit cost, there
are chances for the economy to attain persistent economic growth and development, without being affected
by inflation.

• Policy regarding labor market reforms: If an increase in the flexibility of the labor market permits the
commercial firms to put a check on labor costs, it can lead to a reduction in the pressures created by Cost-
Push Inflation.

Conclusion:
Inflation 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.

State bank role in controlling inflation

 Facts and Figures

• Central Bank of: Pakistan

 • Established: 1947

• Headquarters: Karachi

• Governor: Shamshad Akhter

• Official website: www.sbp.org.pk

 Monetary Policy

• It is a policy of central bank to control the supply of money with the aim of achieving macro economics
stability.

• (Harry Johnson)


 Characteristics

• Tool used by the national govt. to influence the economy

• Controls the supply and availability of money

• Controls the cost of money (interest)

• Contrasted with fiscal policy

 OBJECTIVES OF MONETRY POLICY

•  Full Employment

• Increase in the production

• Increase in the investment

• Economic development

• Stability of Capital Market

•  Proper Distribution of Wealth

• Exchange Rate Stability

• To increase Exports

• Improvement in standard of living

 Price Stability As Basic Objective

•  Improving the transparency of the price mechanism,

 • Reducing inflation risk premier in interest rates.

•  Avoiding unproductive activities to hedge against the negative impact of inflation or deflation.

• Reducing distortions of inflation or deflation,

•  Preventing an arbitrary redistribution of wealth and income as a result of unexpected inflation or

deflation.

 BENEFITS OF MONITRY POLICY

•  Short run- Monetary Policy Transmission Mechanism

• Long-run Neutrality of Money

• Inflation – a Monetary Phenomenon

•  In practice all types of monetary policy involve modifying the amount of base currency (M0) in
circulation.

• This process of changing the liquidity of base currency through the open sales and purchases of
(government-issued) debt and credit instruments is called open market operations.

 DIFFERENCE BETWEEN THE VARIOUES TYPES OF MONETARY POLICY

 Inflation Targeting

• Under this policy approach the target is to keep inflation, under a particular definition such as Consumer
Price Index, within a desired range.

 Price Level Targeting

• Price level targeting is similar to inflation targeting except that CPI growth in one year is offset in
subsequent years such that over time the price level on aggregate does not move.

 Monetary Aggregates

• In the 1980s several countries used an approach based on a constant growth in the money supply.

• This approach was refined to include different classes of money and credit (M0, M1 etc)

• This approach is also sometimes called monetarism.

 Fixed Exchange Rate

• This policy is based on maintaining a fixed exchange rate with a foreign currency.

• There are varying degrees of fixed exchange rates, which can be ranked in relation to how rigid the fixed
exchange rate is with the anchor nation.
 MIXED POLICY

• In practice a mixed policy approach is most like "inflation targeting".

• However some consideration is also given to other goals such as economic growth, unemployment and asset
bubbles. This type of policy was used by the Federal Reserve in 1998.

Biliography:
[1] Federal Bureau of Statistics

[2] Economic Survey of Pakistan 2005-2006

* Economic Theory (K.K. Dewett, P. A. Samuelson, Parkin)

*Journals of the Chief Economist of WB (The Writer)

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