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INFLATION

MACRO ECONOMICS

Trends in Pakistan

Macro Economics
Final Project

GROUP E

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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.

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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
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:

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• 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
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

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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
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.

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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

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

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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.

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.

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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.

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

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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

Tariq Khattak

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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

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currency will depreciate in the coming month, while 30.3 per cent of respondents think that
value of domestic currency will remains the same.
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)].

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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
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 Consum Wholesa Sensiti Annua


er le price ve l GDP
Index Price Deflat
Price Indicat or
Index or

1990-1991 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

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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.

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.

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Whole sale Price Index

➢ 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.

Sensitive Price Indicator

➢ 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.

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Annual GDP Deflator

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

○ Loose monetary policies


○ Higher duties and taxes
○ Decrease in Price of Pakistani Currency
○ Frequent changes in prices of gas, electricity and petrol.
○ Political instability

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.

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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.

HISTORICAL INFLATION TRENDS IN


PAKISTAN

Year CPI Food Non- Core WPI SPI


Food

1990-91 12.7 12.9 12.4 12.6 11.7 12.6

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1991-92 10.6 10.6 10.5 7.5 9.8 10.5

1992-93 9.8 11.9 7.8 7.5 7.4 10.7

1993-94 11.3 11.3 11.2 10.9 16.4 11.1

1994-95 13.0 16.5 10.2 10.7 16.0 15.0

1995-96 10.8 10.1 11.3 10.9 11.1 10.7

1996-97 11.8 11.9 11.7 11.4 13.0 12.5

1997-98 7.8 7.7 8.0 7.5 6.6 7.4

1998-99 5.7 5.9 5.6 4.5 6.4 6.4

1999-00 3.6 2.2 4.7 3.5 1.8 1.8

2000-01 4.4 3.6 5.1 4.2 6.2 4.8

2001-02 3.5 2.5 4.3 2.0 2.1 3.4

2002-03 3.1 2.9 3.2 2.1 5.9 3.6

2003-04 4.6 6.0 3.6 3.0 7.9 6.8

2004-05 9.3 12.5 7.1 7.2 6.8 11.6

2005-06 7.9 6.9 8.6 7.5 10.1 7.0

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


April)

Average of 9.7 10.1 9.3 8.9 10.0 9.9


1990s

Average of 11.4 12.2 10.7 10.7 12.2 12.0


1990-97

Average of 5.7 5.3 6.1 5.2 4.9 5.2


1998-2000

Average of 5.8 6.4 5.5 4.6 6.6 6.9


2000-2007

(Source of data is Federal bureau of Statistics)

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Period GDP Growth Rate Inflation Rate

1950-60 3.1 2.1

1960-70 6.8 3.2

1970-80 4.8 12.3

1980-90 6.5 7.8

1990-00 4.6 9.7

2001-09 5.2 8.4

(Source of data is Federal bureau of Statistics)

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.

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

○ To Achieve Macro Economic Balance

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○ Develop Agricultural Sector


○ Improve coordination of Monetary and Fiscal Policy
○ Strengthen regulatory bodies to break down monopoly
○ Promote Industries in Pakistan
○ To take control over distribution of wealth

REFERENCES
1. http://www.articlestudy.com/2010/04/20/inflation-in-pakistan
2. http://en.wikipedia.org/wiki/Economy_of_Pakistan
3. http://en.wikipedia.org/wiki/Inflation
4. 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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