BS 2010

Inflation in Pakistan
Information Technology Department Economics Report

Submitted by Qanita

Zakir Submitted to Nighat Moin

CONTENTS
ABSTRACT INFLATION
Introduction Types of Inflation Demand-pull Cost-push inflation Pricing power inflation Sectorial inflation Built-in inflation Causes of Inflation Excess money printing High Production Cost International lending and national debts Federal taxes Effects of Inflation Negative Effects Positive Effects How to Survive Inflation?

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LITERATURE REVIEW
Inflation Impact on Economy By Rafia Ehsan Inflation and erosion of quality in Pakistan By Dr Humayun Dar

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FINDINGS AND ANALYSIS

Inflationary Factors in Pakistan Supply-side shocks Increased domestic demand Increase in net imports Rising trade deficit Fiscal policy remained expansionary Expansionary monetary policy Rising import prices Indirect taxes Price Indices in Pakistan Flaws in Measuring Inflation in Pakistan Graphical Analysis of Inflation from 2008 to 2012 Using CPI

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CONCLUSION RECOMMENDATIONS

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ABSTRACT
Pakistan has undergone a significant economic growth during last few years, but the core problems of the economy are still unsolved. Inflation remains the biggest of all these problems. The aim of this report is to find the determinants of inflation in Pakistan, its causes and measures to control it. In this report the literature review explains the view point of Rafia Ehsan and Dr. Humayun Dar who is an economist and PhD from Cambridge University in determining the causes of inflation and establishing links of different variables with inflation such as fiscal and monetary policies, unemployment, demand pull and cost pull factors that affect inflation. The report highlights patterns in Pakistan from 2008 to 2012, which reports the last five years as highly inflationary due to expansionary monetary policy and high oil prices. High international oil prices lead to increase in transportation charges as well as energy intensive industry products such as metal commodities. As producers pass on the increased costs to consumers, this leads to an increase in cost of Pakistani imports, which drives up inflation. The high levels of inflation reflect a volatile economy in which money does not hold its value for long. Workers require higher wages to cover rising costs, and are disinclined to save. Producers in turn may raise their selling prices to cover these increases, scale back production to check their costs (resulting in lay-offs), or fail to invest in future production. Many such problems have been, and still are, being faced by Pakistan. The factors leading to high levels of inflation include deficit financing, foreign remittances, foreign economic assistance, increase in wages, population explosion, black money, prices of imported goods, devaluation of rupee, etc. Government actions are not useful, as we are not seeing any difference in the inflation rates.. 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.

INFLATION

INTRODUCTION
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. The term "inflation" once referred to increases in the money supply (monetary inflation); however, economic debates about the relationship between money supply and price levels have led to its primary use today in describing price inflation. Inflation can also be described as a decline in the real value of moneya loss of purchasing power in the medium of exchange which is also the monetary unit of account. When the general price level rises, each unit of currency buys fewer goods and services. A chief measure of general price-level inflation is the general inflation rate, which is the percentage change in a general price index, normally the Consumer Price Index, over time. Inflation can cause adverse effects on the economy. For example, uncertainty about future inflation may discourage investment and saving. High inflation may lead to shortages of goods 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 by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth. Today, most economists favor a low steady rate of inflation. Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reducing the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.

TYPES OF INFLATION
There are many types of inflation. DEMAND-PULL The most important inflation is called demand-pull or excess demand 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.

COST-PUSH 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. Often a rise in wages in excess of any gains in labor productivity is what raises unit costs of production and thus raises prices. This is less common than demand-pull, but can occur independently as well as in conjunction with it. PRICING POWER INFLATION A third type of inflation could be 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. SECTORIAL INFLATION The fourth type is called sectorial inflation. The term applies whenever any of the other three factors hits a basic industry causing inflation there, and 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 also, so inflation becomes more widespread throughout the economy, although it originated in just one basic sector. BUILT-IN INFLATION induced by adaptive expectations, often linked to the "price/wage spiral" because it involves workers trying to keep their wages up (gross wages have to increase above the CPI rate to net to CPI after-tax) with prices and then employers passing higher costs on to consumers as higher prices as part of a "vicious circle." Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

CAUSES OF INFLATION
There are many causes for inflation, depending on a number of factors. EXCESS MONEY PRINTING 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. In which prices are forced upwards because of a high demand. HIGH PRODUCTION COST 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. INTERNATIONAL LENDING AND NATIONAL DEBTS 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
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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. FEDERAL TAXES 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. For example a rise in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an extension to the range of products to which VAT is applied. These taxes are levied on producers (suppliers) who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden of the tax onto consumers. For example, if the government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push inflation.

EFFECTS OF INFLATION
Most effects of inflation are negative, and can hurt individuals and companies alike, below is a list of negative and positive effects of inflation. NEGATIVE EFFECTS Hoarding (people will try to get rid of cash before it is devalued, by hoarding food and other commodities creating shortages of the hoarded objects). Distortion of relative prices (usually the prices of goods go higher, especially the prices of commodities). Increased risk - Higher uncertainties (uncertainties in business always exist, but with inflation risks are very high, because of the instability of prices). Income diffusion effect (which is basically an operation of income redistribution). Existing creditors will be hurt (because the value of the money they will receive from their borrowers later will be lower than the money they gave before). Fixed income recipients will be hurt (because while inflation increases, their income doesnt increase, and therefore their income will have less value over time). Increased consumption ratio at the early stages of inflation (people will be consuming more because money is more abundant and its value is not lowered yet). Lowers national saving (when there is a high inflation, saving money would mean watching your cash decrease in value day after day, so people tend to spend the cash on something else). Illusions of making profits (companies will think they were making profits while in reality theyre losing money if they dont take into consideration the inflation rate when calculating profits). Causes an increase in tax bracket (people will be taxed a higher percentage if their income increases following an inflation increase). Causes mal-investment (in inflation times, the data given about an investment is often deceptive and unreliable, therefore causing losses in investments).

Causes business cycles (many companies will have to go out of business because of the losses they incurred from inflation and its effects). Currency debasement (which lowers the value of a currency, and sometimes cause a new currency to be born) Rising prices of imports (if the currency is debased, then its purchasing power in the international market is lower).

POSITIVE EFFECTS It can benefit the inflators (those responsible for the inflation) It can benefit early and first recipients of the inflated money (because the negative effects of inflation are not there yet). It can benefit the cartels (it benefits big cartels, destroys small sellers, and can cause price control set by the cartels for their own benefits). It might relatively benefit borrowers who will have to pay the same amount of money they borrowed (+ fixed interests), but the inflation could be higher than the interests, therefore they will be paying less money back. (example, you borrowed $1000 in 2005 with a 5% fixed interest rate and you paid it back in full in 2007, lets suppose the inflation rate for 2005, 2006 and 2007 has been 15%, you were charged %5 of interests, but in reality, you were earning %10 of interests, because 15% (inflation rate) 5% (interests) = %10 profit, which means you have paid only 70% of the real value in the 3 years. Note: Banks are aware of this problem, and when inflation rises, their interest rates might rise as well. So don't take out loans based on this information. Many economists favor a low steady rate of inflation, low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reducing the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements. Tobin effect argues that: a moderate level of inflation can increase investment in an economy leading to faster growth or at least higher steady state level of income. This is due to the fact that inflation lowers the return on monetary assets relative to real assets, such as physical capital. To avoid inflation, investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects. The first three effects are only positive to a few elite, and therefore might not be considered positive by the general public.

HOW TO SURVIVE INFLATION?

Tips to avoid the negative effects of inflation are only suggestions and dont constitute any legal advice, therefore youre free to use your own judgment depending on circumstances, to be more prepared to face inflation effects. Here are some tips:

Be wise when holding cash, whether in your home or in your savings account, if youre earning 5% interest on the money you have in your bank, and inflation rate is 10% then youre in reality losing 5% and not earning anything. Be careful when buying bonds, high inflation rates completely destroy the value of long-term bonds. If you have a variable-rate mortgage, fix it if you can find a good deal, have a low fixed interest rate or 0% interest if you can find one. Invest in durable goods or commodities rather than in money. Check out our commodities list. Invest in things that you're going to use anyway and will serve you for a long time. Invest for long-term capital gains, because short term investments tend to give deceptive results or sense of making profits while in reality youre not making profits. Learn about bartering which is trading goods or services without the exchange of money (it was very popular in hyperinflation times). Manage wisely your recurring monthly bills such as (phone bills, cable TV...), it would help to reduce them or eliminate some of them. Same goes with ephemeral items (movies, restaurants, hotel rooms...) theyre not bad if you spend money on them in moderation. Ask yourself, do I really need these things Im spending my money on? Think how much and how often you will need something before buying it. Use the money saving tips such as: you need to reduce your consumption of things that are rising rapidly in price (eg, gas) without having to reduce your consumption of goods that are rising less rapidly or even falling in price (eg, clothes). Buy only what you need, especially objects that have multi-tasks, and are considered durable goods.

LITERATURE REVIEW

INFLATION IMPACT ON ECONOMY BY RAFIA EHSAN

[Extracted from the article written in Pakistan Times] In Pakistan, the most important thing is the rise in prices of oil, gas, excise duties and the increase in the utility tariffs. These all has an inflationary impact on the economy. Pakistan, with a population of about 16 million people has undergone a remarkable 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. 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. 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 cant be resolved by applying the secondary measures directly, these need strategic planning. Unfortunately, in Pakistan, these core problems have never undergone such a 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.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. 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. Inflation always hurts ones' standard of living. Rising prices mean people have to pay more for the same goods and services. If income increases at a slower rate as inflation, the standard of living declines even if one makes more. So it is the root cause in making and affecting economy and people of the country poor. If we want to control inflation we shall have to inflict strict control over the supply of money and evading any relaxation to the supply of money. This is the most apt way whereby we can control inflation effectively and keep the economy of the country in a strong and stable position.

INFLATION AND EROSION OF QUALITY IN PAKISTAN BY DR HUMAYUN DAR

[Published in The Express Tribune, January 30th, 2012] In a competitive environment, where demand and supply forces predominantly influence price movements, any attempts to keep the prices down artificially results in a dilution of quality and in some cases quantity (which effectively means no real change in price). We can see the quality of supplied goods and services deteriorating when prices are either kept artificially low or when demand is highly price elastic. For example, a cup of tea in Pakistan has gone down in quality and has shrunk in size because its price has been influenced by regulation and, indirectly, by social pressure. Similarly, a cap on the price of roti results in a decrease in its size. While a negative relationship between prices and demand has been studied and is well documented in economic literature, the impact of higher prices (inflation) on the quality of goods and services is relatively ignored by economists. In Pakistan, inflation has killed quality, because demand has in general been price elastic. The cottage industries and handicrafts are real casualties of inflation. Take the example of rugs produced in Gakkhar Mandi. The town used to produce very high quality rugs, which were not only used throughout the country but were also exported. The producers found out that the demand for rugs was highly price elastic. As they were not able to increase their prices (despite increase in their own costs and the prices of inputs like cotton), they gradually started decreasing the weights of their products. Hence, a rug, which used to be 25 kilograms in weight 25-30 years ago, is only five kilograms in weight today. This was achieved by weaving the rugs loose, as compared to previously tightly knitted weaving. This has resulted in a huge drop in quality. Gone are the days of rich, flocculent textures of rugs and the intricate artistry of shawls, replaced by substandard material. Furthermore, erosion of the real income decreased demand for high quality ostentational products produced in the country, which compelled the master workers in traditional industries to migrate to other professions. One exception perhaps is the furniture industry, which appears to be less price elastic and more income elastic. Consequently, with the increase in income levels of the middle and upper middle classes, demand for high quality furniture has increased in the country. The government has failed to induce the creation of international brands out of the traditional capacity in indigenous agriculture and industry. This is contrary to other countries like Indonesia, Malaysia and other Far Eastern countries, where governments have helped the local manufacturers in developing quality brands. On a policy level, inflation targeting has never worked in Pakistan and, given the state of the economy, will never work as the transmission mechanism doesnt respond to monetary or fiscal policies. In Pakistan, monetary discipline, fiscal prudence, exchange rate stability and energy management should be the policy targets. Otherwise, the country will not only lose quality in products but also experience a drop in quality of human capital, which is already evident from the brain drainage the country has experienced for decades.

FINDINGS AND ANALYSIS

INFLATIONARY FACTORS IN PAKISTAN

Several supply and demand factors could be responsible for this surge in inflation. SUPPLY-SIDE SHOCKS Can cause large fluctuations in food and oil prices, effects of which on overall inflation, at times, can be so excessive that these cannot be countered through demand management, including monetary policy. INCREASED DOMESTIC DEMAND First, increased domestic demand created an output gap, putting upward pressure on prices. Growth in private consumption on the average remained over 10 per cent between FY04 and FY06, depicting signs of demand side pressures on price level. The relationship between growth and inflation depends on the state of the economy. High growth, without an increase in inflation, is possible if the productive capacity or potential output of the economy is growing enough to keep pace with demand. This is also possible if the actual output is below the potential output and there is sufficient spare capacity available to cope up with the demand pressures. When the actual output catches up with the potential output, there remains no spare capacity and the economy is working at full employment level, any further gain in growth comes at the cost of rising inflation. If demand continues to grow at this stage, and the productive capacity does not expand, there is a serious threat of rapid inflation in the long run without any additional growth in the output. A prolonged phase of rising inflation in such a case can have severe consequences for the economy. INCREASE IN NET IMPORTS Second, the growing gap between domestic demand and production was filled by a sharp increase in net imports, which grew by above 40 per cent in FY05 and by 24 per cent in FY06. As compared to imports, exports increased by only around 10 per cent in FY05 and by 13 per cent in FY06. This resulted in a record trade deficit. RISING TRADE DEFICIT 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. FISCAL POLICY REMAINED EXPANSIONARY Third, fiscal policy has remained expansionary in the last few years. Expansionary fiscal policy fuels domestic demand and puts pressure on the current account deficit. It widens the investment-saving gap, which has to be financed externally. Financing of fiscal deficit through money creation adds to

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inflationary pressures. Increased government borrowing from central bank can have serious consequences for general price level. EXPANSIONARY MONETARY POLICY Fourth, the expansionary monetary policy- high growth in money supply and loose credit policy- was believed to be contributing to high inflation. Although expansion of credit is usual in expanding economies, excessive credit growth can have adverse effects on real variables. RISING IMPORT PRICES Rising import prices are also considered an important factor for inflation. Exchange rate, if depreciating can also put upward pressure on price level. Increase in prices of goods, such as petrol, raw material etc makes our imports costlier, impacting on cost of production. INDIRECT TAXES Similarly, indirect taxes are also blamed as the main cause of inflation. The indirect taxes, such as sales tax and excise duties raise the prices of consumer goods. This creates inflationary pressure. On the other hand, direct taxes reduce the take-home income and have anti-inflationary effect. A substantial increase in support price of wheat is estimated to have an inflationary effect on consumer prices, particularly food prices. This effect is due to the fact that wheat and wheat-related products account for 5.1 per cent of the CPI basket.

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. 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. 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. 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. In Pakistan, the main focus is placed on the CPI as a measure of inflation as it represents more with a wider coverage of 374 items in 71 markets of 35 cities around the country. As such, the change in CPI becomes an indicator of the inflation that affects all of us. WPI indicates the change in wholesale prices which affects businesses and industries. And SPI that covers a limited number of essential items of daily use including food and fuel can be termed as the inflation for the poor.

FLAWS IN MEASURING INFLATION IN PAKISTAN

In their fight against poverty our economic managers need to know a bit more precisely, how inflation is affecting the poor people. But they use CPI to evaluate the impact of inflation on the cost of living of the poor and the rich alike. The reason why they do not use the SPI for this purpose is that the basket of items for calculating SPI is too small although it includes most essential food and fuel items that the poorest people consume. Perhaps Pakistan needs to develop two separate CPIsone for the urban
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areas and the other for the rural areas. And it needs to use different basket of items for calculating the two CPIs. The list of goods and services that would form the basket for each CPI might naturally differ. And more importantly different weightages can be assigned to some of the items that could be common in both baskets depending upon the varying volumes and frequency of their use by the rural and the urban people. In India, there are four measures of CPI including the CPI for Industrial Workers and the CPIs for agricultural laborers, rural laborers and urban non-manual employees.

GRAPHICAL ANALYSIS OF INFLATION FROM 2008 TO 2012 USING CPI

The inflation rate in Pakistan was last reported at 10.8 percent in March of 2012. From 2003 until 2010, the average inflation rate in Pakistan was 10.15 percent reaching an historical high of 25.33 percent in August of 2008 and a record low of 1.41 percent in July of 2003.

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CONCLUSION
Inflation effects the different sectors of the economy (Effects on the distribution of income and wealth, Effects on production, Effects on the Government, Effects on the Balance of Payment, Effects on Monetary Policy, Effects on Social Sector, Effects on Political environment) and different classes of the people (Debtors & Creditors, Salaried Class, Wages earners, Fixed income group, Investors and shareholders, Businessmen, Agriculturists). A reasonable rate of inflation--around 3- 6 per cent-- is often viewed to have positive effects on the national economy as it encourages investment and production and allows growth in wages. When inflation crosses reasonable limits, it has negative effects. It reduces the value of money, resulting in uncertainty of the value of gains and losses of borrowers, lenders, and buyers and sellers. The increasing uncertainty discourages saving and investment. Not only can high inflation erode the gains from growth, it also makes the poor worse off and widens the gap between the rich and the poor. If much of the inflation comes from increase in food prices, it hurts poor more since over half of family budget of the low wage earners goes for food. Second, it redistributes income from fixed income earners (for instance pensioners) to owners of assets and earners of large and variable income, such as profits. For Pakistans economy, inflation can be bad if it crosses the threshold of six per cent, and can be extremely harmful if it crosses the double digit level. Several supply and demand factors could be responsible for this surge in inflation. Supply-side shocks can cause large fluctuations in food and oil prices, effects of which on overall inflation, at times, can be so excessive that these cannot be countered through demand management.

RECOMMENDATIONS
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. Steps should be taken to reduce our government luxury expenses, to reassess the complete system of direct and indirect taxes, to increase the production of food and industry and to reduce unemployment. 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. Pakistan should become self-reliant.

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