DEFINE INFLATION.

EXPLAIN VARIOUS CAUSES FOR INFLATION IN PAKISTAN

(a) DEMAND SIDE (b) SUPPLY SIDE

INTODUCTION:
Moderate inflation is associated with economic growth, while high inflation can signal an
overheated economy. As an economy grows, business 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 “runway 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 dollars in an
economy exceeds the amount needed for financial transactions. The result is that the purchasing
power of a dollar declines.

In general, when economic growth begins to slow, demand eases and the supply of goods relative
to demand. At this point, the rate of inflation usually drops. Such a period of falling is known as
disinflation.

DEFINITION:
True inflation begins when the elasticity of supply of output in response to increase in money supply
has fallen to zero or when output is unresponsive to changes in money supply. When there exists a
state of full unemployment, the conditions will be clearly inflationary, if there is increase in supply of
money. But we don’t subscribe to the classical view that when there is full employment we can say
that money supply increases it results partly in the increase of output (GNP) and it partly feeds the
rise in prices and when the supply of output lags far behind, the rise in prices is described as
“inflation”.

Some of the definitions of “inflation” are:

 An increase in the general price level of goods and service; alternatively, a decrease in
purchasing power of dollar.
  The number of dollars in circulation exceeds the amount of goods and services available for
purchase; inflation results in a decrease in the dollar’s value.
 The increase in the cost of living (prices for goods and services). Inflation is measured as an
annual average by the CPI (Consumer price index).
 A general and progressive increase in prices; "in inflation everything gets more valuable
except money.
 Inflation is defined as a sustained increase in the general level of prices for goods and
services. It is measured as an annual percentage increase. As inflation rises, every dollar you
own buys a smaller percentage of a good or service.

INFLATION IN PAKISTAN:

The inflation rate in Pakistan was 13.04 percent in March of 2010 and it was approximately 7.7% in 2007
to 20.3% in 2008, and 14.2% in 2009. This was mainly due to:

1. Decelerating economic growth

2. Loose monetary policies
3. Output set-backs
4. Higher duties and taxes
5. A depreciating Pak Rupee
6. Frequent adjustments in the administered prices of gas, electricity, POL products as well as the
support price of wheat.
7. Political instability

“PRICE INDICES IN PAKISTAN”

Most commonly used price indices in Pakistan are:

 The Consumer Price Index (CPI)

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 Wholesale Price Index (WPI)

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 Sensitive Price Index (SPI)

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.
  GDP deflator

In Pakistan, the main focus is placed on the CPI as a measure of inflation as it is more representative
with a wider coverage of 374 items in 71 markets of 35 cities around the country.

Most commonly used price indices in Pakistan

Feature:
Name CPI SPI WPI
Cities covered 35 17 18
Markets covered 71 53 18
Items covered 374 53 425
Commodities covered 92 - 106
Number of commodity groups 10 - 5

Annual rate of inflation (percentage) in Pakistan for period 2000-2009

Period CPI SPI WPI

2000-2001 4.41 4.84 6.21
2001-2002 3.54 3.37 2.08
2002-2003 3.10 3.58 5.57
2003-2004 4.57 6.83 7.91
2004-2005 9.28 11.55 6.75
2005-2006 7.92 7.02 10.10
2006-2007 7.77 10.82 6.94
2007-2008 8.01 11.03 10.26
2008-2009 24.43 30.96 27.98
2010 20.77 - -

CAUSES FOR INCREASE IN INFLATION “DEMAND SIDE”:

The high rate of inflation can be attributed to continuously increasing
demand for goods and services. It is the result of Demand-pull-inflation,
when many individuals are trying to purchase the same good, the price
will inevitably increase. When this happens across the entire economy
for all goods, it is known as demand-pull-inflation.

Anything that shifts the Aggregate Demand Curve to right will have the same result i.e. increase in
demand and result in increased inflation. Listed below are some of the factors responsible for increase
in demand causing demand shocks and ultimately responsible for increase in rate of inflation in Pakistan.
  Increase in consumption spending:

A change in factors affecting any one or more components of aggregate demand, households (C), firms
(I), the government (G) or overseas consumers and business (X) changes planned aggregate demand and
results in a shift in the AD curve which shows an increase in demand.

An increase in demand results in an increase in the

equilibrium quantity. The demand shift means that buyers
want to buy more. Sellers are willing to accommodate
buyers. However, to appease their increased demand,
sellers must charge a higher price to cover their increasing
production cost in accordance with the law of supply. The
figure on the right shows some of the increased demand for
basic needs in Pakistan.

The people in Pakistan are extravagant. The people want to achieve high standard of living. So there is a
demonstration effect in Pakistan. As a result, the rise in prices of goods and services continues. People
having black money spend money lavishly, which increases the demand un-necessarily, while supply
remains unchanged and prices go up.

 Changes in Monetary Policy – i.e. a decrease in interest rates

An expansionary monetary policy will cause an outward shift of the AD curve. If interest rates fall – this
lowers the cost of borrowing and the incentive to save, thereby encouraging consumption. Lower
interest rates encourage firms to borrow and invest. There are time lags between changes in interest
rates and the changes on the components of aggregate demand. Decrease in interest rate causes an
increase in real money supply and so buying power of money increases and people spend more. The
interest rate as declared by the “State Bank of Pakistan” is 12.5 %.( 2009-2010) while it was
approximately 15% in the year 2008-2009.

The supply of money is expanding quickly every year but the supply of goods and services is not
increasing according to that rates. Due to this, prices are rising.

 Changes in Fiscal Policy-i.e. a decrease in tax rate and duties

Fiscal Policy refers to changes in government spending, welfare benefits and taxation, and the amount
that the government borrows. Income tax affects disposable income e.g. lower rates of income tax raise
disposable income and should boost consumption. Similarly, an increase in transfer payments raises AD
– particularly if welfare recipients spend a high % of the benefits they receive.

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.

Tax rates for the salaried class in Pakistan are 0.5% to 20%, and for other taxpayers, 0.5% to 25%.
Pakistan income tax rate is 20%, Pakistan corporate tax rate is 35% and Pakistan sales/VAT Rate is 16 %
( 2009-2010).

 Increase in population

It is one of the major reasons behind high rate of inflation in Pakistan and other Asian countries. Our
population is increasing massively at a rate of approximately 2.1%. Our production capacity is not
increasing at a rate lower than that of our population. There are more people than goods produced in
the country and so demand is less then supply. This causes high increase in prices and rate of inflation
also rises.

 Increase in wages or disposable income:

The rise in wages, pensions and salaries have increased the purchasing power of the people. Wages and
prices chase each other. The minimum wage rate in Pakistan is Rs.7000 (2009). But the income level in
private sectors is increasing at a high rate especially for experienced workers which increase their buying
power.

 Deficit financing:

Deficit financing means spending more than revenue. In this case government of India accepts more
amount of money from the Reserve Bank India (RBI) to spend for undertaking public projects and only
the government of India can practice deficit financing in India. The high doses of deficit financing which
may cause reckless spending, may also contribute to the growth of the inflationary spiral in a country.

Means printing of currency notes by the Government in order to cover the defect in the budged. It will
create inflationary pressure. - 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. Deficit financing raises aggregate demand in
relation to the aggregate supply. This phenomenon is known as 'deficit financing-induced inflation'.

 Hoarding and speculation

Price level goes up due to increase in the general demand. The big gap between increased demand and
supply of rice, sugar, wheat and other important items is because people begin to hold or control their
supply. This increases their demand and price level and as a result inflation rises. Speculation in asset
prices increases also results in inflation. Hoarding and speculation is responsible for 12% of increase in
inflation.

 Foreign Remittances:
The increased remittances by the people working outside the country, purchasing power of their
families are increased day by day.

 Expansion of the Private Sector:

Private sector comes with huge capitals and creates employment opportunities, resulting in increased
income which furthers the increase in demand for goods and services.

 Increasing Public Expenditures

Non developmental expenditures of government lead to raise aggregate demand which results as
increased demand for factors of production and then increased prices.
The developmental and non-developmental expenditures of government
also lead to the inflation. For example non developmental expenditures
such as expenditure on defense, government official’s foreign tours,
increase in salaries of government employees etc leads the economy of
an inflationary situation.  On the other hand in most developmental
projects output starts many years after the money has been spent. Such
type of developmental projects is also a source of inflation.

CAUSES FOR INCREASE IN INFLATION “SUPPLY SIDE”:

Anything that increases unit cost of production will shift the SRAS curve to the left and cause price level
to rise which ends up b increasing inflation. Listed below are some of the factors that are responsible for
increasing inflation in Pakistan that as the shift the SRAS curve to the left. A leftward shift in SRAS curve
shows reduced supply with increase in high prices

 Shortage of factors of production or inputs:

Shortage of factors of production, i.e. raw material, labour capital etc causes the reduced production,
which causes the increase in prices .The supply falls short of demand and prices increase causing
inflation. Our industries are facing severe shortage of input due to hoarding.

 Natural Calamities:

Natural disasters, invasions, diseases etc effect the agricultural production, and shortage of supply
which furthers increases prices. Due to earth quake, shortage of rainfall and deadly infectious diseases,
Pakistan has suffered a lot. Recently the destructive flood, which has badly affected a large portion of
Pakistani land, has further set a debacle for our economic growth. The level of production is decreased
whereas demand has increased and hence, the prices of goods have increased.
  Artificial Scarcities:

Hoarders, black marketers and speculators etc create artificial shortage to earn more profits by keeping
the prices high. In Pakistan bird flu dilemma and sugar crises are the major examples in this regard.
Hoarding and speculation has greatly affected the supply of raw materials in Pakistan these days.
Landlord people control and hold the supply of raw materials necessary to meet the basic needs of
Pakistani people.

 Increase in exports (excess exports):

When the country has tends to earn maximum foreign exchange and exports more and more without
considering the domestic use of the commodities, it creates a shortage of commodities at home which
increases the prices. With reference to Pakistan, the failure of export bonus scheme during 1950's is the
most common example of this type of cause of inflation. Excessive export of rice, sugar and wheat etc
has shortened the supply of these goods in Pakistan.

 Global factors:

This factor includes the changing global environment. Most common example is the rise in oil prices.
This factor of inflation may vary in nature, i.e. it can be political, strategic, economic or logistic in nature.
Soaring oil costs are already having a large impact on the Pakistani economy. Rising fuel prices, and food
costs, have driven inflation to a six-year high while the current account has slumped.

 Neglecting the production of consumer goods:

When the production of consumer goods is neglected with reference to the increased production of
luxuries, it also creates inflation. In Pakistan, in last couple of years our services sector has grown with
the highest rate of 8.8% (mainly telecom sector), while basic necessities have been ignored which
created increase in the prices of consumer goods.

 Application of law of diminishing returns:

This law applies when the industries use old machines and methods and, which increase in cost by
increasing the scale of production. This furthers the increase in prices and hence inflation bursts out.
Technological constraints

 Increase in population:

In Pakistan population is increasing massively. Increase in population leads to increased demand for
goods and services. If supply of commodities is short, increased demand will lead to increase in price
and inflation. With the increase in population demand for goods and services also increases but supply
does not increase at the same rate. Due to imbalance between demand and supply of goods and
services, prices start to rise and cause inflation.
  Decrease in agricultural production:

If agricultural production especially food grains production is very low, it would lead to shortage of food
grains, will lead to inflation. Our agricultural capacity was never enough to meet the domestic needs
completely or maybe was not supplied. The table below shows the agricultural growth of Pakistan last
years.

Agricultural growth
years percent
1960’s 5.1
1970’s 2.4
1980’s 5.4
1990’s 4.4
2000’s 3..2
For over last 2 decades our production capacity has been falling whereas our population is increasing.

 Labour unrest:

As unemployment falls, some labour shortages may occur where skilled labour is in short supply. This
puts extra pressure on wages to rise, and since wages are usually a high percentage of total costs, prices
may rise as firms pass on these costs to their customers. In Pakistan, the rate of unemployment was 14%
(2009 est.) and 12.6% (2008 est.) out of our total labour force of 53.78 million.

 Increase in prices of raw materials (domestic and imported):

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.

 Increase in cost of production:

Increase in the cost of materials or services rendered to the manufacturer. If a foreign economy
collapses, the cost of importing materials from that country can rise exponentially. The cost of delivering
materials to the manufacturing plant might also increase dramatically during an energy crisis or
extended strike. A manufacturer may decide to absorb some of these added expenses in order to
maintain a competitive price, but not all of them. The result could be an increase in the retail price and a
real-life demonstration of the cost-push inflation theory. So inflation occurs when the cost of producing
rises and the increase is passed on to consumers. The cost of production can rise because of rising labor
costs or when the producing firm is a monopoly or oligopoly and raises prices, cost of imported raw
material rises due to exchange rate changes, and external factors, such as natural calamities or an
increase in the economic power of a certain country.

 An increase in energy crisis and prices:

Load shedding of electricity and gas has greatly reduced the production capacity of our industries.
Textiles and apparel, food processing, pharmaceuticals, construction materials, paper products,
fertilizer, shrimp are the major industries in Pakistan but their Industrial production growth rate is -3.6%
(2009 est.) which is a result of increasing shortage of energy production capacity in the country.

 Increase in taxes especially corporation taxes:

An increase in taxes designed to meet the government’s environmental objectives will cause higher
costs and an inward shift in the short run aggregate supply curve. A rise in VAT on raw materials will
have the same effect. Inflation can also be caused by federal taxes put on consumer products. 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.

Conclusion:
During the 1970s, the period of great structural changes and uncertainty, the role of inflation
expectations was quite evident. People consider expected inflation while making their optimization
decisions.

The 1980s were a decade of relatively low average inflation (7.2 per cent). Private sector borrowing,
exchange rate depreciation and adaptive expectations were the main factors behind this growth in
consumer prices. De-nationalisation enlarged the private sector and, as a consequence, private sector
borrowing increased during this period.

In 1990s, the mainstream liberalisation policies picked up momentum. Frequent changes in the
government, inconsistent policies, nuclear explosion and other dramatic political and economic
developments put upward pressure on prices. Average inflation rate increased to 9.6 per cent. Increase
in wheat procurement prices, government and private sector borrowings, exchange rate depreciation
and adaptive expectations were the main factors behind the surge in inflation rate.

During 2001-04, inflation was very low. Interestingly, support price of wheat was not raised during 2001-
03. CPI shot up again in 2004-05 when inflation reached 9.3 per cent. It dropped slightly to eight per
cent in 2005-06. Inflation expectations alone explain 45.73 per cent of the inflation in 2005-06 and 31.1
per cent in 2004-05. This critical role of inflation expectations can be explained by emergence of the
phenomena like hoarding, assets price hikes, and surge in house rents.

Non-government sector borrowing was the second most important factor. During 2004 and 2005 the
growth in non-government sector borrowing has been above 30 per cent, while it was 23 per cent in
2006. This growth is reflected in the contribution of NGSB in inflation, which is 38 per cent in 2004-05
and 35 per cent in 2005-06.

Third important factor is import prices, which explains 26.7 per cent of the inflation in 2005-06 and 13.6
per cent in 2004-05.

In 2004-05, two other important factors for inflation were government sector borrowing and
support/procurement price of wheat, contributing 17.6 per cent and 11.8 per cent respectively. The
government taxes did not cause any significant rise in prices in 2004-05 and 2005-05. This seems logical
since there has been no change in the tax to GDP ratio over the last few years.

There was no further strong pressure on import costs because of a stable exchange rate. This policy
cannot be sustained for long. Trade deficits are setting the direction.

The expansionary monetary policy did contribute in promising GDP growth but it also led to the rise in
consumer prices. The phenomenal growth in the flow of ââ'¬Ëœloose creditââ'¬â"¢ to the private
sector played a significant role in disturbing the price mechanism. Availability of money at virtually no
cost encouraged speculators and hoarders.

We need some serious major projects and plans to overcome this menace of inflation which is eating
away our economy.