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 money—a 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

1
Inflation originally referred to the debasement of the currency. When gold was
used as currency, gold coins could be collected by the government (e.g. the
king or the ruler of the region), melted down, mixed with other metals such
as silver, copper or lead, and reissued at the same nominal value. By diluting
the gold with other metals, the government could increase the total number
of coins issued without also needing to increase the amount of gold used to
make them. When the cost of each coin is lowered in this way, the
government profits from an increase in seignior age. This practice would
increase the money supply but at the same time lower the relative value of
each coin. As the relative value of the coins decrease, consumers would need
more coins to exchange for the same goods and services.

Asset price inflation is an undue increase in the prices of real or financial

assets, such as stock (equity) and real estate. While there is no widely-
accepted index of this type, some central bankers have suggested that it
would be better to aim at stabilizing a wider general price level inflation
measure that includes some asset prices, instead of stabilizing CPI or core
inflation only. The reason is that by raising interest rates when stock prices or
real estate prices rise, and lowering them when these asset prices fall,
central banks might be more successful in avoiding bubbles and crashes in
asset prices.

2
DEMAND PULL INFLATION

Demand-pull inflation is likely when there is full employment of resources and

when SRAS is inelastic. In these circumstances an increase in AD will lead to
an increase in prices. AD might rise for a number of reasons – some of which
occur together at the same moment of the economic cycle

 A depreciation of the exchange rate, which has the effect of

increasing the price of imports and reduces the foreign price of
exports. If consumers buy fewer imports, while foreigners buy more
exports, AD will rise. If the economy is already at full employment,
prices are pulled upwards.

3
 A reduction in direct or indirect taxation. If direct taxes are
reduced consumers have more real disposable income causing
demand to rise. A reduction in indirect taxes will mean that a given
amount of income will now buy a greater real volume of goods and
services. Both factors can take aggregate demand and real GDP higher
and beyond potential GDP.

 The rapid growth of the money supply – perhaps as a

consequence of increased bank and building society borrowing if
interest rates are low. Monetarist economists believe that the root
causes of inflation are monetary – in particular when the monetary
authorities permit an excessive growth of the supply of money in
circulation beyond that needed to finance the volume of transactions
produced in the economy.

 Rising consumer confidence and an increase in the rate of

growth of house prices – both of which would lead to an increase in
total household demand for goods and services

 Faster economic growth in other countries – providing a boost to

exports overseas

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The effects of an increase in AD on the price level can be shown in the next
two diagrams. Higher prices following an increase in demand lead to higher
output and profits for those businesses where demand is growing. The impact
on prices is greatest when SRAS is inelastic.

In the first diagram the SRAS curve is drawn as non-linear. In the second, the
macroeconomic equilibrium following an outward shift of AD takes the
economy beyond the equilibrium at potential GDP. This causes an
inflationary gap to appear which then triggers higher wage and other factor
costs. The effect of this is to cause an inward shift of SRAS taking real
national output back towards a macroeconomic equilibrium at Yfc but with
the general price level higher than it was before.

5
6
THE WAGE PRICE SPIRAL– “EXPECTATIONS-INDUCED
INFLATION”

Rising expectations of inflation can often be self-fulfilling. If people expect

prices to continue rising, they are unlikely to accept pay rises less than their
expected inflation rate because they want to protect the real purchasing
power of their incomes. For example a booming economy might see a rise in
inflation from 3% to 5% due to an excess of AD. Workers will seek to
negotiate higher wages and there is then a danger that this will trigger a
‘wage-price spiral’ that then requires the introduction of deflationary policies
such as higher interest rates or an increase in direct taxation.

The diagram summarises some of the key influences on inflation. Reading

from left to right:

 Average earnings comprise basic pay + income from overtime

payments, productivity bonuses, profit-related pay and other
supplements to earned income
 Productivity measures output per person employed, or output per
person hour. A rise in productivity helps to keep unit costs down.
However, if earnings to people in work are rising faster than
productivity, then unit labour costs will increase
 The growth of unit labour costs is a key determinant of inflation in
the medium term. Additional pressure on prices comes from higher
import prices, commodity prices (e.g. oil, copper and aluminium) and
also the impact of indirect taxes such as VAT and excise duties.
 Prices also increase when businesses decide to increase their profit
margins. They are more likely to do this during the upswing phase of
the economic cycle.

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8
 ISSUES IN MEASURING INFLATION

Measuring inflation in an economy requires objective means of differentiating

changes in nominal prices on a common set of goods and services, and
distinguishing them from those price shifts resulting from changes in value
such as volume, quality, or performance. For example, if the price of a 10 oz.
can of corn changes from $0.90 to $1.00 over the course of a year, with no
change in quality, then this price difference represents inflation. This single
price change would not, however, represent general inflation in an overall
economy. To measure overall inflation, the price change of a large "basket" of
representative goods and services is measured.

Price index
This is the purpose of a price index, which is the combined price of a "basket"
of many goods and services. The combined price is the sum of the weighted
average prices of items in the "basket". A weighted price is calculated by
multiplying the unit price of an item to the number of those items the
average consumer purchases. Weighted pricing is a necessary means to
measuring the impact of individual unit price changes on the economy's
overall inflation. The Consumer Price Index, for example, uses data collected
by surveying households to determine what proportion of the typical
consumer's overall spending is spent on specific goods and services, and
weights the average prices of those items accordingly. Those weighted
average prices are combined to calculate the overall price. To better relate
price changes over time, indexes typically choose a "base year" price and
assign it a value of 100. Index prices in subsequent years are then expressed
in relation to the base year price.

When looking at inflation economic institutions may focus only on certain

kinds of prices, or special indices, such as the core inflation index which is
used by central banks to formulate monetary policy.

An increase in the general level of prices implies a decrease in the purchasing

power of the currency. That is, when the general level of prices rises, each
monetary unit buys fewer goods and services. The effect of inflation is not
distributed evenly, and as a consequence there are hidden costs to some and
benefits to others from this decrease in purchasing power. For example, with
inflation lenders or depositors who are paid a fixed rate of interest on loans or
deposits will lose purchasing power from their interest earnings, while their
borrowers benefit. Individuals or institutions with cash assets will experience
a decline in the purchasing power of their holdings. Increases in payments to
workers and pensioners often lag behind inflation, especially for those with
fixed payments.

9
High or unpredictable inflation rates are regarded as harmful to an overall
economy. They add inefficiencies in the market, and make it difficult for
companies to budget or plan long-term. Inflation can act as a drag on
productivity as companies are forced to shift resources away from products
and services in order to focus on profit and losses from currency inflation.
Uncertainty about the future purchasing power of money discourages
investment and saving. And inflation can impose hidden tax increases, as
inflated earnings push taxpayers into higher income tax rates.

With high inflation, purchasing power is redistributed from those on fixed

incomes such as pensioners towards those with variable incomes whose
earnings may better keep pace with the inflation. This redistribution of
purchasing power will also occur between international trading partners.
Where fixed exchange rates are imposed, rising inflation in one economy will
cause its exports to become more expensive and affect the balance of trade.
There can also be negative impacts to trade from an increased instability in
currency exchange prices caused by unpredictable inflation.

TYPES OF INFLATION

There are four main types of inflation with four different causes.

 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. Historically this has been the most common type and
at times the most serious. Every war produces this type of inflation
because demand for war materials and manpower grows rapidly
without comparable shrinkage elsewhere. Other types of inflation occur
more readily in conjunction with demand-pull inflation.

 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,

10
 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. 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.
One can at such times read in the

Newspapers that business is just waiting a bit to see how soon they
might raise their prices. An oligopolistic firm often realizes that if it
raises its prices, the other major firms in the industry will likely see
that as a goodtime to widen their profit margins too without suffering
much from price competition from the few other firms in the industry.

 Sectoral inflation:
The fourth type is called sectoral 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
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 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.

Hoarding:
people buy consumer durables as stores of wealth in the absence of viable
alternatives as a means of getting rid of excess cash before it is devalued,
creating shortages of the hoarded objects.

Hyperinflation:
If inflation gets totally out of control (in the upward direction), it can grossly
interfere with the normal workings of the economy, hurting its ability to
supply.

Allocative efficiency:
a change in the supply or demand for a good will normally cause its price to
change, signalling to buyers and sellers that they should re-allocate resources
in response to the new market conditions. But when prices are constantly
changing due to inflation, genuine price signals get lost in the noise, so
agents are slow to respond to them. The result is a loss of allocative
efficiency.

Labor-market adjustments:
Keynesians believe that nominal wages are slow to adjust downwards. This
can lead to prolonged disequilibrium and high unemployment in the labor
market. Since inflation would lower the real wage if nominal wages are kept
constant, Keynesian argue that some inflation is good for the economy, as it
would allow labor markets to reach equilibrium faster.

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 THEORIES OF INFLATION

There were different schools of thought as to the causes of inflation. Most can
be divided into two broad areas:

 Quality theories of inflation and

 Quantity theories of inflation.

Quality theory
The quality theory of inflation rests on the expectation of a seller accepting
currency to be able to exchange that currency at a later time for goods that
are desirable as a buyer. The quantity theory of inflation rests on the quantity
equation of money, that relates the money supply, its velocity, and the
nominal value of exchanges. Adam Smith and David Hume proposed a
quantity theory of inflation for money, and a quality theory of inflation for
production.

Quantity theory
Currently, the quantity theory of money is widely accepted as an accurate
model of inflation in the long run. Consequently, there is now broad
agreement among economists that in the long run, the inflation rate is
essentially dependent on the growth rate of money supply. However, in the
short and medium term inflation may be affected by supply and demand
pressures in the economy, and influenced by the relative elasticity of wages,
prices and interest rates. The question of whether the short-term effects last
long enough to be important is the central topic of debate between
monetarist and Keynesian schools. In monetarism prices and wages adjust
quickly enough to make other factors merely marginal behavior on a general
trend-line. In the Keynesian view, prices and wages adjust at different rates,
and these differences have enough effects on real output to be "long term" in
the view of people in an economy.

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 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 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.

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INFLATION IN PAKISTAN

15
 Yearly Inflation Rates of Pakistan ( 1990-91 = 100)

Inflation Rates based on Sensitive Price Indicator (SPI), Consumer Price Index (CPI) and Wholesale
Price Index (WPI) are

Period

SPI

CPI

WPI

1991-1992

10.54

10.58

9.84

1992-1993

10.71

9.83

7.36

1993-1994

11.79

11.27

11.40

1994-1995

15.01

13.02

16.00

1995-1996

10.71 16
10.79

11.10
 HISTORICAL TRENDS

1970s: 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.

1980s: 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-nationalization enlarged the private sector and, as a consequence,
private sector borrowing increased during this period.

1990s: In 1990s, the mainstream liberalization 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.

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
17
 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
inflationary pressures. Increased government borrowing from central bank
can have serious consequences for general price level.

Expansionary monetary policy:

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 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.

SENARIO OF INFLATION IN PAKISTAN 2008

Inflation in Pakistan jumps to 25%; close to 30-year high. Petrol prices in
Pakistan were cut by 6% on 1 November, the seventh change in eight
months, after a decline in crude oil prices in the international market

Karachi: Pakistan’s inflation accelerated to near a three decade high in

October, placing further strains on a nation that the International Monetary
Fund (IMF) says needs $10 billion (Rs47,300 crore) to avoid defaulting on its
debt.

Consumer prices in the country soared 25% from a year earlier after gaining
23.9% in September, the Federal Bureau of Statistics said in Islamabad on
Monday. Pakistan may have to raise interest rates to receive a bailout, if IMF
insists on the same conditions it applied to loans for Iceland and Ukraine.
Higher borrowing costs may not bring inflation down soon as other conditions
attached to an IMF loan would likely include higher energy prices, economists
said.

“The time when inflation actually starts to recede may be pushed forward
further,” said Khalid Iqbal Siddiqui, head of research at Invest Capital
Securities in Karachi. “Even though fuel prices are currently on the way down,
19
there are other utilities whose prices are likely to be raised by the
government, as per an agreement with the IMF.”

State Bank of Pakistan governor Shamshad Akhtar was struggling to bring

inflation under control amid a blowout in the nation’s balance of payments
and a 31% drop in the rupee this year, which has driven up import costs. The
domestic currency reached a record low of 83.55 per dollar on 17 October,
2008.

The nation’s foreign exchange reserves have also shrunk to $3.71 billion on
25 October from $14.2 billion a year ago, raising concern that Pakistan will
not be able to pay its $3 billion debt servicing costs due in the coming year.

Petrol prices in Pakistan were cut by 6% on 1 November, the seventh change

in eight months, after a decline in crude oil prices in the international market.

Pakistan is expected to make a formal request for assistance to IMF this

week, Business Recorder newspaper reported on Monday, without elaborating
on where it obtained the information.

Conditions attached to an IMF loan would include an increase in the central

bank’s benchmark interest rate to 15% from 13%, as well as a 31% rise in
tariffs on electricity and other utilities, the newspaper reported.

Pakistan is also seeking funds from lenders such as the World Bank and the
Asian Development Bank and donor countries included in the “Friends of
Pakistan” group to help stabilize its economy. A meeting of the group, which
includes the US, the UK, China and Saudi Arabia, is scheduled for this month
in the United Arab Emirates.

The country’s credit rating was lowered by Standard and Poor’s (S&P) and
Moody’s Investors Service in October on concern the nation won’t be able
to pay its overseas debt because of eroding foreign reserves. The country
ended its last IMF program in 2004.

“Pakistan faces severe pressure from the external side, the fiscal side, the
monetary side, economic growth and politics,” Elena Okorotchenko, head of
Asian sovereign ratings at S&P, said in a 5 November interview in Singapore.
“There are five angles in which we analyze a country’s ratings and Pakistan is
negative on all counts.”

Meanwhile, data posted on the website of the Federal Bureau of Statistics

showed the country’s trade deficit narrowed by 2.9% in October as exports
rose faster than imports. The trade gap fell to $1.9 billion in the fourth month
of the fiscal year that started on 1 July, from $2 billion a year ago.

Overseas sales climbed 10.2% to $1.52 billion, while imports surged 2.5% to
$3.5 billion, according to the data.

20
The trade gap in the first four months ended 31 October widened 33.3% to
$7.5 billion, from $5.6 billion a year ago.

Exports in the four months rose 16.6% to $6.7 billion and imports climbed
24.8% to $14.3 billion.

IDENTIFYING THE CAUSES OF HIGH INFLATION

Pakistan experienced high economic growth over six per cent during 2004-06.
However, prices also started increasing at a rapid pace and the headline
inflation remained above eight per cent during the last two years. The
average Consumer Price Index (CPI) inflation was 9.3 per cent in 2004-2005
and around eight per cent in 2005-06.

Is there any need to worry about inflation?

When is inflation bad for the economy? 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.
21
In case of Pakistan, annual inflation was above 11 per cent in the 11 of the
past 32 years. Not surprisingly, average real per capita income growth was
2.8 per cent in years having less than 11 per cent inflation as compared to
the years of high inflation with an average of 1.5 per cent.

For Pakistan’s 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.

The question arises as to what were the factors that

stimulated the recent inflation in Pakistan?

During the first four years of the new millennium inflation remained under
five per cent and then suddenly increased to 9.3 per cent in 2004-05 and
settled to eight per cent in 2005-06. The growth in wheat prices and
exchange rate was low in some years and high in others. However, it seems
that excessive money flows towards public and private sector, along with the
import price hike in 2003-04 and 2005-06 and wheat price rise in 2003-04
and 2004-05 created inflationary pressure at an alarming level. Taxes as a
percentage of manufacturing sectors value-added did not show any rise.

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

22
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 loose credit to the private sector played a significant role in disturbing
the price mechanism. Availability of money at virtually no cost encouraged
speculators and hoarders.

Pakistan inflation caused by money printing for budget:

finance minister

June 12, 2008 (LBO) – Unprecedented borrowings from the central bank or 'money printing' to
finance subsidies have caused inflation in Pakistan to go to a historic high, the country's finance
minister has said.

Finance minister Naveed Qamar told Pakistan's parliament that large subsidies not financed in the
original budget had been given by the government in the past year expanding the fiscal deficit.

"As much as 551 billion rupees (up to May 2008) have been borrowed from the central bank,
which is unprecedented in the country's history," Qamar said Wednesday.

"It is not difficult to imagine what this printing of money means. With more money and no new
production, only prices are likely to increase, which is what is happening.

"We have to stop this process otherwise the inflation will be running much higher than what it is
at present, and as I noted it is already highest in the country's history." Inflation was now at 11
percent a year.

In many high inflation Asian countries, from Sri Lanka to Indonesia, political leaders buy
popularity by doling out subsidies instead of building infrastructure, which are then financed with
central bank credit causing very high inflation. In Sri Lanka inflation is now 'officially' at 26.2
percent, also a historic high. In the past few months the country has suppressed two inflation
indices which showed higher levels of inflation.

Much of the subsidies in Asia, especially in energy, goes to the richest sections of society, as the
rural very poor consume very little energy and have little or no access to subsidized public
transport or other utilities which are concentrated in cities. High inflation impoverishes the poor
in particular and the population in general, making it difficult for even the employed to come out
of the poverty trap.

Qamar said the government had spent 407 billion rupees on subsidies including 175 billion
rupees on petroleum, 133 rupees on electricity, 40 billion rupees on wheat, 48 billion on textiles
and fertilizers. Only 114 billion rupees were originally provided in the budget. In a country with a
soft-pegged exchange rate - unlike a country with a freely floating exchange rate - central bank
23
finances or money printing drives up domestic demand, creating currency pressure. When the
central bank tries to maintain the exchange rate peg, it loses foreign reserves. If the central bank
tries to maintain interest rates and the monetary base at the same time the country rapidly
dissolves into a classic 'East Asian' style currency crisis. Vietnam is now going through such a
crisis, though its central bank is now rapidly pushing up interest rates in a bid to slow the growth
of the monetary base.

Qamar said Pakistan's foreign reserves fell from 16.5 billion dollars in October 2007 to less than
12.3 billion dollars by end April. The exchange rate has fallen by 6.4 percent from July 2007 to
April 2008.

Qamar said he hoped to cut subsidies, slash the deficit to 4.7 percent of the economy from 7.0,
cap inflation and build up foreign reserves to bring back economic stability.

It is rare for Asian politicians to admit in public that inflation is a monetary phenomenon related
to central bank activity. The usual practice is to blame 'cost-push' factors which is a symptom
rather than a cause of inflation and also 'external' factors.

Concepts such as 'inflation targeting' where parliament limits the ability of a government to create
inflation to 2 or 3 percent a year are also not widely discussed which contributes to the
perpetuation of high inflation.

INFLATION IN PAKISTAN A CAUSE OF SERIOUS

CONCERN

Recently government has announced the inflation target of 12 per cent in the federal
budget for fiscal year 2009. The government’s current year (2007-2008) fiscal target for
inflation was 6.5 per cent. While according to government figures, the CPI based
inflation stood at 11.11 per cent during July’07 to April’08. But if we look at these
numbers, we see very alarming trends emerging. The food group is important
components of CPI based inflation, so if we keep in mind the 12 per cent target of
inflation for next fiscal year and assume that full year inflation will reach at around 12
per cent, we can analyze some important prices of essential items for the upcoming year.

Government has also announced to cut overall subsidies to Rs.295 bn from Rs.407 bn for
upcoming fiscal year and the difference will be consumed for development purposes.
Table-1 shows some major changes in subsides.

Classification (Rs bn) Budget 07-08 Budget 08-09

(%) (%)

24
WAPDA 113 74 (34.51)
KESC 19.5 13.8 (29.23)
Import of Wheat 40 20 (50.00)
Import of Sugar 6.5 6.3 (3.00)
Ghee Packaged in USC 1.2 1.5 25.00
Sales of Pulses USC 0.2 0.5 150.00
Sales of Atta 0.2 0.5 150.00
Oil 175 140 (20.00)
Refineries/OMCs/Others

From July, 01 the electricity charges will be increased up to 30 per cent while
government has announced to cut subsidies on oil products to Rs.140 bn from Rs.175 bn.

That will directly hurt the consumer because traditionally, whenever government imposes
taxes and cuts down subsidies to industries, all burden goes down to consumers specially
the low income group who are directly affected by the price hikes.

Also, the increase in GST to 16 per cent from 15 per cent will trigger inflation to rise by
more than the targeted rate of 12per cent.

As the government has increased subsidies on the sales of flour, ghee and sugar at utility
stores and announced some relief packages for common men in next fiscal year budget, it
is hoped that it will not take great deal of hard work on government part to remain in the
range of loosely targeted rate of 12 per cent.

The international phenomenon to set the GDP and inflation target is that the target is
always set below the GDP target while in this budget; economic managers unpredictably
have set the inflation target as 12 per cent well above the GDP target of 5.5 per cent.

Taking all these factors into consideration one thing is sure; the upcoming fiscal year will
prove tough for common man in terms of inflation.

PAKISTAN INFLATION ACCELERATES TO FASTEST IN 25

YEARS

Pakistan's inflation accelerated at the fastest pace in at least 25 years in April

because of surging food and fuel prices, straining a six-week-old coalition
government already on the brink of collapse.

Consumer prices jumped 17.21 percent from a year earlier after gaining 14.1
percent in March, the Federal Bureau of Statistics said in a statement in
25
Islamabad today.
Finance Minister Ishaq Dar said on May 4 that soaring oil and food prices are
undermining the fight against poverty. Pakistan's ability to rein in prices may
be hampered as Nawaz Sharif's party said it may quit the coalition led by the
Pakistan Peoples Party today. ``If the trend continues, it will cause serious
concerns to the new government,'' said Farhan Rizvi, an economist at JS
Global. ``Oil prices have added to already high food prices, which directly hit
the masses.''
Oil at more than $125 a barrel and declining wheat production are straining
state finances as food and fuel are subsidized in the nation of 160 million
people. Hundreds of people queue for hours outside state-run shops to buy
the subsidized wheat flour and other essential goods across the nation. Food
prices in April rose 25.5 percent from a year ago and fuel prices climbed 8.6
percent, according to the data. Historical inflation data is compiled by JS
Global Capital Ltd. in Karachi. The statistics bureau doesn't have data
preceding the year 2000.

Stocks, Currency Pakistan's key stock index rose 0.4 percent to 14,286.61
at the 2:15 p.m. local time close today, after falling 4.9 percent last week, the
biggest weekly decline in almost nine months. The rupee rose 1 percent to 69
today, after losing 6.8 percent last week, the most since 1998.

Almost half the population of Pakistan, the world's seventh- most-populous

nation, faces difficulty gaining access to affordable food because of the
soaring cost of cereals, a World Food Program spokesman Paul Risley said on
April 23.

The Rome-based United Nations agency increased its estimate of the number
of so-called food insecure people in Pakistan to 77 million from 60 million.

The nation may import more than 1.5 million metric tons of wheat this year to
ease the shortage, farm minister Chaudhry Nisar Ali said on April 24.

The average price of pulses has risen about 50 percent since January, said
Fareed Qureshi, chairman of the Karachi Retail Market Association. Average
edible oil prices have climbed 16 percent since the start of the year and rice
is 26 percent more costly than it was on Jan. 1, he said.

``Pakistan's prices of wheat, flour, edible oil and pulses are at a record now,''
Qureshi said.

Oil Bill Pakistan, which imports about 85 percent of the oil it uses,
increased prices of gasoline for the first time in more than 22 months on Feb.
29 after record crude prices increased import costs for the nation's refiners.
Oil & Gas Regulatory Authority, the regulator, has since raised prices three
more times.
The trade deficit widened to $2.3 billion in April from $1.1 billion because of
26
the rising oil import bill, the Bureau of Statistics said on May 10.
The central bank increased its benchmark interest rate for a second straight
meeting on Jan. 31 to tame inflation. The discount rate for commercial
lenders was raised half a percentage point to 10.5 percent for the six months
ending June 30. Inflation may exceed the government's target of 6.5 percent
this year, curbing economic growth, the central bank said on March 31.
``The inflation is paced mainly by food and oil prices,'' said Suleman Akhtar,
an economist at Foundation Securities in Karachi. ``In current conditions, a
rise in interest rates would not do much.''
Rising commodity prices are also stoking inflation in neighboring India and
China. Prices in China accelerated to near the fastest in more than 11 years,
the government said today, while inflation in India is at a 3 1/2 year high.
Pakistan's consumer prices may jump as much as 9 percent this fiscal year
ending June 30, exceeding the target of 6.5 percent, the central bank
estimates. Annual inflation may reach 12.5 percent, said JS Global's Rizvi.
Sharif, who leads a faction of the Pakistan Muslim League, the second-largest
party in parliament, may withdraw from the PPP-led government because of a
dispute over sacked judges.
Leaders of the Muslim League will meet today in Islamabad, after the former
prime minister held three days of talks in London with Asif Ali Zardari, the co-
chairman of the PPP, the main party in the coalition. ``The talks have not
moved forward because of a deadlock caused by the PPP,'' Siddique-ul-
Farooq, a spokesman for the Muslim League, said late yesterday.

REMEDIES TO CONTROL INFLATION

SBP TO FIGHT AGAINST INFLATION (2009-3-9)

(Commerce Ministry has reportedly termed State Bank of Pakistan's

(SBP) monetary policy as a failed policy as it is unable to control
inflation and to strengthen trade balance, sources told Business
Recorder. "During the first nine months of 2008, tight monetary policy
could not give its desired results, as the core objective of controlling
inflation and narrowing of trade balance was not achieved," sources
said, quoting ministry officials.
27
The ministry also took up these issues with Prime MinisterYousaf Raza
Gilani in a meeting recently held in the ministry.

The ministry has demanded of the government to lower interest rate

for making Pakistan's exports competitive in the international market
and providing liquidity to exporters, official sources told Business
Recorder.

"We have recommended to the concerned policy makers that for the
next quarter an expansionary monetary policy may be adopted ie
interest may be slashed so that the mechanism of decline of exchange
rate could be reversed," they added.

The State Bank of Pakistan (SBP) has announced a tight monetary

policy, aimed at controlling inflation and trade deficit, which is
persistently increasing. SBP had revised the interest rate upward, with
the view that this act would attract foreign capital for higher return,
which would not only decrease the inflation rate but would also
decrease the exchange rate, according to ministry sources.

The ministry is of the view that international economic situation has

negatively affected the export and import performance of all countries
and caused downward trend in international aggregate demand and
consequently a significant decrease in imports is observed. These
international and national economic factors have adversely affected
Pakistan's trade balance.

According to the ministry, higher interest rate induces foreign capital

inflow, which further appreciates domestic currency and consequently
the exportable commodities become expensive in international
markets. Furthermore, higher interest rate increases export finance
rate and makes the capital input more expensive, which increases
Pakistan's cost of production and makes it less competitive in
international markets.

28
"Our competitors are decreasing their interest rates, which is
decreasing their capital input cost and depreciating their currencies.
Hence, their export products are becoming more competitive in
international markets as compared to Pakistan," sources said.

A decline in inflation rate and exchange was recorded, and the balance
of trade improved substantially. Despite these figures, this
achievement was not primarily due to the monetary policy only. There
was a sharp decline in international oil prices as well as that of edible
oil, which significantly reduced the balance of trade gap and stabilised
domestic prices, sources added.

Exports during July-Jan, 2008-09 increased to $10.934 billion from

$10.122 billion of July-Jan, 2007-08, registering an increase of $0.812
billion, or 8.0 percent. Slow growth in exports was due to power
shortage, rising domestic cost of production, chilling effect on
production enhancing costs and retarding exports.

The major items showing increase during July-December 2008-09, as

compared to the corresponding period of last year, were raw cotton
(229.9 percent), rice (109.5 percent), cement (91.6 percent),
engineering goods (89.4 percent), petroleum products (27.5 percent),
chemicals (24.6 percent), towels (18.7 percent), and cotton cloth (13.0
percent).

Major items showing decline during July-Dec, 2008-09, as compared to

the corresponding period of last year, were petroleum top naptha (36.5
percent), carpets (24.5 percent), leather tanned (17.7 percent), cotton
yarn (14.7 percent), readymade garments (12.2 percent), leather
manufactures (12.1 percent), and bed wear (9.3 percent).

Imports during July-January 2008-09 increased to $21.661 billion from

$20.480 billion during the corresponding period of last year, registering
an increase of 5.8 percent. Growth in imports slowed to 5.8 percent in
July-January 2008-09 as compared to 18.9 percent in July-January
29
2007-08. As a result, trade deficit during July-January 2008-09 grew by
only 3.6 percent as compared to 35.5 percent in the corresponding
period of last year.

Increase in imports growth was chiefly attributed to inflated petroleum

group imports on the back of high global oil prices, import of wheat in
the wake of flour crises, and rise in the import of power generating
machinery.

The major items contributing to an increase in the import bill were

wheat (810.7 percent), power generating machinery (108.8 percent),
construction and mining machinery (51.6 percent) petroleum group
(38.6 percent), other machinery (25.0 percent), electrical machinery
(22.9 percent), iron and steel (12.2 percent), palm oil (7.9 percent),
and chemicals (3.9 percent).

The major items showing decline in imports during July-December

2008-09 as compared to same period of last year are: aircraft, ships &
boats (69.4 percent), telecom (45.1 percent), fertiliser manufactures
(31.2 percent) and road motor vehicles (24.8 percent).

Tanvir Ahmad Sheikh, President Federation of Pakistan Chambers of

Commerce & Industry (FPCCI), says that SBP is preparing monetary
policy without studying the nature of inflation. "In Pakistan, inflation is
not demand pushed which can be controlled through tight monetary
policy. It is the supply side phenomenon. The major causes of rising
inflation in Pakistan are increase in the price of oil, wheat and other
food items. All these are inelastic products. Monetary policy cannot
control their prices. We have to take steps to improve the supply of
these goods. And, we have to improve our inventory management."
"Rather than reducing inflation, SBP policy measures are generating
more inflation," he insists.

Most analysts and economists insist that alongside the SBP measures,
the government has to adopt a pro-production policy, and work harder
30
on the supply side issues of all products including food and energy. But
the question is whether the government will listen?

SBP’S 2ND QUATERLY REPORT

The State Bank of Pakistan said that the underlying inflationary pressures
have started retreating from second quarter of this fiscal year, but the
process is relatively slow. However SBP in 2nd quarterly report released on
Saturday maintained that on annualized basis the main inflation was
expected to be around 19.5-20.5%. After showing a continuous acceleration
since March 2008, the CPI inflation on year-on-year basis started easing from
November 2008 and reached 21.1% in February 2009 as against a peak of
25.3% in August 2008.

The SBP report says that the recent downturn in CPI inflation was mainly due
to relative ease in food inflation that has dropped from 34.1% in August 2008
to 22.9% by February 2009. CPI non-food inflation showed a slight decline for
the third consecutive month and recorded at 19.6%in February 2009. The
downturn adjustment in domestic prices of key 39 fuels in response to a
decline in international oil prices is likely to further ease non-food inflation in
months ahead, said the report.

Moreover a significant decline in metal and other construction and material

prices, as a consequence CPI non-food inflation would decelerate sharply.
More importantly the pace of decline of food commodity prices is slower than
the downtrend in international market, which points towards specific
domestic factors or market structure issues. It is notable that part of gains
was offset by the depreciation of the rupee during 2008.

The SBP0 said that all price indices witnessed a downtrend in recent months.
Domestic inflation since 2008 was mainly driven by deceleration in domestic
food inflation as exhibited by the food groups of both CPI and WPI. While WPI
non-food inflation dropped in tandem with international commodity prices,
CPI non-food inflation showed stubbornness.

The difference in the trends of two inflation indices is because the pass
through of declining global fuel and commodity prices to the wholesale prices
has been quicker as compared to the retail prices. This is mainly as the prices
of most items included in the WPI basket are based on international prices,
said SBP.

31
The impact of decreases in prices of manufacturing inputs such as cotton and
metals is fully reflected in the WPI non-food where as CPI non-food group
exhibits their partial effects as CPI non-food items also incorporates labor
wages which are impacted by second round effects of persistent rise in cost
of living.

About 40% CPI non-food constitutes of house rent index (HRI) which is being
estimated by using 24 month geometric mean, which makes this large
component relatively inflexible. The report said that the impact of continued
tight monetary posture also yield dividend in terms of a relative ease in core
inflation numbers during recent months. Core inflation measured by 20%
trimmed mean registered below 21% in January and February 2009for the
first time since July 2008. It indicates a relative ease in inflationary
expectations in the economy. Similarly core inflation measured by non-food
non-energy (NFNE) is hovering around 18.8% since October 2008, showing
resilience in inflationary pressures. In fact, firmness in the NFNE measure of
core inflation has been supported by a continued rising house rent index
(HRI) during the recent months.

INTEREST RATE TO COME DOWN IN JULY-AUGUST

 March 14 2009, Advisor to Prime Minister to Finance Shaukat Tarin said

on Saturday that the interest rate would come down to single digit in
July-August this year and further fall to about 6% on average next
year.

 Current account deficit had come down from $2.1 billion to $500
million, he said.

 He pointed out that forex reserves were at $10 billion as exchange rate
has been stabilized at 80 a dollar compared to 85 a dollar.

 Tarin said that economic growth would be at 2.5% this year and about
4% next year.

 Talking about circular debt of Pepco, he said efforts were being made
to reduce this and it would be eliminated during the current fiscal year
with the help of term finance certificates and bonds for Wapda.

32
  Borrowing from State Bank has also been controlled and was Rs206
billion during December 2008 well below the target set for the current
fiscal year.

 Inflation rate was 25% and the government was unable to raise money,
and borrowing from SBP had reached Rs 258 billion.

 Banks were not lending as there were fears that government might
freeze bank accounts. Stock exchanges will literally close and trading
activity will come to standstill.

 He said macroeconomic stability would be brought in next 6-12 months

in the country.

 Under medium and long term plan, tax to GDP ratio would be
enhanced and productivity of agriculture and manufacturing sectors
would be increased.

 The government would focus on improving skills and investing in

human resource development.

 We need a comprehensive poverty reduction program that would cost

about Rs250 billion a year for at least next five years, he said.

 Pakistan needs to stand on its own feet rather than borrowing from
international sources.

IMF Stabilization Program

IMF has proposed replacement of General Sales Tax with a broad based value
added tax in Pakistan which can encircle all sectors across the board and
generate more revenue. IMF directors agreed that interest rates should be
kept on hold for some time to avoid financial pressures and to further
consolidate disinflation. This will lead to the strengthening of international
reserves.

SUMMARY OF ECONOMIC SURVEY

The inflation rate as measured by the Consumer Price Index (CPI) averaged at
10.3 percent during (July- April) 2007-08, as against 7.9 percent in the same
33
period last year. Food price inflation is estimated at 15.0 percent compared to
10.2 percent in the same period of last year. Non-food inflation increased to
6.8 percent versus 6.2 percent in the comparable period of last year. The core
inflation (non-food, non-energy sector), increased little over last year
increasing from 6.0 percent in 2006-07 to 7.5 percent in the first ten months
of the current fiscal year. The larger contribution towards the overall CPI
inflation comes from food inflation. Based on current trends, it is expected
that the average inflation rate during 2007-08 will be over 10.5 percent.

Major factors contributing to the rise in inflationary pressures in the economy

during the current year 2007-08 include the extremely high food and energy
prices, which is in fact a global problem. Food inflation was predominantly
driven by unprecedented rise in the prices of few items like wheat, rice and
edible oil etc, owing to supply short-fall of key consumer items as well as the
impact of the significant increase in their global prices. The record high jump
in oil prices lead to an increase in the cost of Pakistani imports as well as
aggravating food shortages across the world through the conversion of many
crops from human consumption to fuel, which have also seriously spurred the
world-wide price

level including those in Pakistan.

Inflation is an important determinant of the macroeconomic stability and thus

attracted policy measures to contain it at tolerable level. The corrective
measures include pursuing tight monetary policy by SBP to control money
supply and credit expansion, easing supply by allowing imports of several
essential items to augment domestic supply, gearing reforms toward
additional agricultural output and effective participation of the public sector
distribution network (USC & TCP).

RECOMMENDATIONS

• To reduce our Government Luxury Expenses both Federal and Provincial.

• To reassess the complete system of Direct and Indirect Taxes.

• To increase the Production of Food, Industry and Service things.

• Should charge Capital Gain tax to Burger and Theft Families and persons

34
• Reduce Unemployment

• Increase in Agriculture, industry

• SBP should take major steps to control inflation

• Pakistan should become self reliant

35