Inflation Causes In Pakistan

Causes of Inflation in Pakistan

Chapter 1 1.1 1.1.1 1.1.2 1.2 1.2.1 1.3 1.3.1 1.3.2 1.4 1.4.1 1.4.2 1.4.3 1.4.4 1.4.5 1.5 1.5.1 1.5.2 1.5.3 1.6 1.7 1.8

Introduction & Background Measures Of Price Inflation Wholesale Price Index Consumer Price Index Implicit GNP Price Deflator Implicit Price Deflator Of Total Domestic Absorption Unit Value Index Of Imports Index Of Retail Price The Tax Price Index (TPI) Problems And Costs Of Inflation Arbitrary Redistribution Of Income Breakdown Of Adjustment Mechanisms Effect On Company Accounting Failure Of Government Intervention Problem Of Domestic Price Rises Causes Of Inflation Too Much Spending – Demands Pull Inflation Cost Push Inflation Too Much Money – The Monetarist Explanation Problem Statement Scope And Limitations Objectives Of The Study Definitions Of Terms

1 4 4 5 5 5 6 6 8 9 10 11 11 11 12 13 13 14 18 21 21 22 23

Chapter 2

Literature Review

25

Chapter 3 3.1 3.2 3.3 3.4 3.5

Research Methodologies Purpose Of The Study Type Of Investigation Study Setting Time Horizon Research Instruments

33 34 34 35 35 35

Chapter 4

Interpretation & Analysis Of Data

37

Chapter 5

Conclusions & Recommendations

53

References

60

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Causes of Inflation in Pakistan

EXECUTIVE SUMMARY

Generally, monetary growth, public policy, administered prices, rise in the prices of imported goods, inflationary expectations and output growth are termed as the determinants of inflation in Pakistan. One group of economists considers inflation a monetary phenomenon, while the other assigns more weight age to rise in administered prices and increase in prices of imported goods as determinants of inflation.

Causes of Inflation

The GDP growth has a significant dampening effect on inflation. This sector recorded a meager growth of 2.5 per cent per annum during last five years which is even lower than 3.0 per cent population growth rate. The effect of poor agriculture growth is also evident from the fact that 'food group (weight 49.35 per cent), in CPI recorded 107 per cent inflation from 1990-91 to May, 1997 as compared with over all inflation of 97.57 percent and non- food inflation of 88.0 per cent during the same period. Prices, however, increased soon after the government's announcement. Inflation in Pakistan is claimed to be a monetary phenomena. Pakistan saw a very high rate of monetary growth between 1990-91 and 1995-96, averaging 18.8 per cent per annum. Inflationary Gap=monetary growth-(real GDP growth +price inflation) The National Credit Consultative Council (NCCC) has approved a monetary growth rate figure of 14 per cent for 1997-98. Increases in the world price of imports in the world market and a 40 per cent devaluation / depreciation in the Pakistan rupee from January 1991 to June 1997 fuelled

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Causes of Inflation in Pakistan inflation to unmanageable levels. The tax to GDP ratio in Pakistan is only 13 to 14 per cent, leaving the government short of funds to run the machinery of the government. The government has to borrow to service the existing debt. The government has to compete with the private sector and offer attractive rates of return on its securities.

Consequences of inflation

Almost all targets, such as GDP growth, price inflation, bank borrowing, trade deficit, budget deficit, are violated. A low saying rate in the country is also one of the causes of rising inflation. In the wake of 14 per cent inflation and an average 10 per cent deposit rates, depositors are getting negative real rates of return on their deposits. Trading further raises the price level by manipulation of the market through hoarding and black marketing by the rent seekers while production eases the upward pressure on price level in an economy. Inflation expedites this trend further.

Devaluation is also one of the consequences of inflation. Due to double digit inflation Pakistan has been caught in the vicious circle of devaluation (devaluation inflation loss of competitiveness again devaluation).

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Causes of Inflation in Pakistan

DEDICATION

I dedicate this humble effort to my loving parents without whom I would have been nothing, to my teachers whose guidance, strength of character and spiritual learning showed me the light in dark moments of life and to every kid who is growing up to be a warrior for my mother country Kashmir

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Causes of Inflation in Pakistan

ACKNOWLEDGEMENTS

This study could not have been accomplished without the guidance and supervision of Dr. Zafar Moeen Nasir who provide the timely assistance almost all the time during the undertaking of my project. I am equally thankful to all the departments/agencies/multilateral institutions for providing the relevant material and data to prepare the project in right manner. I am thankful to my friends without their support and guidance, I would have been in great difficulty. I sincerely hope that this study though more objective but would contribute definitely in determining the cause and effects of one of the major problem in economic sector.

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Causes of Inflation in Pakistan

CHAPTER 1

INTRODUCTION & BACKGROUND

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Causes of Inflation in Pakistan

INTRODUCTION

The subject of price inflation has been a concern of wide importance for economists and common economic agents during the past two decades. Various theories have been put forward to explain continuing inflation all over the world. In Pakistan also the subject of inflation has been the central issue in most of the studies on macroeconomics. Various factors which have been considered in the literature as strong forces in determining price inflation include monetary expansion, stagnation of output, increasing import prices, increasing wage rates, sticky expectations (habit persistence), etc. The evidence, however, does not fully support all these factors as the causes of inflation. This is partly due to the controversial nature of the subject of macroeconomics.

It may not be wrong to suggest that macroeconomics has been advanced to its present form mainly due to hostile controversy among various schools. The other main reason for the poor performance of empirical macroeconomic models in the study of price inflation in our opinion is the inherent weakness of econometric techniques when applied to aggregate time series data. But there is no denial to the fact that each step in research adds to the existing knowledge.

This study is yet another attempt to identify the major sources of inflation in Pakistan. Due to recent Gulf crises it has become all the more important to update our knowledge on the inflationary process in Pakistan. While this study was in progress, the government

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Causes of Inflation in Pakistan of Pakistan announces an increase in the prices of petroleum products by 41.5% on November 14, 1990. This price shock has given a new impulse to our interest in the subject.

It has often been suggested that a stable macroeconomic environment promotes growth by providing a more conducive environment for private investment. Being the key component of a stable macroeconomic environment low and stable inflation assumes greater importance. It is, therefore, essential that inflation rate be kept stable even when it is low. Prices on the average can be rising, falling, or stable. Inflation is a process of rising prices. Inflation rate is measured as the percentage change in the average level of prices. Inflation rate rises and falls over the years but it rarely becomes negative. If the inflation rate is negative, it means the average price level is falling which is not good for the economy. A recent study suggests that some level of inflation is essential for promoting growth and investment. In other words, there exists a threshold beyond which inflation exerts a negative effect on growth. The threshold is lower for industrial than for developing countries. Notwithstanding the existence of a threshold the goal of the macroeconomic policy should be to bring inflation down to single digit and keep it there. Several costs of high and variable inflation have been identified. These costs typically arise from distortions in economic decision-making arising from high or variable inflation rates and result in lower levels of output than would otherwise be the case. High inflation is also a regressive and arbitrary tax, the burden of which is typically borne disproportionately by those in fixed income group and poor. Maintaining low and stable inflation should be seen as a necessary part of the poverty alleviation strategy. The key

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Causes of Inflation in Pakistan point is that price stability is not an end in itself; it is essential for sustaining higher economic growth - the single most important factor influencing poverty.

1.1 MEASURES OF PRICE INFLATION

Inflation rate is defined as the percentage growth rate of some measure of general (or overall) price level prevailing in an economy between any two periods. In macroeconomics context the general price level is supposed to represent the overall picture of the prices of goods and services prevailing in an economy. A good measure of general price level should be based on the prices of most of the important goods and services. In Pakistan different measure of general price level are either directly available or they can be easily constructed from the available data. The choice of an appropriate general price level essentially depends on the purpose for which the price situation is being studied. In the context of our present study we will be interested in the following measures of general price level.

1.1.1 Wholesale Price Index:

The wholesale price index is based on the wholesale prices of most of the important items being consumed. This measure of general price level is a useful price indicator for business community, in particular the wholesale traders.

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Causes of Inflation in Pakistan

1.1.2 Consumer Price Index:

This measure of general price level is based on the retail prices of most of the important household consumption items. The consumer price index is useful to study changes in the cost of living over time.

1.2 Implicit GNP Price Deflator:

The implicit GNP price deflator based on some particular period is obtained by dividing GNP at current prices by GNP at constant price level is the Paasche price index of all the goods and services produced by a nation. Due to its broad coverage, the implicit GNP price deflator is regarded as a comprehensive measure of general price level and is useful to assess the over time changes in the unit value of aggregate output produced by a nation.

1.2.1 Implicit Price Deflator of Total Domestic Absorption:

The general price level measured by the implicit GNP price deflator is not suitable to evaluate the over time changes in the cost of buying a fixed basket of goods and services in an economy. The reason is that in the measurement of general price level through this price deflator the price of exports, which are not consumed domestically, are also included while the prices of imports, which are domestically consumed, are excluded. To

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Causes of Inflation in Pakistan overcome this problem we suggest another implicit measure of general price level: the implicit price deflator of total domestic absorption or total resources or the value of goods and services available for domestic expenditure. The total domestic absorption is defined as GNP plus imports minus exports or alternatively private and public expenditure on consumption and gross investment. The price inflation based on this implicit price deflator in our opinion is a better measure of changes in the cost of buying a fixing basket in an economy than the implicit GNP price deflator.

1.3 Unit Value Index of Imports:

The unit value index of imports is the implicit deflator of the value of imports. This overall measure of the prices of imports is useful to study changes in the imported inflation in a country.

1.3.1 Index of retail price

The monthly index of retail prices or RPI is the most widely reported measure, and comprises the total cost of a representative basket of final goods and services. All households are included, except pensioners, who are mainly dependent on state income, and the wealthiest 4 per cent. Clearly those businesses whose target population includes the 15 per cent of households that consist of retired people could be misled if they based their calculations on the RPI alone!

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Causes of Inflation in Pakistan An index expresses data relative to a given base year value. If 1990 is made the base year, its price level will be assigned a value of 100. Base-year prices will then be divided into successive year prices and multiplied by 100 to yield a series. To translate this into an annual percentage, the following formula is used:

Year 2 index – Year 1 index Year 1 index

The index is derived from the prices of around 600 items on a specific day month, and weighted according to importance. Weights are revised annually, using sample data from the Family Expenditure Survey, to reflect changing patterns of household consumption. Published the following month, the RPI is not seasonally adjusted. Instead it is expressed as a rate of increase on the same month a year earlier. A full understanding of the underlying trends requires study of the contribution of the various components to the aggregate outcome. In February 1991, for example, the price of many household goods, such as footwear, actually fell, despite an RPI rise of 9 per cent. Marketers also need to recognize that the published RPI informs customers’ expectations and perceptions of price changes. During times of high inflation customers often ‘perceive’ themselves to be worse off and there is a marked tendency to trade down – buying basics products, more inferior goods and ‘value for money’ promotions.

The index includes a wide cross-section of items, including housing costs. And therefore is used by governments to determine the annual increase in index-linked benefits, such as

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Causes of Inflation in Pakistan unemployment pay and tax thresholds. The index reflects changes in the cost of living or the money that must be spent to purchase typical baskets of good consumed by a representative household.

The RPI has become a matter of concern in recent years, since, unlike indexes in many other industrialized countries, it may have overstated inflation, owing to the inclusion of mortgage interest payments and the community charge. Sharp rises in these have caused the RPI to rise above the so-called ‘fundamental rate of inflation’. By feeding into indexlinked payments, it will also raise prices by inflating government expenditure. With the RPI making headlines in financial markets, it would be politically attractive for the government to remove these elements. The difficulty of justifying the case that mortgage payments do not reflect rises in housing costs has so far prevented this.

1.3.2 Tax price index (TPI)

The index measures the charge in gross income to maintain the real living standards of taxpayers on average earnings after allowing for changes in direct taxes and national insurance contributions. The newly elected Conservative government in 1979 to put downward pressure on wage demands as planned tax cuts were progressively introduced it. Unfortunately for the government the need for tight budgets and sharp increases in national insurance actually caused the TPI to rise, eclipsing its value in depressing inflationary expectations.

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Causes of Inflation in Pakistan

1.4 Problems and costs of inflation

Inflation assumes problem proportions when the general level of prices rises both continuously and unpredictably. However, it is far from agreed that zero or even falling prices are preferable. Prices fell between 1920 and 1934, yet this period was associated with stagnation, unemployment and widespread poverty. In comparison, the period from 1952to 1967 was associated with historically rapid economic growth and near full employment, despite inflation averaging 3-4 per cent.

The mild or creeping inflation appeared a small price to pay for such performance. It is associated with growth held true in many countries, and its beneficial effects included:

•

A stimulus to investment, margins and profit through the effects of stocks appreciation and the repayment of debt using gradually depreciating currency.

•

Money illusions on behalf of workers made nominal wage payments appear more than they were in real terms. Prices changed so slowly that compensating wage climb did not occur.

•

The cost of living was rising but the standard of living was rising ever faster, as earning easily outpaced prices. Varying level of pay settlement enabled structural change to take place without any groups suffering actual pay cuts.

•

Capital was raised easily, since shares formed a hedge against inflation. Money illusions over nominal interest rates also encourage savings.

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Causes of Inflation in Pakistan The nature of this inflation differs markedly from the image prevailing after 1967, as the costs and inefficiencies of more rapid inflation reversed the benefits outlined above. Once inflation exceeds the critical rate of around 10 per cent, it becomes a problem that negatively affects most groups within society.

1.4.1 Arbitrary redistribution of income

Such inflation causes as arbitrary redistribution of income, from the weak to the strong, the saver to the borrower and from the retired to that still in full employment. People on fixed incomes suffer the greatest erosion, closely followed by those unable to keep pace with its rise, owing to weak bargaining power. Nominal interest rates, for example, failed to keep pace with prices through much of 1970s, are imposing on pensioners.

Debtors, such as mortgage-holders and the government, benefit from the process as the real value of their debts evaporates. Inflation is ‘taxation without representation’, as rising prices and incomes increases tax yields. Know as fiscal drag, this process literally drags previously exempt low wage earners into the tax net. Since both the above mechanisms make governments the major beneficiary from inflation, it should not be assumed that they would consistently pledge themselves to its defeat.

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Causes of Inflation in Pakistan

1.4.2 Breakdown of adjustment mechanisms

Weakening confidence in money causes movement into ‘inflationary hedges’ such as land gold and fine arts, efforts and resources are therefore diverted into protecting wealth rather than create it.

1.4.3 Effect on company accounting

Business using historical cost accounting standards can be misled by paper profits. When plant is for replacement, depreciation allowances will be inadequate. A machine tool costing, say $10,000 with an expected life of 20 years would be normally depreciated at $500 per annum. Annual inflation of 10 per cent would, however, cause such a fund to be over $50,000 short at the time of replacement.

1.4.4 Failure of government intervention

Attempts by governments to alleviate the symptoms of inflation through devices such as discretionary allowances, price freezes, subsides and controls merely serve to impair the market mechanisms still further, as one control leads to the need for another. Such intervention gives the appearance a government is taking action, but only addresses the symptoms rather than underlying causes.

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Causes of Inflation in Pakistan

1.4.5 Problem of domestic price rises

The extent to which domestic prices rises faster than international competitors also produces problems. If he currency is part of fix exchange rate mechanism such as the ERM, then a rising balance of payments deficits will force its value to the lower end of the permitted range. The government would therefore be forced to raise interest rates and deflate the economy and until differential inflation was squeezed out of the system. In this respect the real problem is not the inflation itself but the economy pain suffered in squeezing it out of the system.

Downward flexibility in the exchange rate has also proved unable to avoid this outcome. Successive devaluations of the pound provided only short-term relief of business seeking to compete at home and abroad. The falling pound, which made overseas manufactures less competitive, also made imported foods, fuels, materials and other inputs more expensive, feeding directly into domestic factory costs and wage demands. The outcome was a wage-price-devaluation spiral, with shortening time spans between the spirals.

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Causes of Inflation in Pakistan

1.5 Causes of inflation

Inflation is often defined in reference to its causes. ‘Too much money cashing too few goods’ is one such example. There is, however, little agreement as to the precise cause of the inflation, especially amongst economists. There major inflation theories will be discussed below and the various strands from each will then be woven into a general framework for understanding the process concerned.

1.5.1 Too much spending – demands pull inflation

This explanation derives from Keynesian analysis. The inflationary gap occurs when aggregate spending plans (C +I + G + X – M) exceed full employment output at current prices. The pressure of this excess demand is unable to induce extra output, so prices rise to ration out the available supply. Attempts to secure extra resources will suck in imports and imports and bid up wage levels, fuelling further spending. If excess demand persists, a price-wage spiral will result.

Phillips had identified a stable relationship between the pressure of demand and the rate of change in money wages over the period 1861-1957. Given a trend productivity growth of 2 to 2 ½ percent, zero inflation would be achieved at 2-½ percent unemployment. Attempts to operate the economy below this level would generate demand-pull inflation. The Phillips curve predicted inflation very accurately up to 1966, but began to understate it by 4-5 per cent up to 1969, and by over 10 per cent in the early 1970s.

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Causes of Inflation in Pakistan

1.5.2 Cost push inflation

This occurs when price rises originate in increased factor costs without excess demand being present. It may be seen their real income to what proves to be unsupportable levels.

If pricing is based on a cost-plus formula, for example, higher costs will be automatically reflected in price rises as business struggle to maintain profit margins. Such supply-sides pressures may be expected to diminish rapidly if such rises result in sharply reduces sales, output and factor employment. If, on the other hand, businesses and unions believe the government is unwilling to contemplate the consequences of resisting cost push pressure, then employers will condone inflationary settlements and pass them on in higher prices.

The government would then have to accommodate the price increases by expanding money supply and aggregate demand by the amount necessary to maintain sales at the higher price level. Any government prepared to underwrite such a wage-price spiral will ensure that little incentive will be provided for management to resist cost pressures.

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Causes of Inflation in Pakistan The sources of cost-push inflation are as follows.

Wage push

The primary engine here would be a struggle between labor and capital to achieve real shares of output that are mutually inconsistent. While desired shares can sum to over 100 per cent of the cake, actual shares cannot. Thus as unions demand and obtain higher wage settlements to raise their shares, businesses restore profitability by raising prices and reducing the real value of the pay increases. This process can only be halted if one of the following occurs:

•

Wage or profit expectations are adjusted.

•

The government refuses to underwrite the process, so suppressing the conflict.

•

Another is forced to accept a lower share, e.g. rent receivers.

•

Money illusion on the part of workers or business.

A similar struggle over shares could equally arise between different wage groups. Key wage groups achieving a wage increase justified by productivity gains may promote comparability claims. If concede, these would raise final prices, eroding the value of the rises obtained by the high productivity workers, and promoting compensating claims. A rigid wage structure provides many such linkages, and could readily support a general wage-wage spiral.

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Causes of Inflation in Pakistan

Profit push inflation

This arises when businesses seek to widen margins by raising output prices more than the rise in input prices. The need to rebuild profitability after its heavy erosion in the 1970s led to profit push after 1982. Input prices were low, owing to falling primary product prices and near constant unit labor costs as productivity improved sharply. Profit push contributed to inflation through most of the remaining decade.

Tax push

This occurs when wage groups have real income targets. The effect of progressive taxation and increases in tax rates is to make these unattainable, causing compensating wage claims. The switch from direct to indirect taxation, as occurred in 1979, served to raise the RPI by 3 ½ percentage points, while government policies to cut borrowing by reducing nationalized industry subsidies and raising council-housing rents and rates have also caused above average rises in the RPI. The 1991 budget also shifted the balance of taxation By raising VAT and excises to finance a cut in the community charge.

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Causes of Inflation in Pakistan

Import push

Import account for over a fifth of total final expenditure, so any rise in their prices will be reflected in domestic inflation after a lag. The international dimension to inflation is very important in an open economy like Britain’s. Inflation is very much an international problem, with industrial nations experiencing similar patterns. The causes of this international inflation must be a large part of the explanation of British inflation, while domestic factors can be examined to explain any divergence from the average. The common factor in recent inflationary surges was oil-price shocks. This could be viewed as OPEC in a struggle to increase its share of the world cake at the expense of oil consumers. Accommodating this with an expansion in world money supply produced inflation, while eroding the real value of OPEC gains. OPEC therefore responds with a further round of price increases. These sharp and unanticipated rises and a generalized impact on other costs and prices, as energy- users found themselves unable to reduce their dependence in the short term.

Well placed in energy terms, the UK, however, fared much less well than importdependent competitors, making further explanation necessary. The downward float of the pound in the early 1970s was one factor, since it caused import prices to rise sharply, feeding into inflation and promoting compensating wage demand.

Cost-push pressures as outlined above were identified as explanation of the underprediction of inflation after 1970. Despite unemployment rising to 1 million (4 per cent),

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Causes of Inflation in Pakistan inflation remained high, producing a condition termed stagflation. It was argued that this new inflation was due to union militancy, underpinned by strong membership growth. The incidence of strikes was rising, led by a new and younger breed of shop steward. Politicians too were partly to blame by stimulating faster growth expectations at election times. These proved unsupportable, especially in recession. More sophisticated media coverage made inflation more noticeable than before, while unpopular experience of decimalization and the introduce of VAT served policies lost their effectiveness, there was a dam burst of defensive wage claims.

1.5.3 Too much money – the monetarist explanation

Sustained inflation is always associated with monetary expansion. Such expansion in excess of the quantity required to support the full employment level of real expenditure will normally precede faster inflation. The process that links the supply of money to price rises is complex, with long and uncertain lags. The long run relationship is represented by the quantity theory equation of Irving Fisher:

MV=PT Where: M = supply of money, P = price level V = velocity of circulation of money T = level of transactions.

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Causes of Inflation in Pakistan This expression is known as an identity, in that the value of one side by definition equals the other. If the level of transactions is fixed at full employment, and velocity changes only slowly over time, any recourse to the printing press by the government will feed directly into the price level. Reform of the monetary system in 1971 produced an unplanned expansion in money supply that added to inflationary pressure, as did financial deregulation in the mid-1980s.

Monetarist explained the breakdown of the Phillips curve by relating the rate change in money wages to the expected rate of inflation. Expectations were seen as a part of an error-learning process, in that they would be adjusted to the extent they had been proved wrong in the past. The only way that the government could maintain unemployment below the natural rate was its actual inflation exceeded expected inflation, thereby reducing real wages to justify the extra jobs created.

Error learning meant that this could only be achieved at the expense of accelerating inflation. In figure any attempt to reduce unemployment to Uf by expanding the money supply causes an increase in money wages to W1. The anticipated inflation this produces shifts the short-run Phillips curve to P2 as expectations adjust and compensating wage demands rise to W2. To maintain employment at Uf, money supply must again increase, and the process repeats but an accelerating rate shown as wage rises to W3. There is no permanent trade-off a little less unemployment for a little more inflation. Instead the acceleration would be unsustainable, ending in hyperinflation. Only with zero excess demand is a steady inflation rate possible under this theory. On this analysis, then, curing

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Causes of Inflation in Pakistan the problem, although painful, is no worse than sickness, since inaction will only produce a worsening in the condition.

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Causes of Inflation in Pakistan

1.6 PROBLEM STATEMENT

In Pakistan there is wide spread of poverty unemployment and inflation is considered as the main cause of this. There are different factors responsible for inflation. In Pakistan people purchasing power is decreasing as compared to rise in general price level. Inflation is caused by general price level, change in relative prices etc. increase rate of inflation is a big hurdle in the development of country. Government is working hard to eliminate the effect of inflation and carried out various steps.

In this study I studied about the various factor that cause inflation and suggested the ways that can be used to stop its effect.

1.7 SCOPE AND LIMITATIONS

Pakistan’s economy has faced many ups and downs since its independence. Some major improvements came about during the reign of Ayub Khan. But those improvements were short lived, and since then there have also been times when Pakistan had to face severe sanctions imposed on it due to the nuclear tests in 1998. Therefore in order to completely analyze the situation we need to consider all the major changes that took place within these 50 years after independence with a major emphasis on the past 5 years situation. Inflation rate has been at its lowest due to government policies, stable rupee and increase in foreign reserves.

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Causes of Inflation in Pakistan The limitations of the study are that this is a secondary data based research data may not show true picture if taken from government’s institutes, the major limitation is of time. With all these limitations one has to be very cautious in getting analyzing interpreting the secondary data.

1.8 OBJECTIVES OF THE STUDY

The basic objective of this study is to point out the basic point that is responsible for inflation. In Pakistan inflation is increasing at very hg rate. Objectives are as under

•

Poverty Alleviation.

•

Gender development.

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Reduce risks faced by poor.

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Enhance outreach.

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Economic development.

The current research work has therefore aimed at gaining insight into the extent of achieving of these objectives of a developing country like Pakistan.

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Causes of Inflation in Pakistan DEFINITION OF DIFFICULT TERMS

Inflation refers to the continual increase in prices.

The value or purchasing power of money refers to the amount of goods or services one pound can buy. Inflation means the value of money is falling because prices keep rising.

The retail price index (RPI) is a monthly survey carried out by the government, which measures price changes.

The rate of inflation is the percentage change in the RPI over the last twelve months.

Cost-push Inflation occurs when a firm passes on an increase in production costs to the consumer.

Demand-pull inflation occurs when there is 'too much money chasing too few goods' because the demand for current output exceeds supply.

Deflation is when the general level of prices is falling.

Hyperinflation is extremely rapid inflation.

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Causes of Inflation in Pakistan Stagflation is the combination of high unemployment and economic stagnation with inflation.

Consumer Price Index (CPI) is a measure of price changes in consumer goods and services such as gasoline, food, clothing, and automobiles. The CPI measures price change from the perspective of the purchaser.

Producer Price Indexes (PPI) is a family of indexes that measure the average change over time in selling prices by domestic producers of goods and services. PPIs measure price change from the perspective of the seller.

Treasury Inflation-Protected Securities (TIPS) are a special type of Treasury note or bond. TIPS are like any other Treasury, except that the principal and coupon payments are tied to the CPI and increased to compensate for any inflation.

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Causes of Inflation in Pakistan

CHAPTER 2

LITERATURE SURVEY

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Causes of Inflation in Pakistan Price inflation has been a widely studied issue in literature. The subject has also attracted considerable attention of economists in Pakistan. In particular the subject gained more interest in 1970’s and 1980’s when the inflation rate reached the two digital levels. Various studies have been undertaken to explore factors behind high rate of inflation in Pakistan. In this section we will review some of these studies with emphasis on their methodology and numerical findings.

According to our knowledge the first study on inflation conducted in Pakistan is by Porter (1961). This study deals with the trends of price level in Pakistan during 1950’s. The essential feature of the study is the explanation of inflation in the context of structural elements. The author highlighted the importance of agricultural sector bottleneck as a factor in determining the inflation rate in Pakistan where economy is heavily dependent on agricultural sector and the banking system is not fully developed. Disagreeing with the application of standard monetary theory in explaining inflationary process in Pakistan, he argued that prices movements and the demand for real money balances in Pakistan correspond with the trends in harvest. In case of harvest failure there is tendency among many stockists to hold purchased cereal rather than money. Therefore the demand for the real money balances decreases along with increase in price level. Furthermore, in case of harvest failure producers reduce their surplus to the market by a larger proportion than the decline in their output, which raises the portion of national income, consumed in the non-monetized sector. This further reduces demand for real money balances for transaction purpose.

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Causes of Inflation in Pakistan Another study on inflation Pakistan by Islam (1963) covers the period 1950-51 to 195859. According to the author during this period increased government expenditure resulted in a rapid increase in money supply. At the same time the output of some important items of mass consumption like food crops remain stagnant. As a result the ratio of money supply to national output increased rapidly, resulting in price inflation. The author further argued that after the collapse of Korean War import prices increased which also contributed to price inflation. He suggested that industrialization process via the policy of import substitution was also a cause of price inflation in Pakistan.

After (1973) analyzed the causes of price inflation in Pakistan with the help of a few linear regression equations estimated over the annual observations for 1959-60 to 197273. The regression equations contained the growth rate of money supply in the current and previous years and the current level of GDP measured at constant prices as explanatory variables in determining inflation rate measured alternatively by the growth rates of wholesale price index and consumer price index. The author concluded that demand factors played a major role in the inflationary process.

The most comprehensive study on inflation in Pakistan has been conducted by Mangla (1981). With the help of regression analysis he tested four main hypotheses in his study, namely the two-way causation hypothesis based on monetarists models, the imported inflation hypothesis, the cost-push hypothesis and the dominant impulse hypothesis. The study is based on annual observations over the period 1961-1979.

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Causes of Inflation in Pakistan The essential idea behind two-way causation hypothesis in the monetarist’s model of inflation, as explained by Mangla, is that the increase in price level trends to increase government expenditure faster than government revenues. The resulting budget deficit induces increase in money supply and further builds up inflationary pressures. In other words, the increase in money supply is both the cause of inflation and the result thereof. In his regression exercise the author found that the two-way causation hypothesis of monetarists model performed moderately in case of Pakistan. The author concluded that there is strong likelihood of inflation being explained partly by some other factors as well.

To test the import inflation hypothesis Mangla related domestic price changes to changes in money supply, import prices and real output. He found that the changes in money supply and import prices significantly affected the domestic inflation rate. He also observed that the relative importance of monetary changes as compared to import prices in explaining domestic inflation rate declined over time most probably due to increasing degree of openness of the economy of Pakistan.

The cost-push hypothesis performed poorly in Mangla’s study as the effect of money wages on price inflation was found to be statistically insignificant in most of his estimated regression equations.

In the dominant impulse hypothesis Mangla suggested that fluctuation in aggregate price level are dominant by four systematic impulses operating in the economy, the fiscal, the

33

Causes of Inflation in Pakistan monetary, the financial and the foreign. The empirical evidence performed by the author suggests that the first two of these impulses dominated the latter two in shaping the inflationary phenomenon. The financial and the foreign impulses had only a marginal effect on price level.

Bilquees attempted two studies on inflation in Pakistan. In her first study Bilquees (1981) applied the monetarists and structural models of inflation on Pakistan using annual data for the period 1969-61 to 1977-78. According to monetarist’s model inflation results from monetary expansion while according to structural model the real cause of inflation is low output due to structural bottlenecks (constraints in agricultural sector, foreign exchange and domestic resources, etc.). In her regression exercise Bilquees found inconclusive results as signs of a number of estimated regression coefficients were contrary to the theory. She concluded that both the models are capable of explaining price inflation but not satisfactorily and, therefore exclusive reliance on either of the two models would yield erroneous results.

In her second study Bilquees (1987) analyzed inflationary trends in Pakistan and compared these with inflation in industrialized countries, non-oil producing developing countries and the Asian region countries. She also discussed the available literature on inflation in Pakistan.

The author pointed out that inflation rate during 1960’s averaged around 3 percent except for the year 1966-67 when the inflation rate reached its peak rates of sixties, that is, 9.27

34

Causes of Inflation in Pakistan percent. She provided various explanations of inflation during this period like increase in non-development expenditure, slow down of PL-480 import, rehabilitation of war displaced persons, etc. She observed, however that despite the increase in money supply inflation rate still remained under control due to high growth rate of output and government’s policy of providing subsidized food to urban population. Bilquees further pointed out the inflation rate increased rapidly in the seventies. It reached its peak rate of seventies at 26.60 percent in 1974-75. After a sharp decline in11975-76 to 14.11 percent it remained in single digit level in the following three years. The inflation rate then increased to 12 percent in 1979-80 and 1980-81 but again declined to 8 percent in 198182. She argued that in 1960’s higher growth rate of GDP, which even exceeded the growth rate of money supply in the early years, prevented prices from rising. The position, however, was reversed during the seventies; the inflation rate followed the increase in money supply while GDP registered a slow growth. During seventies inflation rate increased two fold and money supply increased four fold compared to the increase in GDP. She suggested that the major cause of high inflation in seventies was worldwide inflation.

While comparing inflation in Pakistan with that in other countries, the author found that on the whole, the inflation rate in Pakistan has been higher than that in the Asian region countries in particular during the period of high inflation, 1973-75. Pakistan’s inflation rate moved fairly close to the average rate in the world and the industrial countries. On the basis of this comparison she concluded that Pakistan has been significantly affected by the inflationary trends in world.

35

Causes of Inflation in Pakistan In a recent study Hassan’s (1988) analyzed inflation in Pakistan in the context of Phillips curve relationship. He estimated a three equations macro model underlying the Phillips curve relationship in the framework of rational expectations using quarterly data for the period 1972-I to 1981-IV. In his estimates the natural rate hypothesis (vertical long run Phillips curve hypothesis) was rejected at 5 % significant level. His estimates, however, confirmed the existence of a short run trade-off between excess demand for labor and inflation rate.

The most recent study by Naqvi and Khan (1990), entirely based on the PIDE Macroeconomic Model (1989), deals with the inflation phenomenon in Pakistan over the period 1989-90 and 1990-91. According to their analysis inflation in Pakistan has been caused by increase in money supply, slower growth in the commodity producing sectors as compared to the services sector and increase in import prices. The authors found that the considerable range of inflation was nit due to any domestic policy since 74 percent of inflation in 1989-90 was exogenously given or predetermined (due to increase in import prices or inflation in previous period). The fiscal factors, though significant determinants of inflation, were less important in forming inflationary process as compared to the import prices and the composition of GDP (the ratio of value added in the commodity producing sectors to the value added in the services sector).

We concluded this section with the observation that there has been mixed evidence on the process of price inflation in Pakistan. Various authors have applied different theories in explaining inflation phenomenon in Pakistan. In general any signal theory could not

36

Causes of Inflation in Pakistan fruitfully explain inflationary process in Pakistan. But this is a typical outcome if econometric analysis with time series data and it would not be fair to under-value someone’s efforts. In our opinion in most of the studies the quality of the results has been severely undermined by lack of sufficient data.

37

Causes of Inflation in Pakistan

CHAPTER 3

RESEARCH METHODOLOGY

38

Causes of Inflation in Pakistan

3.1 Purpose of the study

This study is descriptive in nature. Descriptive study is a study where we try to describe certain characteristics of the existing phenomena on which interest centers. In this study I studied about the factors causing inflation. This study was based on secondary data. It will be of great help to students of economics and business studies.

3.2 Type of investigation

There are generally three types of studies, which include; exploratory study, descriptive study and hypothesis study. This piece of research has mainly employed descriptive approach in general and the hypotheses have also been evaluated in the same manner. A descriptive study is under taken in order to ascertain and to be able to describe the characteristics of variables in a situation, the goal of a descriptive study is to describe the relevant aspects of the phenomena of interest to the researcher from an individual and organizational point of view and other relevant perspectives.

Hypotheses study are those which include the testing of the hypothesis to explain the nature of certain relationships or to establish the differences among groups or the independence of two or more groups or the independence of two or more factors in a situation.

39

Causes of Inflation in Pakistan

3.3 Study setting

The study is based on secondary data because to conduct a primary survey time is so limited. I have collecting data from government organization and taking help from researches that have been already done.

3.4 Time horizon

It was on-shot or cross-sectional study. Cross –sectional is a study in which data are gathered just once, perhaps over the period of days or weeks or months. The time frame of this study was 6 months but note that the researcher has given only two months to conduct a survey and its interpretation.

3.5 Research instruments

Data can be collected in a variety of ways in different settings and from different sources. Research instruments include face to face interviews, telephone interviews, computer assisted interviews, questionnaires that are personally administered, sent through the mail or electronically administered, observation of individuals and events with or without videotaping or audio recording and a variety of other motivational techniques such as projective tests

40

Causes of Inflation in Pakistan Research instruments for this study included, interviews from economists, columnists and other relevant people. The sources of information on the Inflation are various libraries such as Institute of Banking library, State Bank of Pakistan library, and different universities libraries such as Quaid-e-Azam University, International Islamic University etc. Online journals on Micro credit are helpful in getting familiar with the previous research work on inflation.

41

Causes of Inflation in Pakistan

CHAPTER 4

INTERPERTATION & ANALYSIS OF DATA

42

Causes of Inflation in Pakistan

Inflation trend in 1990’s

Pakistan has sustained a double-digit inflation between 9.8 to 13.0 percent during the first seven years of the 1990s. Not surprisingly, one of the critical macroeconomic issues in Pakistan’s policy arena during those periods has been as to how to put inflation under effective control. The persistence of a double-digit inflation along with large fiscal deficit (7.0% of GDP) has been the major source of macroeconomic imbalances in the 1990s. There has been a general agreement that lax fiscal management resulting in the excessive growth in money supply, the supply side bottlenecks, the adjustment in government – administered prices, the imported inflation (pass through of exchange rate adjustment), escalations in indirect taxes, and inflationary expectations have the major factors responsible for the persistence of a double-digit inflation during most period of the 1990s. Both food and non-food inflation contributed to the persistence of the double-digit inflation. Food and non-food inflation averaged 12.2 percent and 10.7 percent, respectively during the seven years of the 1990s [Table 4.2} Inflation slowed to an

43

Causes of Inflation in Pakistan average of 5.7 percent in the remaining three years of the 1990s, mainly on account of 5.3 percent food inflation and 6.1 percent non-food inflation. Non-food inflation was mainly driven by the prices of POL products and the associated rise in transport charges. Inflationary pressures have continued to diminish over the last three years mainly on account of tight monetary policy, prudent fiscal management, and improved supply of food items in the country. Although the exchange rate adjustments and the rise in international price of POL products have put upward pressures on inflation but these pressures were countered by the tight monetary policy fully supported by fiscal stance and improvement in the supply situation in the country. During the last three years (200001 – 2002/03) overall inflation averaged 3.7 percent as against double-digit inflation during most period of the 1990s. As stated earlier, the decline in overall inflation owe heavily to a low (3.1%) food inflation, as non-food inflation averaged 4.3 percent during the last three years.

44

Causes of Inflation in Pakistan

45

Causes of Inflation in Pakistan Current inflation trend

Inflation averaged at 3.3 percent during July-April 2002-03. The low level of inflation in the midst of 12.5 percent increase in money supply is the result of better supply situation of essential commodities, appreciation of exchange rate, prudent fiscal management and continued sterilization of monetary impact of massive foreign exchange inflows. Food and non-food inflation have been estimated at 3.1 percent and 3.4 percent, respectively as against 2.1 percent and 4.4 percent respectively in the corresponding period of last year [See Table-4.3]. The higher increase in food inflation over the comparable period of last year is attributable to increase in prices of wheat, wheat flour, rice basmati, meat, tea, vegetable ghee and cooking oil. The increase in vegetable ghee and cooking oil is the result of increase in international price of palm oil and imposition of GST on the local manufacturing of ghee in the Federal Budget 2002-03. As shown in Table 4.4, out of 19 widely consumed daily items the prices of 9 items have declined in the range of 3.8 percent (Chicken Farm) to 51.5 percent (potato). At the same time, the prices of 10 items have increased in the range of 2.7 percent (Fresh Milk) to 15.8 percent (tea). It may be noted that prices of all the four types of pulses (Masur, Moong, Mash and Gram) have declined because of increase in their production. Accordingly, the contribution of food inflation in overall inflation is estimated at 38.1 percent in 2002-03 as against 25.1 percent last year.

46

Causes of Inflation in Pakistan Slower increase in non-food inflation as compared with last year resulted mainly on account of lesser increase in fuel and lighting group (8.5% as against 9.6% of last year) and transport & communication group (5.5% as against 7.1% last year). It is important to note that during July 1-May 15, 2002-03, 22 adjustments in prices of petrol have taken place - 13 times the prices were raised and 8 times reduced while one time it remain unchanged. On July 1, 2002 the price of petrol was Rs.33.71/Litre and on May 16, 2003 it stood at Rs.28.88/Litre - a decline of 14.3 percent. The prices of petroleum product and its various grades including kerosene oil fluctuated moderately during the fiscal year 2002-03. The prices of the various components of petroleum products generally witnessed a rising trend but reached at all time high on March 16, 2003 as a result of the continuous escalation of POL prices in the international market. During the last four adjustments the prices of POL products declined sharply across the board. Most importantly, the price of petrol, which stood at Rs.37.11/Litre on March 16, 2003, declined to Rs.28.88/Litre on May 16, 2003 – a decline of Rs.8.23/Litre or 22.2 percent. Similarly, the price of diesel (HSD) declined from Rs.25.93/Litre to Rs.19.91/Litre – a decline of Rs.6.02/Litre or 23.2 percent during the same period. The price of Kerosene declined from Rs.24.62 to Rs.18.53 – a decline of Rs.6.09/Litre or 24.7 percent. Contrary to the general perception, the government has judiciously passed on the benefit of lower international prices of POL products to the people by lowering the domestic price of these products [See Table-4.5 and Fig-2]. The contribution of non-food inflation is estimated at 61.3 percent, which is lower than last year (77.5%). Within non-food inflation, almost one-half contribution has come from fuel & lighting and transport and communication.

47

Causes of Inflation in Pakistan

The month-wise analysis of inflationary trend as documented in Table-4.6 suggests that overall inflation continued to exhibit a broadly declining trend since July 2002. On yearon-year basis the overall inflation stood at 4.0 percent in July 2002 but declined to 2.2 percent in April 2003. Food inflation decelerated from 5.8 percent to 0.5 percent by March 2003. Non-food inflation on the other hand continued to rise because of the rising trend in oil prices. It has started declining since March 2003.

48

Causes of Inflation in Pakistan

49

Causes of Inflation in Pakistan

Wholesale Price Index (WPI)

The WPI, on average basis, increased by 6.1 percent during July-April, 2002-03. This increase in WPI is significantly higher than the increase of 2.1 percent last year. To this increase, maximum contribution was made by the fuel & lighting group (15.7 percent), followed by raw material (9.4 percent), and manufacturing group (2.6 percent). The larger increase in the index of fuel & lubricant at 15.7 percent against 3.5 percent last year is mainly attributable to increase in prices of POL products. The increase in the prices of raw material has mainly been due to the fact that price indices of certain important items like cotton, cotton yarn, vegetable ghee etc. have increased at higher rate during the current fiscal year than last year [See Table-4.6].

50

Causes of Inflation in Pakistan

Sensitive Price Indicator (SPI)

The SPI is used to capture the movement in prices of 53 essential items, consumed by the urban households with income of Rs.3000-Rs.12000 per month. The increase in SPI during the first ten months of the current fiscal year (July- April) 2002-03 is estimated at 3.7 percent against 3.2 percent last year mainly due to the increase in prices of some basic food items such as wheat (7.8%), wheat flour (5.8%), rice basmati (9.2%), mutton (13.8%), beef (13.7%), vegetable ghee (8.4%), cooking oil (10.5%) and tea (15.8%). Much of the increase in prices of wheat is attributable to its lower production (-4.2%) in 2001-02. The increase in Meat prices is due to increasing demand and vegetable ghee is due to imposition of GST on local manufacturing of ghee as well as substantial increase in the international price of palm oil. However, prices of some basic food items like sugar, pulses, red chilies, chicken (Farms), onion and potatoes have shown significant decline up to the range of 52% on account of improved supply position of these items [See Table-4.4 for details].

51

Causes of Inflation in Pakistan Price Stabilization Measures

Price stabilization measures are important when there are unusual variations in the prices. Presently, the government in commensurate with its policy of decontrol, deregulation and liberalization, believes in tackling the inflationary pressures through economic measures rather than formal price control. However, close vigilance is kept on unusual rise in prices through weekly meetings of the Kitchen Items Committee, now called the Sensitive Items Price Committee (SIPC) and through the weekly meetings of the ECC of the Cabinet. Other measures in the realm of supply augmentation, reduction in import duty to facilitate larger imports, improved marketing practices, timely distribution, coordination with private sector and persuading traders/manufacturers to refrain from unfair practices are undertaken to ensure price stability in the country.

The above analysis clearly suggests that the Government has succeeded in keeping inflation not only low but it is much lower than the target (4.0%) for this fiscal year. The increase in prices of daily consumable items has also remained low. In many cases the prices of some essential items have fallen when compared with last year. In some cases the price have increased as well. This is the normal practice in any economy. The whole idea of the country’s monetary and fiscal policy is not to maintain negative inflation (decline in general price level) but to keep inflation at low level. The government has succeeded in keeping inflation low (3.3%) during the current fiscal year. Even in future, inflation rate should remain within the range of 3 to 4 percent. Keeping inflation at low level should be regarded as protecting the poor from inflation tax.

52

Causes of Inflation in Pakistan

Despite several announcements during the 1990s by each of the last three elected governments regarding reduction of inflation from double to single digits, there is no evidence at present that in the coming years this dream will materialize. This can be attributed primarily to the bleak economic Scenario prevailing in the country.

Several studies have been conducted to explore the causes of inflation during the 1990s. Generally, monetary growth, public policy, administered prices, rise in the prices of imported goods, inflationary expectations and output growth is termed as the determinants of inflation in Pakistan. However, their actual contribution towards inflation is debatable. One group of economists considers inflation a monetary phenomenon, while the other assigns more weight age to rise in administered prices and increase in prices of imported goods as determinants of inflation. Overall, host of factors from both the demand and supply side are responsible for the recent price spiral in Pakistan. The following is a brief review of the factors responsible for inflation during this period.

53

Causes of Inflation in Pakistan Causes of Inflation

The GDP growth has a significant dampening effect on inflation. Pakistan's GDP has grown at an average rate of more than 6 per cent per annum during the last decade. During the first half of 1990, however, the growth rate remained at an average of 4 per cent per annum which may be attributable to the transition of economy from greater government role to private sector, inefficiency of public sector enterprises, lower production in large scale manufacturing, poor agriculture sector performance and distortion public policies. Most public sector enterprises have become inefficient and have been incurring losses for several years. More than 4000 industrial units in the private sector are 'sick' due to which performance of the manufacturing sector is poor for the last few years and recorded a negative growth of 1.4 per cent this year. The agricultural sector, which contributes 26 per cent to the

GDP, also exhibited

vulnerability during the last five years' period. This sector recorded a meager growth of 2.5 per cent per annum during last five years, which is even lower than 3.0 per cent population growth rate. The effect of poor agriculture growth is also evident from the fact that 'food group (weight 49.35 per cent), in CPI recorded 107 per cent inflation from 1990-99 to May, 1999 as compared with over all inflation of 97.57 percent and non- food inflation of 88.0 per cent during the same period. Furthermore, the country faced a severe wheat shortage this year due to lower than targeted production of wheat in the country, delay in its import and failure of responsible authorities in its prompt distribution in different areas of the country.

54

Causes of Inflation in Pakistan As far as administered prices are concerned the government increased the procurement price of wheat, gram, rice, sugarcane, etc, this year in the range of 10 per cent to 40 per cent to give impetus to the production of these crops. Actual quantities of these crops will come into the market with a time lag of at least six months. Prices, however, increased soon after the government's announcement. Distortionary public policy towards agriculture sector in the past has put us into the situation that, Pakistan, an agricultural country, is bound to import wheat, milk, cooking oil, pulses, meat, etc to the tone of $ 2.0 billion annually. Solution of half of trade deficit problem of the country hinges in selfsufficiency in agricultural production. Similarly, the index of fuel, lighting and lubricants' in CPI, which comprises electricity gas and POL products increased 19 per cent during the year from end June, 99 to May 2000and 98.59 per cent from 1990-91 to May 1999 which caused rise in cost of production and transportation cast. One reason for rise in the prices of POL products in the country is a price hike of POL in the international market determined by demand and supply forces. The other one is the frequent devaluation of domestic currency, which is controllable with better economic management in the country. Almost every increase in administered prices adds more and more grieves, miseries and hardships to the consumer life.

Inflation in Pakistan is claimed to be a monetary phenomena. Pakistan saw a very high rate of monetary growth between 1995-96 and 1999-2002 averaging 18.8 per cent per annum. Taking into account real GDP growth and inflation, we calculate an average inflationary gap of 4.0 per cent for the period, as measured by the following formula.

55

Causes of Inflation in Pakistan Inflationary Gap=monetary growth-(real GDP growth +price inflation) The National Credit Consultative Council (NCCC) has approved a monetary growth rate figure of 14 per cent for 1997-98. This is indicative of a failure on the part of the monetary authorities to control monetary growth due to high inflation, financing requirements of large and persistent budget deficits of the government and the monetary overhang of previous years' excessive monetary growth.

Increases in the world price of imports in the world market and a 40 per cent devaluation / depreciation in the Pakistan rupee from January 1995to June 1999 fuelled inflation to unmanageable levels. Without removing the causes of devaluation, we are lowering the value of our currency to make our commodities competitive. As devaluation fuel inflation, it becomes necessary to devalue further to keep our market competitiveness intact. This has put the Pakistani rupee in a devaluation spiral.

Large and persistent levels of trade and current account deficits due to stagnant exports and high levels of imports are posing several implication for inflation. More than 60 per cent of our exports consist of cotton and cotton-based products, which are facing cutthroat competition in the world market. Our major imports are machinery, chemicals and oil, which registered a faster growth in price in international market due to the monopolies created by developed countries.

56

Causes of Inflation in Pakistan The tax to GDP ratio in Pakistan is only 13 to 14 per cent, leaving the government short of funds to run the machinery of the government. The government has to resort to debt financing, money financing and financing from external sources, which put upward pressures of different magnitudes on the price level.

The ratio of indirect to total tax revenues in Pakistan is more than 70 percent. It has been the practice of all governments from past to present to tap revenues from indirect taxes, due to which inflation in the country has reached a very high level. The debt burden of Pakistan is almost equal to GDP, which has made budget making a very unpleasant task for the government every year. The government has to borrow to service the existing debt. Due to this, the debt pool is inflating day by day. As getting unlimited funds from abroad is not possible (although least inflationary in nature) the government has to resort to note printing which fuels inflation severely. Borrowing from the banking and nonbanking sector also has its limitations. The government has to compete with the private sector and offer attractive rates of return on its securities. The government is offering more than a 17 per cent rate of return on its securities leaving banks in a liquidity crunch and putting upward pressure on the lending rate to the private sector. In the wake of a high lending rate the revival of the economy is looking difficult.

The percentage increase in the following food and beverages items in February 2004 over February 2003 shows how difficult life has become for the poor: Wheat (22 pc); wheat flour (18pc); milk fresh(3.8pc); curd(3.2pc);branded powdered milk(9.7pc); loose powered milk(7.7pc); branded turmeric powder(47.3); bread

57

Causes of Inflation in Pakistan plain(4.4pc);

rusk(5.1);bread

tandori(18.3pc);

tea

prepared(6.8pc);

beef

with

bone(20.2pc); mutton(21.2pc); onion(161pc); chillies green(65.3pc); carrot(6.5pc); garlic(74.8pc).

58

Causes of Inflation in Pakistan Consequences of inflation

During an inflationary period it becomes very difficult for the government to fulfill its commitments of achieving macro economic targets. Almost all targets, such as GDP growth, price inflation, bank borrowing, trade deficit, budget deficit, are violated. This hurts the credibility of the government. Costs of development project and nondevelopment expenditure increase due to which the government needs more funds next year by the amount of inflation to keep economic activity at the level of previous year.

A low saying rate in the country is also one of the causes of rising inflation. In the wake of 14 per cent inflation and an average 10 per cent deposit rates, depositors are getting negative real rates of return on their deposits. Income of the individuals is being diverted from saving to consumption and non- productive channels like purchase of real estate and conspicuous consumption leaving saving at a very low level of 11 per cent in the country.

Redistribution of income takes place during an inflationary regime. Resources are moving from lender to borrower. As in the case of Pakistan, lenders are small deposit holders and borrowers the rich elite. Double-digit inflation is aggravating the already high inequality between the rich and the poor.

A kind of rent seeking culture develops due to inflation where the businessman earns lucrative profits by trading existing production. This provides a disincentive for him to be involved in the production process. An entrepreneurial culture cannot develop in this

59

Causes of Inflation in Pakistan situation. Trading further raises the price level by manipulation of the market through hoarding and black marketing by the rent seekers while production eases the upward pressure on price level in an economy.

As inflation is a regressive tax on fixed and low-income groups, it can cause anxiety, unrest and many other social problems in the country.

Dollarization, as defined by the ratio of foreign currency deposits total monetary assets (M2), takes place due the decline in the value of domestic currency. This process never reverses until or unless the value of the local currency is not restored as is evident from the study of transitional economics of the socialist block and other developing countries. Foreign currency deposits in Pakistan have reached the $ 9.4 billion mark since their inception in 1992 to date acting as a hanging sword on the head of the government. Inflation expedites this trend further.

Devaluation is also one of the consequences of inflation. Due to double-digit inflation Pakistan has been caught in the vicious circle of devaluation (devaluation inflation loss of competitiveness again devaluation).

As a result of inflation real money balances (M/P) decline and we need more money to exchange the same quantity of goods and services. This puts pressure on the printing press to print more and more currency notes to meet the requirement. This is the extra cost attached to inflation.

60

Causes of Inflation in Pakistan The State Bank of Pakistan has promised to take steps to counter the inflation or contain it. But they are likely to be mostly monetary measures, primarily through reducing the money supply or currency in circulation. It will suck up the excess money in the market by offering better yields, as it had done recently in the case of the six-monthly treasury hills. It sold such bills for Rs. 29.5 billion instead of the Rs 15 billion it had originally sought and at a yield of 1.72 per cent instead of a lower percentage it had offered earlier. It may do more of the same hereafter to reduce the money supply. But such a remedy may not be very effective in an informal economy in which the money afloat outside the control of the banks is very large and its pressure on demand is very heavy. In addition, between, July 1 and January 31 the currency in circulation had shot up by Rs 88 billion and the net private sector credit had a record offtake of Rs 206 billion. Quite a large part of this credit was not used for production but as consumer banking, particularly to buy imported luxuries or consumer durables, like cars. While the official figures of inflation has risen far above the official projection and continues to do so, the people do not accept the official figures. They find that the cold market reality belies them and the rate of inflation is far higher. When wheat prices rise by 25 per cent following the rise in official support prices and it is short in supply in many areas, the food prices are bound to shoot up. Along with that when the meat prices have shot up, far exceeding the previous record of Rs 200 a kilo and the onion prices have risen high, inflation in food prices is bound to be heavy. The traders are always ready to exploit shortages or create shortages and push up the prices unconscionably.

61

Causes of Inflation in Pakistan Petrol and other oil prices have been rising every fortnight for long and that pushes up freight rates and transport costs. All these have a multiplier effect on prices. If along with that electricity and other energy prices rise pushing up the cost of industrial production and transportation, it is a free for all for the profiteers. Along with that, the rent in the urban areas also rise substantially. The finance officials argue that if the meat or fish prices rise in Karachi that does not mean the same kind of increase has taken place in Gujranwala or Sialkot. Hence that rise is not fully reflected in the varied national indices. But surely the rise in the POL prices, electricity rates, wheat prices, etc does affect all the consumers.

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Causes of Inflation in Pakistan

CHAPTER 5

CONCLUSIONS & RECOMMENDATIONS

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Causes of Inflation in Pakistan

Conclusions

Consensus has developed among the economists that the inflation and output growth are negatively correlated specially at the level of double digit inflation. An unclear trade-off between inflation and unemployment at a very low level of inflation of 3 to 4 per cent is also identified. On the basis of these findings a low inflation of 2-3 per cent is desirable. It can be achieved through curtailment of monetary expansion, lowering budget deficit, promoting efficiency by education and skill, enhancing agriculture production through research and credit availability, promoting national savings by offering positive rate of return on deposits and identifying profitable avenues of investment and revival of the economy by solving the problems of sick industrial units and quick and transparent privatizations of public sector enterprises. During the first seven months of the current financial year ending January 30, the Federal Bureau of Statistics says inflation (consumer price index) was 3.38 per cent, while the Sensitive Price Index, which covers largely food items, was 4.78 per cent and the

wholesale

price

index

6.43

per

cent.

If the prevailing price push continues, as seems likely, the consumer price index may cross the 4 per cent barrier soon and move to a far higher figure. And if the continuing massive unemployment is aggravated by rising inflation, particularly of essential items, the

hardships

of

the

people

can

be

enormous.

64

Causes of Inflation in Pakistan

The fact that CPI inflation has risen by 4.31 per cent in February 2003 primarily owing to increase in the items falling in food and beverages bring home a crucial point. That is the effective inflation for the poor people who spend most of their income on food is much higher than the nominal 4.31 per cent increase in CPI value during last month. Food & beverages have more than 40 per cent weight in overall CPI consisting 374 items.

Recommendations

Inflation can be tackled through monetary measures

but also through fiscal

actions and other policy decisions ,by implying that whereas the SBP would keep overall money supply in check the government would try to contain its borrowing from the SBP that is very inflationary. The government should check the price-hikes in wheat flour and cement and steel, etc The government policy not allowing WAPDA and the KESC to go for an in justified increase in power tariff is another example of what the government can do to check inflation. Similarly, efforts to document the economy are going to contain rising currency in circulation that is creating asset price bubbles in the economy pushing up the price line.

65

Causes of Inflation in Pakistan But policy makers take pride in then fact that an impressive 14.7 per cent growth in large sector manufacturing in July-December 2003 shows that the economy is reaping the benefits of high level of liquidity in the banking system. The inflationary pressure is so visible that the SBP governor Dr. Ishrat Husain stated at the midterm review of meeting national credit consultative Council (NCCC) in January 2003 that economic growth of 5.3 per cent could be attained with inflation at 4-5 per cent. Data released by the FBS show that CPI inflation of 3.49 per cent in the first 8 months of FY04 over the same period of FY03 is slightly lower than where is stood in the first 8 months of the last fiscal year. In July-Feb 2002/03, CPI had risen by 3.54 per cent over July-Feb 2001/02.

.

Downsizing the budget deficit by cutting administrative expenditures and through increases in revenues by broadening the tax base. The government should consult that group of privileged people who is not contributing to government exchequer currently so that it does not have to resort to increasing administered prices to get extra revenue.

Inflation in Pakistan is hard to control efficiently and quickly with out enhancement of agricultural production. There is need to provide credit to small farmers. His weak financial position and skill level prevent him from employing modern equipment and inputs to his farm. It is no easy task for mall farmers in Pakistan to obtain credit. It is

66

Causes of Inflation in Pakistan possible only after several visits to the bank and after paying some percentage of the loan to mobile credit officer (MCO) or to other officials. This increases the effective rate of return and multiplies his miseries.

Banks are unable to offer a positive real rate of return to depositors in Pakistan due to huge intermediation costs and stuck up loans. Implementation of recently approved laws by the parliament will help cure this situation. Process of privatization of the nationalized commercial banks (NCBs) should be speeded up keeping in view the transparency of this process.

As a long-term policy measure, human capital must be equipped with skill and knowledge to enhance its productivity and efficiency, and ultimately tame inflation. The standard of living and the level of education have a strong bearing on population growth and other matters of social and economic well being. Autonomy granted to SBP is also a right step towards financial soundness and restoration of the value of currency. Performance of SBP hinges on the success of recovery drive, controlling monetary expansion to public sector for budgetary support and reducing the lending rate by lowering the intermediation cost of the banking system. Fiscal policy should be made instead of monetary policy.

67

Causes of Inflation in Pakistan

References

•

Faiz Bilquees, 1981, Inflation In Pakistan – An Empirical Analysis

•

Usman Afridi And Asghar Qadir, 1982, Dual Sector Inflation In Pakistan

•

Syed Nawab Haider Naqvi And Ashfaque H. Khan, 1989, Inflation And Growth An Analysis Of Recent Trends In Pakistan

•

1999-2000, Economic Survey Of Pakistan

68

Causes of Inflation in Pakistan •

2000-2001, Economic Survey Of Pakistan

•

2001-2002, Economic Survey Of Pakistan

•

References From Quaid E Azam University Islamabad

•

Pakistan Institute Of Development Economics (PIDE)

•

Dawn Newspaper, www.Dawn.Com

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Causes of Inflation in Pakistan

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Causes of Inflation in Pakistan

References

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Faiz Bilquees, 1981, Inflation In Pakistan – An Empirical Analysis

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Usman Afridi And Asghar Qadir, 1982, Dual Sector Inflation In Pakistan

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Syed Nawab Haider Naqvi And Ashfaque H. Khan, 1989, Inflation And Growth An Analysis Of Recent Trends In Pakistan

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1999-2000, Economic Survey Of Pakistan

•

2000-2001, Economic Survey Of Pakistan

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2001-2002, Economic Survey Of Pakistan

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References From Quaid E Azam University Islamabad

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Pakistan Institute Of Development Economics (PIDE)

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Dawn Newspaper, www.Dawn.Com

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