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Final Inflation Report

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    INFLATION

    Definitions:

    A persistent and appreciable rise in the general level of prices is calledinflation

    OR

    Inflation is the continued upward movement in the general level ofprices. OR

    Inflation is the process in which there is a continuous increase in the

    general price level. If the price level rises persistently, then peopleneed more and more money to make transactions. But a one timeincrease in the price level is not Inflation. But it is an ongoing process.To illustrate this we have a graph

    Inflation v/s One Time Rise in Price Level

    0

    20

    40

    60

    80100

    120

    140

    160

    2002

    2003

    2004

    2005

    2006

    2007

    years

    priceleve

    l

    ongoing

    one time change

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    HISTORY OF INFLATION:

    Inflation originally referred to the debasement of the currency. Whengold was used as currency, gold coins could be collected by thegovernment, melted down, mixed with other metals such as silver,copper or lead, and reissued at the same nominal value. By diluting thegold with other metals, the government could increase the totalnumber of coins issued without also needing to increase the amount ofgold used to make them. When the cost of each coin is lowered in this

    way, the government profits from an increase in seignior age. By the nineteenth century, economists categorized three separate

    factors that cause a rise or fall in the price of goods: a change in thevalue or resource costs of the good, a change in the price of moneywhich then was usually a fluctuation in metallic content in thecurrency, and currency depreciation resulting from an increased supplyof currency relative to the quantity of redeemable metal backing thecurrency. Following the proliferation of private bank note currencyprinted during the American Civil War, the term "inflation" started toappear as a direct reference to the currency depreciation that occurredas the quantity of redeemable bank notes outstripped the quantity ofmetal available for their redemption. The term inflation then referredto the devaluation of the currency, and not to a rise in the price ofgoods.

    THEORY OF INFLATION:

    Inflation is the rise in the prices of goods and services in an economy over aperiod of time. When the general price level rises, each unit of the functionalcurrency buys fewer goods and services; consequently, inflation is a declinein the real value of money a loss of purchasing power in the internal

    medium of exchange, which is also the monetary unit of account in aneconomy. Inflation is a key indicator of a country and provides importantinsight on the state of the economy and the sound macroeconomic policiesthat govern it. A stable inflation not only gives a nurturing environment foreconomic growth, but also uplifts the poor and fixed income citizens who arethe most vulnerable in society.Inflation means a sustained rise in prices. Inflation can be Creeping, walkingor trotting, running, hyper or gallop, demand pull, cost push, mixed, markup

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    or stagflation according to velocity and nature. Inflation is caused by somedemand side factors (Increase in nominal money supply, Increase indisposable income, Expansion of Credit, Deficit Financing Policy, Blackmoney spending, Repayment of Public Debts, Expansion of the PrivateSector, Increasing Public Expenditures) and some Supply side factors

    (Shortage of factors of production or inputs, Industrial Disputes, NaturalCalamities, Artificial Scarcities, Increase in exports (excess exports), Globalfactors, Neglecting the production of consumer goods, Application of law ofdiminishing returns).

    TYPES OF INFLATION:

    There are six main types of inflation. The various types of inflation arebriefed below.

    1. Demand-pull Inflation

    2. Cost-Push Inflation

    3. Price Power Inflation

    4. Sectoral Inflation

    5. Fiscal Inflation

    6. Hyper Inflation

    1. Demand-pull inflation:

    This type of inflation occurs when total demand for goods and services in an

    economy exceeds the supply of the goods and services. When the supply isless, the prices of these goods and services would rise, leading to a situationcalled as demand-pull inflation. This type of inflation affects the marketeconomy adversely during the wartime.

    2. Cost-push Inflation:

    As the name suggests, if there is increase in the cost of production of goodsand services, there is likely to be a forceful increase in the prices of finishedgoods and services. For instance, a rise in the wages of laborers would raise

    the unit costs of production and this would lead to rise in prices for therelated end product. This type of inflation may or may not occur inconjunction with demand-pull inflation.

    3. Pricing Power Inflation:

    Pricing power inflation is more often called as administered price inflation.This type of inflation occurs when the business houses and industries decide

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    to increase the price oftheir respective goods and services to increase theirprofit margins. A point noteworthy is pricing power inflation does not occur atthe time of financial crises and economic depression, or when there is adownturn in the economy.

    This type of inflation is also called as oligopolistic inflation because

    oligopolies have the power of pricing their goods and services.

    4. Sectoral Inflation:

    This is the fourth major type of inflation. The sectoral inflation takes placewhen there is an increase in the price of the goods and services produced bya certain sector of industries. For instance, an increase in the cost of crudeoil would directly affect all the other sectors, which are directly related to theoil industry. Thus, the ever-increasing price of fuel has become an importantissue related to the economy all over the world. Take the example of aviation

    industry. When the price of oil increases, the ticket fares would also go up.This would lead to a widespread inflation throughout the economy, eventhough it had originated in one basic sector. If this situation occurs whenthere is a recession in the economy, there would be layoffs and it wouldadversely affect the work force and the economy in turn.

    5. Fiscal Inflation:

    Fiscal Inflation occurs when there is excess government spending. Thisoccurs when there is a deficit budget. For instance, Fiscal inflation originatedin the US in 1960s at the time President Lydon Baines Johnson. America isalso facing fiscal type of inflation under the president ship of George W. Bushdue to excess spending in the defense sector.

    6. Hyper Inflation:

    Hyperinflation is also known as runaway inflation or galloping inflation. Thistype of inflation occurs during or soon after a war. This can usually lead tothe complete breakdown of a countrys monetary system. However, this typeof inflation is short-lived. In 1923, in Germany, inflation rate touchedapproximately 322 percent per month with October being the month of

    highest inflation.

    HOW TO MEASURE RATE OF INFLATION:

    Inflation is usually estimated by calculating the inflation rate of a price index,

    usually the Consumer Price Index. The Consumer Price Index measures

    prices of a selection of goods and services purchased by a "typical

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    consumer. The inflation rate is the percentage rate of change of a price

    index over time.

    Other widely used price indices for calculating price

    inflation include the following:

    * Cost-of-living indices (COLI) are indices similar to the CPI which are

    often used to adjust fixed incomes and contractual incomes to maintain the

    real value of those incomes.

    * Producer price indices (PPIs) which measures average changes in

    prices received by domestic producers for their output. This differs from the

    CPI in that price subsidization, profits, and taxes may cause the amount

    received by the producer to differ from what the consumer paid. There is

    also typically a delay between an increase in the PPI and any eventualincrease in the CPI. Producer price index measures the pressure being put on

    producers by the costs of their raw materials. This could be "passed on" to

    consumers, or it could be absorbed by profits, or offset by increasing

    productivity. In India and the United States, an earlier version of the PPI was

    called the Wholesale Price Index.

    * Commodity Price Indices which measure the price of a selection of

    commodities. In the present commodity price indices are weighted by the

    relative importance of the components to the "all in" cost of an employee.

    * Core Price Indicesbecause food and oil prices can change quickly due

    to changes in supply and demand conditions in the food and oil markets, it

    can be difficult to detect the long run trend in price levels when those prices

    are included. Therefore most statistical agencies also report a measure of

    'core inflation', which removes the most volatile components (such as food

    and oil) from a broad price index like the CPI. Because core inflation is less

    affected by short run supply and demand conditions in specific markets,

    central banks rely on it to better measure the inflationary impact of current

    monetary policy.

    Other common measures of inflation are:

    * GDP Deflatoris a measure of the price of all the goods and services

    included in Gross Domestic Product (GDP). The US Commerce Department

    publishes a deflator series for US GDP, defined as its nominal GDP measure

    divided by its real GDP measure.Page 5 of27

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    * Regional InflationThe Bureau of Labor Statistics breaks down CPI-U

    calculations down to different regions of the US.

    * Historical Inflation before collecting consistent econometric data

    became standard for governments, and for the purpose of comparing

    absolute, rather than relative standards of living, various economists havecalculated imputed inflation figures. Most inflation data before the early 20th

    century is imputed based on the known costs of goods, rather than compiled

    at the time. It is also used to adjust for the differences in real standard of

    living for the presence of technology.

    * 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 levelinflation 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.

    Inflation rate is the percentage rate of change of a price index overtime. To measure the inflation rate; we calculate the annualpercentage change in the price level.

    Inflation Rate= Current Year PricePrevious Year Price x

    100

    Previous Year Price

    Example:

    If this year price level is 126 and the last year price level was 120, then

    Inflation rate= 126-120 x 100 = 5%

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    120

    So the 5% is inflation rate of the current year. This equation shows theconnection between the inflation rate and the price level. For a given priceby last year, the higher the price levels in the current year the higher theinflation rate. If the price level is rising, the inflation rate increases. Also thehigher the new price level, lower is the value of money and the higher is theinflation rate.

    INFLATION IN PAKISTAN:

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

    and around eight per cent in 2005-06.

    Inflation In The Fiscal year 2008-09:

    This year the increase in the price level has been extraordinary in Pakistan. The inflation rate measured through the Consumer Price Index (CPI) hasclimbed to 22.3 percent during (July-April) 2008-09 over the correspondingincrease of 10.3 percent. Inflation accelerated at a rapid pace mainlybecause of raising food prices; a weaker rupee/dollar exchange rate; thegradual withdrawal of subsidies on gas, electricity and petroleum; the

    imposition of custom duty on the imports of various items; and anupwardrevision in the support price of wheat and sugarcane crops. The overall CPI-base inflation during the first ten months of the current fiscal year 2008-09(JulyApril) averaged at 22.4 percent, much higher than that of the last fiscal year2007-08 (JulyApril) when inflation stood at 10.2 percent. The food groupalso increased sharply when compared to last year figures, measuring 26.6percent for the first ten months of fiscal year 2008-09 as compared to 15percent during the corresponding period last year. The steep rise in foodinflation was largely due to an increase in the prices of a few essential itemssuch as wheat, rice, edible oil, meat, pulses, tea, milk and fresh vegetables.

    Non-food inflation also showed a sharp increase of 19 percent during thesame period as compared to 6.8 percent of last year. Most concerning,however, is the sharp increase in core inflation, measuring a substantial17.8 percent during the first ten months of the current fiscal year ascompared to 7.5 percent during the corresponding period last year (SeeTable 7.2)Based on current trends, it is expected that the average inflation for the year(2008-09) as measured by the CPI will be around 21 percent. These

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    developments in the CPI are also reflected in other measures of inflationused in Pakistan, namely the Wholesale Price Index (WPI) as well as theSensitive Price Index (SPI).

    Table 01:

    Item (2006-2007)

    (2007-08) (July-April)(2007-08) (2008-09)

    CPI(General)

    7.8 12.0 10.2 22.4

    FoodGroup

    10.4 17.5 15.0 26.6

    Non-foodGroup

    6.0 7.9 6.8 19.0

    Coreinflation

    5.9 8.3 7.5 17.8

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    0

    5

    10

    15

    20

    25

    30

    2006-7 2007-08 2007-

    08(July-

    April)

    2008-

    09(July-

    April)

    CPI(General)

    Food Group

    Non-Food Group

    Core Inflation

    Source: Federal Bureau of Statistics Revenue (FBS)

    The food group has been the most significant contributor to the pick up ininflation during 2008-09 and the food price index is at its highest point since1980, averaging 26.6 percent over the July April period. Within the foodgroup, the inflation of perishable food items is estimated at 23.2 percentwhereas non-perishable food items at 28.6 percent. Their contribution to thisyears overallCPI trend is registered at 5.3 percent and 45.1 percent respectivelyindicating a larger increase in prices of such items as pulses, sugar, wheatand tea.Given the speed at which food prices increased, high food inflation is likely topersist in the country over the next few months. The higher food prices havehad a devastating effect on the Pakistani people as a major share of

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    consumer spending is on food items. Hence, inflation has a direct impact onthe poverty level as people suffer more from the high price of food than theygain from higher income. The escalation in food inflation began right fromthe start of the fiscal year, i.e. July 2008 and continued to persist up untilDecember 2008 at an average of 31.3 percent for the fiscal year. However,

    thereafter it started to slowdown from 29.9 percent in January 2009 to28.0 percent in March 2009 and further to 26.6 percent in April 2009, stayingin tandem with the trend seen in international food and fuel prices. Ashortfall in the production of some essential commodities in the country inrelation to their demand has also driven up food prices. In fact, there are 13food items (such as wheat and flour; sugar, poultry, mash pulse, meat, milk,tea, fresh vegetables etc) that account for almost 23 percent of the totalweight in the Consumer Price Index (CPI). It is from these critical items thatthere has been a sharp pick up in food inflation in Pakistan. Food in generalhas become more expensive in Pakistan, resulting in a steep rise in the priceof some basic commodities. For instance, the average price of sugar has

    risen above 41 percent, wheat prices by 17 percent, chicken prices by 24percent, beef prices by 13 percent and onion prices by 64 percent since July2008 over April 2009. With a 23 percent weight inCPI, the contribution of these few items to the overall CPI inflation is 18percent. However, prices of certain other food items such as potatoes, rice,red chilies, edible oil and all the pulses, with the exception of mash pulse,have declined. Non-food price inflation rose to 19.0 percent for the July-Aprilperiod as against 6.8 percent during the same period last year. Both the foodand non-food inflation contributed to the overall CPI inflation but in differentways as various factors influenced the two CPI components separately. Theincrease in food inflation was influenced mainly from a shortfall in the supply

    of some essential consumer food items such as wheat, meat, sugar, milk andpoultry whereas the non-food price inflation was mainly driven by the priceof POL products and the resultant rise in transportation costs. In theinternational markets, oil prices dropped significantly from a peak of $145/barrel in July 2008 to around $35 /barrel by December 2008 A similar impactwas witnessed in the prices of food items with a reduction of 21 percent inthe international price of wheat, 40 percent fall in the prices of rice, 38percent reduction in palm oil prices and a 4 percent decrease in sugar prices.However, unfortunately for Pakistan, benefits of this reduction in worldcommodity prices could not be realized owing to a depreciation of the rupee.The impact of depreciation along with the imposition of addition duty on

    imports has been reflected in both the import costs of commodity and capitalgoods. Based on current tendencies, the contribution of food and non-foodinflation to the overall CPI is estimated at 48.0 percent and 50.7 percentrespectively. When we further categorize inflation into different groups, thehigher inflationary trends on an average-over average basis were observedin the transport group (30%) and fuel group (25%), showing the impact ofrising energy prices. The cleaning and laundry group increased by 19percent while the medicine group rose 12 percent but their weights in the

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    CPI basket are small (5.9. percent and 2.1 percent respectively), hence theircontribution to inflation was also minimal. On the other hand, the house rentindex, which has a 23.4 percent weight in the total CPI, has shown a higherpick in inflation of 16.8 percent (See Table 7.3 and Fig-2).Other major factors that effected domestic prices, both in the recent past as

    well as those currently having an impact, include: Firstly, in order to reducethe pressure on the countrys fiscal position, the Government startedphasing out subsidies on petroleum products. This led to an increase in theprice of diesel, causing transportation costs to rise which in turn translated tohigher prices of many other goods in the country. Secondly, the Governmentrevised the support price of wheat in September 2008 by increasing it over50 percent from Rs 625 /40 Kg to Rs 950 /40 Kg which in turn pushed up theretail prices of both wheat and wheat flour across the country. Thirdly, thegradual hike in power and gas tariffs during fiscal year 2008-09 also addedto the domestic inflation rate. Electricity charges carry a significant weight of4.4 percent in the overall CPI whereas natural gas has a weight of 2.1

    percent, thus an increase in their prices would have a noteworthy impact onthe headline inflation rate. Fourthly, the decision to increase the importduties on various items in tandem with the depreciation of the rupee vis--vis the dollar caused domestic prices to rise. This caused imports to be morecostly than anticipated and hence served as another creeping cause ofinflation. It is worth mentioning that appropriate policy response to tameinflation also includes monitoring the scarcity of essential items throughtimely imports, keeping a close vigilance on the stock and availability ofessential items, the provision of incentives to the commodity producingsector, and keeping the money supply within the targeted range. Given thedecelerating trend in food price inflation, the CPI headline inflation rate is

    likely to come down during the remaining months of the current fiscal year.Hence the current fiscal year is expected to end with average inflation rateof 21 percent.Due to this inflation, prices of the commodities increase very fastly.

    Table 02:

    CommodityGroup

    (July-April)

    PointContribution

    (July-April)

    Weight

    Percent

    Percent

    (2007-08) (2008-09)

    (2007-08) (2008-09)

    CPI 100 10.27 22.35 10.27 22.35

    Food 40.3 15.02 26.61 59.03 48.03

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    1)Perishable 5.14 4.46 23.24 2.23 5.34

    2)Non-perishable

    35.2 12.94 28.61 44.36 45.06

    Non-Food 59.7 6.82 19.01 39.60 50.75

    Core 52.4 7.49 17.83 38.61 47.97

    Apparel,Textile6.1 7.86 14.87 4.67 4.06

    House rent 23.4 8.78 16.78 19.92 17.60

    Energy 7.3 3.42 24.98 2.88 9.73

    Household 3.3 6.56 13.53 2.10 1.99

    Transport 7.3 0.66 29.53 0.34 6.91

    Recreation 0.8 0.42 12.71 0.03 0.47

    Education 3.5 6.89 16.74 2.32 2.58

    Cleaning 5.9 9.76 18.72 5.59 4.92

    Medicare 2.1 8.38 12.44 1.69 1.15

    Historical Trend in Inflation:

    Historically viewed, Pakistan's experience in growth and inflation can beexpressed in five distinct phases. Starting with the fifties there was lowinflation with low growth, whereas in the sixties there was low inflation withhigh growth. The seventies entailed high inflation with low growth; theeighties saw moderate inflation with high growth; and in the ninetieswitnessed high inflation with moderate growth. Over the following nineyears, i.e. 2000-01 to 2008-09, inflation saw a low of 3.1 percent in 2002-03to a high of 22.3 percent during the current year, which is also the highest

    level in two decades. The overall annual inflation is expected to average 21percent while GDP growth to remain at 2.0 percent for the year 2008-09.

    Table 03: Trend in GDP Growth Rate and Inflation Rate

    Period GDP Growth rate Inflation rate1950-1960 3.1 2.11960-1970 6.8 3.21970-1980 4.8 12.31980-1990 6.5 7.81990-2000 4.6 9.7

    2000-2009 5.2 8.4

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    0

    2

    4

    6

    8

    10

    12

    14

    1950-60 1960-70 1970-80 1980-90 1990-00 2001-09

    GDP Growth Rate

    Inflation Rate

    Is there any need to worry about inflation?

    When is inflation bad for the economy?A reasonable rate of inflation--around 3- 6 per centbut in our graph whichrepresent the inflation rate and growth rate of Pakistan, after the period of1960-70 there is no satisfactory rate of GDP and inflation up till 2009.When inflation crosses reasonable limits, it has negative effects. It reducesthe value ofmoney, resulting in uncertainty of the value of gains and lossesof borrowers, lenders, and buyers and sellers. The increasing uncertaintydiscourages saving and investment.

    In case of Pakistan:Annual inflation was above 11 per centin the past 32 years. For Pakistaneconomy, 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.

    A near History of Inflation in Pakistan with reference to

    CPI, SPI and WPI: [1]

    Consumer Price Index (CPI) is the main measure of price changes at theretail level. It measures changes in the cost of buying a representative fixedbasket of goods and services and generally indicates inflation rate in thecountry. The Consumer price index was computed for the first time with1948-49 as a base for industrial workers in the cities of Lahore, Karachi and

    Sialkot only. Continuous efforts have been made, since then, to make CPImore representatives by improving and expanding its scope and coverage interms of items, category of employees, cities and markets. Accordingly, theCPI series were computed with 1959-60, 1969-70, 1975-76, 1980-81 and1990-91 as base years. At present, the CPI is being computed with 2000-01as base year. And according to the studies of CPI, the inflation rate duringthe fiscal year 2000-2001 was 4.41, during the fiscal year 2001-2002 itdropped down to 3.54, further dropped to 3.10 during the fiscal year 2002-

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    2003, rose again to 4.57 during 2003-2004, increased drastically to 9.28during 2004-2005 and then dropped to 7.92 during 2005-2006. And by themid of October 2006, the CPI is reported to be 8.43.The Sensitive Price Indicator (SPI) is computed on weekly basis to assess theprice movements of essential commodities at short intervals so as to review

    the price situation in the country. The SPI is being presented in the EconomicCoordination Committee of the Cabinet (ECC). Sensitive price indicator wasoriginally computed with 1969-70 as base which was subsequently switchedover to 1975-76, 1980-81 and 1990-91 as base year. Presently, the SPI isbeing computed with base 2000-2001. And Sensitive Price Indicator (SPI)shows the facts as; 4.84 in 2000-2001, 3.37 in 2001-2002, 3.58 in 2002-2003, 6.83 in 2003-2004, 11.55 in 2004-2005 and 7.02 in 2005-2006.Recently (By the mid of October 2006) the SPI is reported as 9.86.The Wholesale Price Index (WPI) is designed to measure the directionalmovements of prices for a set of selected items in the primary and wholesalemarkets. Items covered in the series are those which could be precisely

    defined and are offered in lots by producers/manufacturers. Prices used aregenerally those, which conform to the primary sellers realization at ex-mandi, ex-factory or at an organized Wholesale level. The WPI initially wascomputed with 1959-60 as base. Since then, continuous efforts have beenmade to make the WPI more representatives by improving and expending itsscope and coverage in terms of commodities, quotations/markets, etc.Accordingly, WPI series were computed with 1969-70, 1975-76, 1980-81 and1990-91 as base years. Presently, the WPI is being computed with 2000-01as base. The Wholesale Price Index (WPI) tells the story as; 6.21 in 2000-2001, 2.08 in 2001-2002, 5.57 in 2002-2003, 7.91 in 2003-2004, 6.75 in2004-2005 and 10.10 in 2005-2006.

    CAUSES OF INFLATION IN PAKISTAN:

    Now what are the causes of inflation in Pakistan? There are four main causesthat can create inflation at high rate.1) Demand-pull inflation.

    2) Cost- push inflation.

    3) Money supply

    4) Artificially created

    1) Demand -pull inflation:

    It is generated when the aggregate demand increases than supply.Following are the causes of demand pull inflation in Pakistan.

    High monetary expansion:

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    The supply of money expanding quickly every year but the supply ofgoods and services is not increasing according to that ratio. So in thiscondition there will be more demand due to excess of money and thereis less supply so in this condition producer have to increase thereprices to meet with the demand.

    Foreign aid: The volume of foreign aid is increasing with the passage of time.almost every year we receive million of dollars aid when this aid isused in the country, it increase the demand because with that aidpeople will have more purchasing power so with the more purchasingpower than there will 8me more demand this excessive demand tendsthe economy towards inflation.

    Consumptions Habits:In Pakistan most population usually feel proudness for using those

    items (goods and services) which are commonly used in advancecountries.

    Population Explosion: The population is increasing at 1.9% in Pakistan. So this rate ofincrease in population will increase the demand for many commoditiesif the demand increases than you know there will be more inflation.

    Increase in wages:The rise in wages, salaries, and pension has increased the purchasingpower of the people.

    Nationalization of industries:After the nationalization of industries in Pakistan the investor class ishesitating to do the investment due to fear of nationalization. So in thiscase there will be less industries who fulfills the demand of the goodsand services so there is increase in price level which is the symptomsof inflation.

    Income from the Foreign:The Pakistanis who are in abroad .those families who are receiving inPakistan there purchasing power increasing day by day .in other wordstheir demand increases.

    2) Cost -push inflation:

    Sale tax:Government of Pakistan has imposed sale tax on large number of

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    goods like oil, gas, electricity, telephone etc. It has also contributed therate of inflation.

    Devaluation of rupee:It is an important factor in increasing the general level of price.

    Pakistan has devalued his currency many times in term of dollar.Devaluation has increase the cost of product and the price of theimported goods while the value of export has fallen.

    Rising prices of imported goods:Different commodities are imported whose prices are rising in theworld market. So these commodities are bringing inflation with them.

    Increase in indirect Taxation:The government of Pakistanis increasing the taxes on the goods everyyear. The direct taxes have also increased the rate of inflation.

    3) Money supply:

    It plays a large role in inflationary pressure as well. Monetarist economistsbelieve that if the Federal Reserve does not control the money supplyadequately, it may actually grow at a rate faster than that of the potentialoutput in the economy, or real GDP. The belief is that this will drive up pricesand hence, inflation. Low interest rates correspond with high levels of moneysupply and allow for more investment in big business and new ideas whicheventually leads to unsustainable levels of inflation as cheap money is

    available. The credit crisis of 2007 is a very good example of this at work .

    4) Artificial created:

    Inflation can artificially be created through a circular increase in wageearners demands and then the subsequent increase in producer costs whichwill drive up the prices of their goods and services. This will then translateback into higher prices for the wage earners or consumers. As demands gohigher from each side, inflation will continue to rise.

    MEASURES TO REMOVE INFLATION INPAKISTAN:

    Now the question is how we can overcome to the inflation? Whatmeasures should be adopted to remove the inflation?

    The inflation was well under control from the fiscal year 2000-2004.

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    However it shoots up to 9.3% in the year 2005 mainly due to the rise inthe support price of wheat and the surge in the international price ofoil. it has been bought down to 7.9% in 2006-2007.However the foodinflation was 10.2% for the fiscal year 2006-2007.The Government ofPakistan being well aware of the adverse effects of inflation, is taking

    following measure to bring down the inflationary pressure in theeconomy.

    Increase in the supply of essential goods:The Government of Pakistan is regularly monitoring the domesticstock of essential goods and their price in the market. The supply ofessential goods is being improved through the import of thesecommodities.

    Supply of essential items through utility store:The Government of Pakistan is expanding the supply of theessential items such as sugar, wheat, pulses at subsidized ratesthrough the utility stores in the country which are likely to increase to5000 in 2007-2008.

    Restriction on the import of luxury items:The import of luxury items must be restricted. It will protect s frominternational inflation and it will be favorable for the balance ofpayment as well as for price level of goods.

    Denationalization:

    Nationalized industries should be denationalized and private sectorshould be allowed to play its role more effectively. In denationalizedsystem foreign investor will invest there money in Pakistan and mademore industries. So if the industries increase than there will be moreproduction and less inflation.

    Change in taxation system: The taxation system should be revised in order to encourage theprivate sector. Tax holidays must be given to expand the industrialsector.

    Sick industries problem:Sick industries should be handed over to private sector and theirproduction and profit can be restored to stabilize the economy.

    Check on unplanned cities:The unplanned and unregulated growth of cities should be checked.

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    Effective Administration:The administration should be made effective and clear to increase theoutput of the country.

    Discipline:

    Discipline should be restored in factories and office to improve theoutput of the country.

    Co-ordination between Monetary and Fiscal Policy:Govt. should coordinate the monetary and fiscal policy in such amanner that it should check the rate of inflation.

    Special Bazaars:Govt. has established the Friday and Sunday bazaars in every city toprovide the basic necessities of life at lower prices. These can be

    improved further in small towns and villages.

    Reduction in Interest Rate:To increase the credit facility to private sector govt. should reduce thebank rate. It will reduce the cost and price of production. Due to thefall in price aggregate demand will also increase.

    Increase in the supply of essential goods: The govt. is regulatory monitoring the domestic stock of essentialgoods and their prices in the market. The supply of essential goods isbeing improved through the import of these commodities.

    Supply of Essential items through Utility Stores:The govt. is expanding the supply of essential items such as sugar,wheat, pulses at subsidized rates through the utility stores in thecountry which are likely to increase to 5000 in 2007-08.

    Cash Reserve Ratio and Discount Ratio:The SBP has increased the cash reserve ratio from commercial banks from 5%to 7% and discount ratio to 9.5% to 9% for controlling the money supply.

    A variety of methods have been used in attempts tocontrol inflation.

    Monetary policy:

    Today the primary tool for controlling inflation is monetary policy. Mostcentral banks are tasked with keeping the federal funds lending rate at

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    a low level; normally to a target rate around 2% to 3% per annum, andwithin a targeted low inflation range, somewhere from about 2% to 6%per annum. A low positive inflation is usually targeted, as deflationaryconditions are seen as dangerous for the health of the economy.

    There are a number of methods that have been suggested to controlinflation. Central banks such as the U.S. Federal Reserve can affectinflation to a significant extent through setting interest rates andthrough other operations. High interest rates and slow growth of themoney supply are the traditional ways through which central banksfight or prevent inflation, though they have different approaches. Forinstance, some follow a symmetrical inflation target while others onlycontrol inflation when it rises above a target, whether express orimplied.

    Monetarists emphasize keeping the growth rate of money steady, andusing monetary policy to control inflation (increasing interest rates,slowing the rise in the money supply). Keynesians emphasize reducingaggregate demand during economic expansions and increasingdemand during recessions to keep inflation stable. Control ofaggregate demand can be achieved using both monetary policy andfiscal policy (increased taxation or reduced government spending toreduce demand)

    Fixed exchange rates:

    Under a fixed exchange rate currency regime, a country's currency istied in value to another single currency or to a basket of othercurrencies (or sometimes to another measure of value, such as gold). Afixed exchange rate is usually used to stabilize the value of a currency,vis-a-vis the currency it is pegged to. It can also be used as a means tocontrol inflation. However, as the value of the reference currency risesand falls, so does the currency pegged to it. This essentially meansthat the inflation rate in the fixed exchange rate country is determinedby the inflation rate of the country the currency is pegged to. Inaddition, a fixed exchange rate prevents a government from using

    domestic monetary policy in order to achieve macroeconomic stability.

    Under the Bretton Woods agreement, most countries around the worldhad currencies that were fixed to the US dollar. This limited inflation inthose countries, but also exposed them to the danger of speculativeattacks. After the Bretton Woods agreement broke down in the early1970s, countries gradually turned to floating exchange rates. However,in the later part of the 20th century, some countries reverted to a fixed

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    exchange rate as part of an attempt to control inflation. This policy ofusing a fixed exchange rate to control inflation was used in manycountries in South America in the later part of the 20th century (e.g.Argentina (1991-2002), Bolivia, Brazil, and Chile).

    Gold Standard:

    Under a gold standard, paper notes are convertible into pre-set, fixedquantities of gold.

    The gold standard is a monetary system in which a region's commonmedia of exchange are paper notes that are normally freelyconvertible into pre-set, fixed quantities of gold. The standard specifieshow the gold backing would be implemented, including the amount ofspecie per currency unit. The currency itself has no innate value, but is

    accepted by traders because it can be redeemed for the equivalentspecie. A U.S. silver certificate, for example, could be redeemed for anactual piece of silver.

    Gold was a common form of representative money due to its rarity,durability, divisibility, fungibility, and ease of identification.[43]Representative money and the gold standard were used to protectcitizens from hyperinflation and other abuses of monetary policy, aswere seen in some countries during the Great Depression. However,they were not without their problems and critics, and so were partially

    abandoned via the international adoption of the Bretton WoodsSystem. Under this system all other major currencies were tied at fixedrates to the dollar, which itself was tied to gold at the rate of $35 perounce. The Bretton Woods system broke down in 1971, causing mostcountries to switch to fiat money money backed only by the laws ofthe country. Austrian economists strongly favor a return to a 100percent gold standard

    Wage and Price Controls:

    Another method attempted in the past has been wage and pricecontrols ("incomes policies"). Wage and price controls have beensuccessful in wartime environments in combination with rationing.However, their use in other contexts is far more mixed. Notablefailures of their use include the 1972 imposition of wage and pricecontrols by Richard Nixon. More successful examples include the Pricesand Incomes Accord in Australia and the Wassenaar Agreement in theNetherlands.

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    In general wage and price controls are regarded as a temporary andexceptional measure, only effective when coupled with policiesdesigned to reduce the underlying causes of inflation during the wageand price control regime, for example, winning the war being fought.

    They often have perverse effects, due to the distorted signals theysend to the market. Artificially low prices often cause rationing andshortages and discourage future investment, resulting in yet furthershortages. The usual economic analysis is that any product or servicethat is under-priced is over consumed. For example, if the official priceof bread is too low, there will be too little bread at official prices, andtoo little investment in bread making by the market to satisfy futureneeds, thereby exacerbating the problem in the long term.

    Temporary controls may complement a recession as a way to fightinflation: the controls make the recession more efficient as a way to

    fight inflation (reducing the need to increase unemployment), while therecession prevents the kinds of distortions that controls cause whendemand is high. However, in general the advice of economists is not toimpose price controls but to liberalize prices by assuming that theeconomy will adjust and abandon unprofitable economic activity. Thelower activity will place fewer demands on whatever commodities weredriving inflation, whether labor or resources, and inflation will fall withtotal economic output. This often produces a severe recession, asproductive capacity is reallocated and is thus often very unpopularwith the people whose livelihoods are destroyed (see creativedestruction).

    Cost-of-living Allowance:

    The real purchasing-power of fixed payments is eroded by inflationunless they are inflation-adjusted to keep their real values constant. Inmany countries, employment contracts, pension benefits, andgovernment entitlements (such as social security) are tied to a cost-of-living index, typically to the consumer price index.[49] A cost-of-livingallowance (COLA) adjusts salaries based on changes in a cost-of-livingindex. Salaries are typically adjusted annually.[49] They may also betied to a cost-of-living index that varies by geographic location if the

    employee moves.

    Annual escalation clauses in employment contracts can specifyretroactive or future percentage increases in worker pay which are nottied to any index. These negotiated increases in pay are colloquiallyreferred to as cost-of-living adjustments or cost-of-living increasesbecause of their similarity to increases tied to externally-determinedindexes. Many economists and compensation analysts consider the

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    idea of predetermined future "cost of living increases" to be misleadingfor two reasons: (1) For most recent periods in the industrialized world,average wages have increased faster than most calculated cost-of-living indexes, reflecting the influence of rising productivity and workerbargaining power rather than simply living costs, and (2) most cost-of-

    living indexes are not forward-looking, but instead compare current orhistorical data.

    EFFECTS OF INFLATION ON ECENOMY IN PAKISTAN:The following are the effects of inflation in Pakistan.

    Negative Effects:

    An increase in the general level of prices implies a decrease in thepurchasing power of the currency. That is, when the general level ofprices rises, each monetary unit buys fewer goods and services, so inPakistan due to high rate of inflation people have low purchasing

    power and they cannot get luxury goods and services as well asnecessary goods and services.

    Unpredictable rates of Inflation discourage investments and savings.Because there is no convenient plans for the price level of goods andservices, so the investor does not make long term plan for theircompanies. As in Pakistan there is high and unpredictable inflationrate. So in those types of countries, investor does not predict about thelong term planning for their organization.

    The effects of inflation can be brutal for the elderly who are looking to

    retire on a fixed income. The rupees that they expect to retire with willbe worth less and less as time goes on and inflation goes higher.

    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

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    devalued, creating shortages of the hoarded objects.

    Hyperinflation:

    If inflation gets totally out of control (in the upward direction), it cangrossly interfere with the normal workings of the economy, it hurting

    its ability to supply.

    Allocative Efficiency:

    A change in the supply or demand for a good will normally cause its

    price to change, signaling 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 resultis a loss of Allocative efficiency.

    Shoe Leather Cost:

    High inflation increases the opportunity cost of holding cash balances

    and can induce people to hold a greater portion of their assets in

    interest paying accounts. However, since cash is still needed in order

    to carry out transactions this means that more "trips to the bank" are

    necessary in order to make withdrawals, proverbially wearing out the

    "shoe leather" with each trip.

    Menu Costs:

    With high inflation, firms must change their prices often in order to

    keep up with economy wide changes. But often changing prices is itself

    a costly activity whether explicitly, as with the need to print new

    menus, or implicitly.

    Business Cycles:

    According to the Austrian Business Cycle Theory, inflation sets off the

    business cycle. Austrian economists hold this to be the most damaging

    effect of inflation. According to Austrian theory, artificially low interest

    rates and the associated increase in the money supply lead to reckless,

    speculative borrowing, resulting in clusters of mal investments, which

    eventually have to be liquidated as they become unsustainable.

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    Positive Effects:

    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, Keynesians argue that some inflation is good

    for the economy, as it would allow labor markets to reach equilibrium

    faster.

    Debt relief:

    Debtors who have debts with a fixed nominal rate of interest will see a

    reduction in the "real" interest rate as the inflation rate rises. The

    real interest on a loan is the nominal rate minus the inflation rate.

    [dubious discuss] (R=n-i) For example if you take a loan where the

    stated interest rate is 6% and the inflation rate is at 3%, the real

    interest rate that you are paying for the loan is 3%. It would also hold

    true that if you had a loan at a fixed interest rate of 6% and the

    inflation rate jumped to 20% you would have a real interest rate of

    -14%. Banks and other lenders adjust for this inflation risk either by

    including an inflation premium in the costs of lending the money by

    creating a higher initial stated interest rate or by setting the interest ata variable rate.

    Room to maneuver:

    The primary tools for controlling the money supply are the ability to set

    the discount rate, the rate at which banks can borrow from the central

    bank, and open market operations which are the central bank's

    interventions into the bonds market with the aim of affecting the

    nominal interest rate. If an economy finds itself in a recession with

    already low, or even zero, nominal interest rates, thenthe bank cannot

    cut these rates further (since negative nominal interest rates are

    impossible) in order to stimulate the economy - this situation is known

    as a liquidity trap. A moderate level of inflation tends to ensure that

    nominal interest rates stay sufficiently above zero so that if the need

    arises the bank can cut the nominal interest rate.

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    Tobin Effect:

    The Nobel Prize winning economist James Tobin at one point had

    argued that a moderate level of inflation can increase investment in an

    economy leading to faster growth or at least higher steady state level

    of income. This is due to the fact that inflation lowers the return on

    monetary assets relative to real assets, such as physical capital. To

    avoid inflation, investors would switch from holding their assets as

    money (or a similar, susceptible to inflation, form) to investing in real

    capital projects. See Tobin monetary model.

    Indicators:

    Gross Domestic Product (GDP):

    The most important indicator is the GDPreport. Basically, the GDP isthe widest measure of the state of the economy. The figure is releasedat 8:30 am EST on the last day of each quarter and reflects theprevious quarter. The GDP is the aggregated monetaryvalue of all thegoods and services produced by the entire economy during the quarter(with the exception of internationalactivity). The key number to lookfor is the growth rate of GDP. Generally, the U.S. economy grows ataround 2.5-3% per year and deviations from this range can have a

    significant impact. Growth above this level is often thought to beunsustainable and a precursor to high inflation, and the Fed usuallyresponds by trying to slow down the "overheated" economy. Growthbelow this range (and especially negative growth) means that theeconomy is running slowly, which can lead to increased unemploymentand lower spending. It is worth noting that each initial GDP report willbe revised twice before the final figure is settled upon: the "advance"report is followed by the "preliminary" report about a month later anda final report a month after that. Significant revisions to the advancenumber can cause additional ripples through the markets. The GDPnumbers are reported in two forms: current dollar and constant dollar.

    Current dollar GDP is calculated using today's dollars and makescomparisons between time periods difficult because of the effects ofinflation. Constant dollar GDP solves this problem by converting thecurrent information into some standard era dollar, such as 1997dollars. This processfactors out the effects of inflation and allows easycomparisons between periods. Don't confuse Gross Domestic Productwith Gross National Product (GNP). GDP includes only goods andservices produced within the geographic boundaries of the U.S.,

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    regardless of the producer's nationality. GNP doesn't include goods andservices produced by foreign producers, but does include goods andservices produced by U.S. firms operating in foreign countries. Forexample, if a U.S. firm was operating a chain ofstores in France, thegoods and services produced by those stores would not be included in

    the GDP, but would be included in the GNP. As the global economygrows, the difference in GDP and GNP is falling for developed countrieslike the U.S. But for smaller, developing countries, the difference canbe substantial.

    Consumer Price Index (CPI):

    The CPI is the most widely used measure of inflation. The report isreleased at 8:30 am EST around the 15th of each month and reflectsthe previous month's data. The CPI measures the change in the cost ofa bundle ofconsumer goods and services. The bundle includes about

    200 types of goods and thousands of actual products, ranging fromfoods and energy to expensive consumer goods. The prices aremeasured by taking a sample of prices at different stores. In additionto the overall CPI number, it is important to also look at the "core rate."The core rate excludes volatile goods like food and energy and gives acloser measure of real inflation. Most reports of the CPI numbers willinclude both the overall and the core numbers. The CPI is alsoimportant because it is used to adjust the annual changes to SocialSecuritypayments. There has been much debate about how well theCPI measures inflation and some feel that it is an imperfect way totrack rising prices

    The Producer Price Index (PPI):

    As mentioned above, the PPI is one of the two most important ways tomeasure inflation (along with the CPI). The PPI is released at 8:30 amEST during the second full week of each month and reflects theprevious month's data. The index measures the price of goods at thewholesale level. So, while the CPI tracks the cost paid by consumers forgoods, the PPI tracks how much the producers are receiving for thegoods. There are three types of goods measured by the PPI: crude,intermediate, and finished. Crude goods are raw materials used in

    production of something else, intermediate goods are components of alarger product, and finished goods are what is actually sold to areseller. The finished goods data are the most closely watched becausethey are the best measure of what consumers will actually have to pay.

    Employment Cost Index (ECI):

    The ECI is another important measure of inflation. Released at 8:30 am

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    EST on the last Thursday of January, April, July, and November, the ECImeasures the cost of labor including wages, benefits, and bonuses. Thereason the ECI is thought to be an indicator of inflation is that as wagesincrease, the added cost is often passed to consumers shortlythereafter in the form of higher prices (inflation). In combination with

    the productivity report (see below) the ECI can reveal whether theincreased cost of labor is justified or not.

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