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 Chapter 2 Chapter 3 3.1 3.2 3.3 3.4 3.5
Chapter 4 Chapter 5 References
Introduction & Background Measures Of Price Inflation Wholesale Price Index Cons
umer Price Index Implicit GNP Price Deflator Implicit Price Deflator Of Total Do
mestic Absorption Unit Value Index Of Imports Index Of Retail Price The Tax Pric
e Index (TPI) Problems And Costs Of Inflation Arbitrary Redistribution Of Income
Breakdown Of Adjustment Mechanisms Effect On Company Accounting Failure Of Gove
rnment Intervention Problem Of Domestic Price Rises Causes Of Inflation Too Much
Spending – Demands Pull Inflation Cost Push Inflation Too Much Money – The Mone
tarist Explanation Problem Statement Scope And Limitations Objectives Of The Stu
dy Definitions Of Terms Literature Review Research Methodologies Purpose Of The
Study Type Of Investigation Study Setting Time Horizon Research Instruments Inte
rpretation & Analysis Of Data Conclusions & Recommendations
1 4 4 5 5 5 6 6 8 9 10 11 11 11 12 13 13 14 18 21 21 22 23 25 33 34 34 35 35 35
37 53 60
1
EXECUTIVE SUMMARY
Generally, monetary growth, public policy, administered prices, rise in the pric
es of imported goods, inflationary expectations and output growth are termed as
the determinants of inflation in Pakistan. One group of economists considers inf
lation 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 reco
rded a meager growth of 2.5 per cent per annum during last five years which is e
ven lower than 3.0 per cent population growth rate. The effect of poor agricultu
re 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 w
ith 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. Pakis
tan saw a very high rate of monetary growth between 1990-91 and 1995-96, averagi
ng 18.8 per cent per annum. Inflationary Gap=monetary growth-(real GDP growth +p
rice inflation) The National Credit Consultative Council (NCCC) has approved a m
onetary growth rate figure of 14 per cent for 1997-98. Increases in the world pr
ice of imports in the world market and a 40 per cent devaluation / depreciation
in the Pakistan rupee from January 1991 to June 1997 fuelled
2
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 fu
nds to run the machinery of the government. The government has to borrow to serv
ice 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 d
eficit, budget deficit, are violated. A low saying rate in the country is also o
ne of the causes of rising inflation. In the wake of 14 per cent inflation and a
n average 10 per cent deposit rates, depositors are getting negative real rates
of return on their deposits. Trading further raises the price level by manipulat
ion 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 ex
pedites this trend further.
Devaluation is also one of the consequences of inflation. Due to double digit in
flation Pakistan has been caught in the vicious circle of devaluation (devaluati
on inflation loss of competitiveness again devaluation).
3
DEDICATION
I dedicate this humble effort to my loving parents without whom I would have bee
n nothing, to my teachers whose guidance, strength of character and spiritual le
arning showed me the light in dark moments of life and to every kid who is growi
ng up to be a warrior for my mother country Kashmir
4
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 departmen
ts/agencies/multilateral institutions for providing the relevant material and da
ta to prepare the project in right manner. I am thankful to my friends without t
heir support and guidance, I would have been in great difficulty. I sincerely ho
pe that this study though more objective but would contribute definitely in dete
rmining the cause and effects of one of the major problem in economic sector.
5
CHAPTER 1
INTRODUCTION & BACKGROUND
6
INTRODUCTION
The subject of price inflation has been a concern of wide importance for economi
sts and common economic agents during the past two decades. Various theories hav
e been put forward to explain continuing inflation all over the world. In Pakist
an also the subject of inflation has been the central issue in most of the studi
es on macroeconomics. Various factors which have been considered in the literatu
re as strong forces in determining price inflation include monetary expansion, s
tagnation of output, increasing import prices, increasing wage rates, sticky exp
ectations (habit persistence), etc. The evidence, however, does not fully suppor
t all these factors as the causes of inflation. This is partly due to the contro
versial nature of the subject of macroeconomics.
It may not be wrong to suggest that macroeconomics has been advanced to its pres
ent 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 techni
ques when applied to aggregate time series data. But there is no denial to the f
act 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 upda
te our knowledge on the inflationary process in Pakistan. While this study was i
n progress, the government
7
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 gro
wth by providing a more conducive environment for private investment. Being the
key component of a stable macroeconomic environment low and stable inflation ass
umes 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 st
able. 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 fall
s over the years but it rarely becomes negative. If the inflation rate is negati
ve, it means the average price level is falling which is not good for the econom
y. A recent study suggests that some level of inflation is essential for promoti
ng growth and investment. In other words, there exists a threshold beyond which
inflation exerts a negative effect on growth. The threshold is lower for industr
ial 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-m
aking arising from high or variable inflation rates and result in lower levels o
f output than would otherwise be the case. High inflation is also a regressive a
nd arbitrary tax, the burden of which is typically borne disproportionately by t
hose 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
8
Causes of Inflation in Pakistan point is that price stability is not an end in i
tself; it is essential for sustaining higher economic growth - the single most i
mportant factor influencing poverty.
1.1 MEASURES OF PRICE INFLATION
Inflation rate is defined as the percentage growth rate of some measure of gener
al (or overall) price level prevailing in an economy between any two periods. In
macroeconomics context the general price level is supposed to represent the ove
rall picture of the prices of goods and services prevailing in an economy. A goo
d measure of general price level should be based on the prices of most of the im
portant goods and services. In Pakistan different measure of general price level
are either directly available or they can be easily constructed from the availa
ble data. The choice of an appropriate general price level essentially depends o
n 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 pri
ce level.
1.1.1 Wholesale Price Index:
The wholesale price index is based on the wholesale prices of most of the import
ant items being consumed. This measure of general price level is a useful price
indicator for business community, in particular the wholesale traders.
9
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 st
udy 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 d
ividing GNP at current prices by GNP at constant price level is the Paasche pric
e index of all the goods and services produced by a nation. Due to its broad cov
erage, 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 v
alue 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 suita
ble to evaluate the over time changes in the cost of buying a fixed basket of go
ods 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 con
sumed domestically, are also included while the prices of imports, which are dom
estically consumed, are excluded. To
10
Causes of Inflation in Pakistan overcome this problem we suggest another implici
t 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 d
omestic expenditure. The total domestic absorption is defined as GNP plus import
s minus exports or alternatively private and public expenditure on consumption a
nd gross investment. The price inflation based on this implicit price deflator i
n our opinion is a better measure of changes in the cost of buying a fixing bask
et 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 th
e 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, a
nd comprises the total cost of a representative basket of final goods and servic
es. All households are included, except pensioners, who are mainly dependent on
state income, and the wealthiest 4 per cent. Clearly those businesses whose targ
et population includes the 15 per cent of households that consist of retired peo
ple could be misled if they based their calculations on the RPI alone!
11
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 v
alue of 100. Base-year prices will then be divided into successive year prices a
nd multiplied by 100 to yield a series. To translate this into an annual percent
age, 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 samp
le data from the Family Expenditure Survey, to reflect changing patterns of hous
ehold consumption. Published the following month, the RPI is not seasonally adju
sted. Instead it is expressed as a rate of increase on the same month a year ear
lier. A full understanding of the underlying trends requires study of the contri
bution of the various components to the aggregate outcome. In February 1991, for
example, the price of many household goods, such as footwear, actually fell, de
spite an RPI rise of 9 per cent. Marketers also need to recognize that the publi
shed RPI informs customers’ expectations and perceptions of price changes. Durin
g 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 infe
rior goods and ‘value for money’ promotions.
The index includes a wide cross-section of items, including housing costs. And t
herefore is used by governments to determine the annual increase in index-linked
benefits, such as
12
Causes of Inflation in Pakistan unemployment pay and tax thresholds. The index r
eflects changes in the cost of living or the money that must be spent to purchas
e 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 ris
es 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 mar
kets, it would be politically attractive for the government to remove these elem
ents. The difficulty of justifying the case that mortgage payments do not reflec
t 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 standa
rds 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 progre
ssively introduced it. Unfortunately for the government the need for tight budge
ts and sharp increases in national insurance actually caused the TPI to rise, ec
lipsing its value in depressing inflationary expectations.
13
1.4 Problems and costs of inflation
Inflation assumes problem proportions when the general level of prices rises bot
h continuously and unpredictably. However, it is far from agreed that zero or ev
en falling prices are preferable. Prices fell between 1920 and 1934, yet this pe
riod was associated with stagnation, unemployment and widespread poverty. In com
parison, the period from 1952to 1967 was associated with historically rapid econ
omic 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 performanc
e. 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 appre
ciation 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 stru
ctural 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.
14
Causes of Inflation in Pakistan The nature of this inflation differs markedly fr
om the image prevailing after 1967, as the costs and inefficiencies of more rapi
d inflation reversed the benefits outlined above. Once inflation exceeds the cri
tical rate of around 10 per cent, it becomes a problem that negatively affects m
ost groups within society.
1.4.1 Arbitrary redistribution of income
Such inflation causes as arbitrary redistribution of income, from the weak to th
e strong, the saver to the borrower and from the retired to that still in full e
mployment. People on fixed incomes suffer the greatest erosion, closely followed
by those unable to keep pace with its rise, owing to weak bargaining power. Nom
inal interest rates, for example, failed to keep pace with prices through much o
f 1970s, are imposing on pensioners.
Debtors, such as mortgage-holders and the government, benefit from the process a
s the real value of their debts evaporates. Inflation is ‘taxation without repre
sentation’, as rising prices and incomes increases tax yields. Know as fiscal dr
ag, this process literally drags previously exempt low wage earners into the tax
net. Since both the above mechanisms make governments the major beneficiary fro
m inflation, it should not be assumed that they would consistently pledge themse
lves to its defeat.
15
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 prot
ecting wealth rather than create it.
1.4.3 Effect on company accounting
Business using historical cost accounting standards can be misled by paper profi
ts. 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 no
rmally depreciated at $500 per annum. Annual inflation of 10 per cent would, how
ever, 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 s
uch as discretionary allowances, price freezes, subsides and controls merely ser
ve to impair the market mechanisms still further, as one control leads to the ne
ed for another. Such intervention gives the appearance a government is taking ac
tion, but only addresses the symptoms rather than underlying causes.
16
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 su
ch as the ERM, then a rising balance of payments deficits will force its value t
o the lower end of the permitted range. The government would therefore be forced
to raise interest rates and deflate the economy and until differential inflatio
n was squeezed out of the system. In this respect the real problem is not the in
flation 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 o
utcome. Successive devaluations of the pound provided only short-term relief of
business seeking to compete at home and abroad. The falling pound, which made ov
erseas manufactures less competitive, also made imported foods, fuels, materials
and other inputs more expensive, feeding directly into domestic factory costs a
nd wage demands. The outcome was a wage-price-devaluation spiral, with shortenin
g time spans between the spirals.
17
1.5 Causes of inflation
Inflation is often defined in reference to its causes. ‘Too much money cashing t
oo few goods’ is one such example. There is, however, little agreement as to the
precise cause of the inflation, especially amongst economists. There major infl
ation theories will be discussed below and the various strands from each will th
en 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 wh
en 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 out
put, 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 fur
ther 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 prod
uctivity growth of 2 to 2 ½ percent, zero inflation would be achieved at 2-½ per
cent unemployment. Attempts to operate the economy below this level would genera
te 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.
18
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 unsu
pportable levels.
If pricing is based on a cost-plus formula, for example, higher costs will be au
tomatically reflected in price rises as business struggle to maintain profit mar
gins. Such supply-sides pressures may be expected to diminish rapidly if such ri
ses result in sharply reduces sales, output and factor employment. If, on the ot
her hand, businesses and unions believe the government is unwilling to contempla
te 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 m
oney supply and aggregate demand by the amount necessary to maintain sales at th
e higher price level. Any government prepared to underwrite such a wage-price sp
iral will ensure that little incentive will be provided for management to resist
cost pressures.
19
Causes of Inflation in Pakistan The sources of cost-push inflation are as follow
s.
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 deman
d and obtain higher wage settlements to raise their shares, businesses restore p
rofitability 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 t
he process, so suppressing the conflict. Another is forced to accept a lower sha
re, 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, erodin
g the value of the rises obtained by the high productivity workers, and promotin
g compensating claims. A rigid wage structure provides many such linkages, and c
ould readily support a general wage-wage spiral.
20
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, owin
g to falling primary product prices and near constant unit labor costs as produc
tivity improved sharply. Profit push contributed to inflation through most of th
e 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 comp
ensating wage claims. The switch from direct to indirect taxation, as occurred i
n 1979, served to raise the RPI by 3 ½ percentage points, while government polic
ies to cut borrowing by reducing nationalized industry subsidies and raising cou
ncil-housing rents and rates have also caused above average rises in the RPI. Th
e 1991 budget also shifted the balance of taxation By raising VAT and excises to
finance a cut in the community charge.
21
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 d
imension to inflation is very important in an open economy like Britain’s. Infla
tion is very much an international problem, with industrial nations experiencing
similar patterns. The causes of this international inflation must be a large pa
rt of the explanation of British inflation, while domestic factors can be examin
ed to explain any divergence from the average. The common factor in recent infla
tionary 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. Accommo
dating this with an expansion in world money supply produced inflation, while er
oding the real value of OPEC gains. OPEC therefore responds with a further round
of price increases. These sharp and unanticipated rises and a generalized impac
t 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 importde
pendent competitors, making further explanation necessary. The downward float of
the pound in the early 1970s was one factor, since it caused import prices to r
ise sharply, feeding into inflation and promoting compensating wage demand.
Cost-push pressures as outlined above were identified as explanation of the unde
rprediction of inflation after 1970. Despite unemployment rising to 1 million (4
per cent),
22
Causes of Inflation in Pakistan inflation remained high, producing a condition t
ermed stagflation. It was argued that this new inflation was due to union milita
ncy, underpinned by strong membership growth. The incidence of strikes was risin
g, led by a new and younger breed of shop steward. Politicians too were partly t
o blame by stimulating faster growth expectations at election times. These prove
d unsupportable, especially in recession. More sophisticated media coverage made
inflation more noticeable than before, while unpopular experience of decimaliza
tion and the introduce of VAT served policies lost their effectiveness, there wa
s 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 lon
g run relationship is represented by the quantity theory equation of Irving Fish
er:
MV=PT Where: M = supply of money, P = price level V = velocity of circulation of
money T = level of transactions.
23
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 transacti
ons 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 pr
ice level. Reform of the monetary system in 1971 produced an unplanned expansion
in money supply that added to inflationary pressure, as did financial deregulat
ion in the mid-1980s.
Monetarist explained the breakdown of the Phillips curve by relating the rate ch
ange 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 exte
nt they had been proved wrong in the past. The only way that the government coul
d maintain unemployment below the natural rate was its actual inflation exceeded
expected inflation, thereby reducing real wages to justify the extra jobs creat
ed.
Error learning meant that this could only be achieved at the expense of accelera
ting 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 inflat
ion this produces shifts the short-run Phillips curve to P2 as expectations adju
st 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 sh
own as wage rises to W3. There is no permanent trade-off a little less unemploym
ent for a little more inflation. Instead the acceleration would be unsustainable
, ending in hyperinflation. Only with zero excess demand is a steady inflation r
ate possible under this theory. On this analysis, then, curing
24
Causes of Inflation in Pakistan the problem, although painful, is no worse than
sickness, since inaction will only produce a worsening in the condition.
25
1.6 PROBLEM STATEMENT
In Pakistan there is wide spread of poverty unemployment and inflation is consid
ered as the main cause of this. There are different factors responsible for infl
ation. In Pakistan people purchasing power is decreasing as compared to rise in
general price level. Inflation is caused by general price level, change in relat
ive 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 ca
rried out various steps.
In this study I studied about the various factor that cause inflation and sugges
ted 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 maj
or 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 t
o face severe sanctions imposed on it due to the nuclear tests in 1998. Therefor
e 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 e
mphasis on the past 5 years situation. Inflation rate has been at its lowest due
to government policies, stable rupee and increase in foreign reserves.
26
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 gover
nment’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 respon
sible for inflation. In Pakistan inflation is increasing at very hg rate. Object
ives are as under
• • • • •
Poverty Alleviation. Gender development. Reduce risks faced by poor. Enhance out
reach. 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.
27
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 m
onths.
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.
28
Causes of Inflation in Pakistan Stagflation is the combination of high unemploym
ent and economic stagnation with inflation.
Consumer Price Index (CPI) is a measure of price changes in consumer goods and s
ervices such as gasoline, food, clothing, and automobiles. The CPI measures pric
e change from the perspective of the purchaser.
Producer Price Indexes (PPI) is a family of indexes that measure the average cha
nge over time in selling prices by domestic producers of goods and services. PPI
s measure price change from the perspective of the seller.
Treasury Inflation-Protected Securities (TIPS) are a special type of Treasury no
te or bond. TIPS are like any other Treasury, except that the principal and coup
on payments are tied to the CPI and increased to compensate for any inflation.
29
CHAPTER 2
LITERATURE SURVEY
30
Causes of Inflation in Pakistan Price inflation has been a widely studied issue
in literature. The subject has also attracted considerable attention of economis
ts in Pakistan. In particular the subject gained more interest in 1970’s and 198
0’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. I
n this section we will review some of these studies with emphasis on their metho
dology 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 d
uring 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 bank
ing system is not fully developed. Disagreeing with the application of standard
monetary theory in explaining inflationary process in Pakistan, he argued that p
rices movements and the demand for real money balances in Pakistan correspond wi
th the trends in harvest. In case of harvest failure there is tendency among man
y stockists to hold purchased cereal rather than money. Therefore the demand for
the real money balances decreases along with increase in price level. Furthermo
re, 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 dem
and for real money balances for transaction purpose.
31
Causes of Inflation in Pakistan Another study on inflation Pakistan by Islam (19
63) covers the period 1950-51 to 195859. According to the author during this per
iod increased government expenditure resulted in a rapid increase in money suppl
y. 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 ou
tput increased rapidly, resulting in price inflation. The author further argued
that after the collapse of Korean War import prices increased which also contrib
uted to price inflation. He suggested that industrialization process via the pol
icy 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 19
59-60 to 197273. The regression equations contained the growth rate of money sup
ply in the current and previous years and the current level of GDP measured at c
onstant prices as explanatory variables in determining inflation rate measured a
lternatively by the growth rates of wholesale price index and consumer price ind
ex. The author concluded that demand factors played a major role in the inflatio
nary process.
The most comprehensive study on inflation in Pakistan has been conducted by Mang
la (1981). With the help of regression analysis he tested four main hypotheses i
n his study, namely the two-way causation hypothesis based on monetarists models
, the imported inflation hypothesis, the cost-push hypothesis and the dominant i
mpulse hypothesis. The study is based on annual observations over the period 196
1-1979.
32
Causes of Inflation in Pakistan The essential idea behind two-way causation hypo
thesis in the monetarist’s model of inflation, as explained by Mangla, is that t
he increase in price level trends to increase government expenditure faster than
government revenues. The resulting budget deficit induces increase in money sup
ply and further builds up inflationary pressures. In other words, the increase i
n money supply is both the cause of inflation and the result thereof. In his reg
ression exercise the author found that the two-way causation hypothesis of monet
arists model performed moderately in case of Pakistan. The author concluded that
there is strong likelihood of inflation being explained partly by some other fa
ctors 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 chang
es in money supply and import prices significantly affected the domestic inflati
on rate. He also observed that the relative importance of monetary changes as co
mpared 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 mon
ey 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 aggregat
e 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 emp
irical evidence performed by the author suggests that the first two of these imp
ulses dominated the latter two in shaping the inflationary phenomenon. The finan
cial and the foreign impulses had only a marginal effect on price level.
Bilquees attempted two studies on inflation in Pakistan. In her first study Bilq
uees (1981) applied the monetarists and structural models of inflation on Pakist
an 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 (c
onstraints 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 con
cluded that both the models are capable of explaining price inflation but not sa
tisfactorily 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 de
veloping countries and the Asian region countries. She also discussed the availa
ble literature on inflation in Pakistan.
The author pointed out that inflation rate during 1960’s averaged around 3 perce
nt 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 in
flation during this period like increase in non-development expenditure, slow do
wn 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 prov
iding subsidized food to urban population. Bilquees further pointed out the infl
ation rate increased rapidly in the seventies. It reached its peak rate of seven
ties at 26.60 percent in 1974-75. After a sharp decline in11975-76 to 14.11 perc
ent it remained in single digit level in the following three years. The inflatio
n 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 pri
ces from rising. The position, however, was reversed during the seventies; the i
nflation rate followed the increase in money supply while GDP registered a slow
growth. During seventies inflation rate increased two fold and money supply incr
eased four fold compared to the increase in GDP. She suggested that the major ca
use of high inflation in seventies was worldwide inflation.
While comparing inflation in Pakistan with that in other countries, the author f
ound 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 t
he world and the industrial countries. On the basis of this comparison she concl
uded 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 infla
tion in Pakistan in the context of Phillips curve relationship. He estimated a t
hree equations macro model underlying the Phillips curve relationship in the fra
mework of rational expectations using quarterly data for the period 1972-I to 19
81-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 labo
r and inflation rate.
The most recent study by Naqvi and Khan (1990), entirely based on the PIDE Macro
economic Model (1989), deals with the inflation phenomenon in Pakistan over the
period 1989-90 and 1990-91. According to their analysis inflation in Pakistan ha
s been caused by increase in money supply, slower growth in the commodity produc
ing sectors as compared to the services sector and increase in import prices. Th
e authors found that the considerable range of inflation was nit due to any dome
stic policy since 74 percent of inflation in 1989-90 was exogenously given or pr
edetermined (due to increase in import prices or inflation in previous period).
The fiscal factors, though significant determinants of inflation, were less impo
rtant in forming inflationary process as compared to the import prices and the c
omposition of GDP (the ratio of value added in the commodity producing sectors t
o the value added in the services sector).
We concluded this section with the observation that there has been mixed evidenc
e on the process of price inflation in Pakistan. Various authors have applied di
fferent 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 Pakis
tan. 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 mo
st of the studies the quality of the results has been severely undermined by lac
k of sufficient data.
37
CHAPTER 3
RESEARCH METHODOLOGY
38
3.1 Purpose of the study
This study is descriptive in nature. Descriptive study is a study where we try t
o describe certain characteristics of the existing phenomena on which interest c
enters. 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 a
nd business studies.
3.2 Type of investigation
There are generally three types of studies, which include; exploratory study, de
scriptive 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 o
f a descriptive study is to describe the relevant aspects of the phenomena of in
terest 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 explai
n the nature of certain relationships or to establish the differences among grou
ps or the independence of two or more groups or the independence of two or more
factors in a situation.
39
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 da
ta are gathered just once, perhaps over the period of days or weeks or months. T
he 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 differ
ent sources. Research instruments include face to face interviews, telephone int
erviews, computer assisted interviews, questionnaires that are personally admini
stered, sent through the mail or electronically administered, observation of ind
ividuals 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, in
terviews from economists, columnists and other relevant people. The sources of i
nformation on the Inflation are various libraries such as Institute of Banking l
ibrary, State Bank of Pakistan library, and different universities libraries suc
h as Quaid-e-Azam University, International Islamic University etc. Online journ
als on Micro credit are helpful in getting familiar with the previous research w
ork on inflation.
41
CHAPTER 4
INTERPERTATION & ANALYSIS OF DATA
42
Inflation trend in 1990’s
Pakistan has sustained a double-digit inflation between 9.8 to 13.0 percent duri
ng the first seven years of the 1990s. Not surprisingly, one of the critical mac
roeconomic 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 sour
ce of macroeconomic imbalances in the 1990s. There has been a general agreement
that lax fiscal management resulting in the excessive growth in money supply, th
e supply side bottlenecks, the adjustment in government – administered prices, t
he imported inflation (pass through of exchange rate adjustment), escalations in
indirect taxes, and inflationary expectations have the major factors responsibl
e for the persistence of a double-digit inflation during most period of the 1990
s. 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 per
cent, respectively during the seven years of the 1990s [Table 4.2} Inflation slo
wed to an
43
Causes of Inflation in Pakistan average of 5.7 percent in the remaining three ye
ars of the 1990s, mainly on account of 5.3 percent food inflation and 6.1 percen
t non-food inflation. Non-food inflation was mainly driven by the prices of POL
products and the associated rise in transport charges. Inflationary pressures ha
ve continued to diminish over the last three years mainly on account of tight mo
netary policy, prudent fiscal management, and improved supply of food items in t
he country. Although the exchange rate adjustments and the rise in international
price of POL products have put upward pressures on inflation but these pressure
s were countered by the tight monetary policy fully supported by fiscal stance a
nd improvement in the supply situation in the country. During the last three yea
rs (200001 – 2002/03) overall inflation averaged 3.7 percent as against double-d
igit inflation during most period of the 1990s. As stated earlier, the decline i
n overall inflation owe heavily to a low (3.1%) food inflation, as non-food infl
ation averaged 4.3 percent during the last three years.
44
45
Causes of Inflation in Pakistan Current inflation trend
Inflation averaged at 3.3 percent during July-April 2002-03. The low level of in
flation in the midst of 12.5 percent increase in money supply is the result of b
etter supply situation of essential commodities, appreciation of exchange rate,
prudent fiscal management and continued sterilization of monetary impact of mass
ive 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 percen
t respectively in the corresponding period of last year [See Table-4.3]. The hig
her increase in food inflation over the comparable period of last year is attrib
utable to increase in prices of wheat, wheat flour, rice basmati, meat, tea, veg
etable ghee and cooking oil. The increase in vegetable ghee and cooking oil is t
he result of increase in international price of palm oil and imposition of GST o
n the local manufacturing of ghee in the Federal Budget 2002-03. As shown in Tab
le 4.4, out of 19 widely consumed daily items the prices of 9 items have decline
d in the range of 3.8 percent (Chicken Farm) to 51.5 percent (potato). At the sa
me time, the prices of 10 items have increased in the range of 2.7 percent (Fres
h 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 th
eir production. Accordingly, the contribution of food inflation in overall infla
tion 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 compare
d with last year resulted mainly on account of lesser increase in fuel and light
ing group (8.5% as against 9.6% of last year) and transport & communication grou
p (5.5% as against 7.1% last year). It is important to note that during July 1-M
ay 15, 2002-03, 22 adjustments in prices of petrol have taken place - 13 times t
he 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 stoo
d 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, 200
3 as a result of the continuous escalation of POL prices in the international ma
rket. During the last four adjustments the prices of POL products declined sharp
ly 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 decl
ine of Rs.8.23/Litre or 22.2 percent. Similarly, the price of diesel (HSD) decli
ned from Rs.25.93/Litre to Rs.19.91/Litre – a decline of Rs.6.02/Litre or 23.2 p
ercent during the same period. The price of Kerosene declined from Rs.24.62 to R
s.18.53 – a decline of Rs.6.09/Litre or 24.7 percent. Contrary to the general pe
rception, the government has judiciously passed on the benefit of lower internat
ional prices of POL products to the people by lowering the domestic price of the
se 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-fo
od inflation, almost one-half contribution has come from fuel & lighting and tra
nsport and communication.
47
The month-wise analysis of inflationary trend as documented in Table-4.6 suggest
s that overall inflation continued to exhibit a broadly declining trend since Ju
ly 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 decl
ining since March 2003.
48
49
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 la
st 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 pr
ices 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, cott
on yarn, vegetable ghee etc. have increased at higher rate during the current fi
scal year than last year [See Table-4.6].
50
Sensitive Price Indicator (SPI)
The SPI is used to capture the movement in prices of 53 essential items, consume
d by the urban households with income of Rs.3000-Rs.12000 per month. The increas
e in SPI during the first ten months of the current fiscal year (July- April) 20
02-03 is estimated at 3.7 percent against 3.2 percent last year mainly due to th
e 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 i
s 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 GS
T on local manufacturing of ghee as well as substantial increase in the internat
ional price of palm oil. However, prices of some basic food items like sugar, pu
lses, red chilies, chicken (Farms), onion and potatoes have shown significant de
cline up to the range of 52% on account of improved supply position of these ite
ms [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 decontr
ol, deregulation and liberalization, believes in tackling the inflationary press
ures through economic measures rather than formal price control. However, close
vigilance is kept on unusual rise in prices through weekly meetings of the Kitch
en Items Committee, now called the Sensitive Items Price Committee (SIPC) and th
rough 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 sec
tor and persuading traders/manufacturers to refrain from unfair practices are un
dertaken 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 fis
cal 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 wit
h 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 pol
icy is not to maintain negative inflation (decline in general price level) but t
o 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 shoul
d remain within the range of 3 to 4 percent. Keeping inflation at low level shou
ld be regarded as protecting the poor from inflation tax.
52
Despite several announcements during the 1990s by each of the last three elected
governments regarding reduction of inflation from double to single digits, ther
e 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 th
e 1990s. Generally, monetary growth, public policy, administered prices, rise in
the prices of imported goods, inflationary expectations and output growth is te
rmed as the determinants of inflation in Pakistan. However, their actual contrib
ution towards inflation is debatable. One group of economists considers inflatio
n a monetary phenomenon, while the other assigns more weight age to rise in admi
nistered prices and increase in prices of imported goods as determinants of infl
ation. Overall, host of factors from both the demand and supply side are respons
ible 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 h
as grown at an average rate of more than 6 per cent per annum during the last de
cade. During the first half of 1990, however, the growth rate remained at an ave
rage of 4 per cent per annum which may be attributable to the transition of econ
omy from greater government role to private sector, inefficiency of public secto
r enterprises, lower production in large scale manufacturing, poor agriculture s
ector 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 perform
ance of the manufacturing sector is poor for the last few years and recorded a n
egative growth of 1.4 per cent this year. The agricultural sector, which contrib
utes 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 tha
n 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 reco
rded 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 s
ame 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 a
reas 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 pro
duction of these crops. Actual quantities of these crops will come into the mark
et 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 in
dex of fuel, lighting and lubricants in CPI, which comprises electricity gas an
d POL products increased 19 per cent during the year from end June, 99 to May 20
00and 98.59 per cent from 1990-91 to May 1999 which caused rise in cost of produ
ction 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, miseri
es 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 c
ent per annum. Taking into account real GDP growth and inflation, we calculate a
n average inflationary gap of 4.0 per cent for the period, as measured by the fo
llowing formula.
55
Causes of Inflation in Pakistan Inflationary Gap=monetary growth-(real GDP growt
h +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 du
e to high inflation, financing requirements of large and persistent budget defic
its of the government and the monetary overhang of previous years excessive mon
etary growth.
Increases in the world price of imports in the world market and a 40 per cent de
valuation / depreciation in the Pakistan rupee from January 1995to June 1999 fue
lled inflation to unmanageable levels. Without removing the causes of devaluatio
n, 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 devalu
ation spiral.
Large and persistent levels of trade and current account deficits due to stagnan
t exports and high levels of imports are posing several implication for inflatio
n. More than 60 per cent of our exports consist of cotton and cotton-based produ
cts, which are facing cutthroat competition in the world market. Our major impor
ts are machinery, chemicals and oil, which registered a faster growth in price i
n 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 1
4 per cent, leaving the government short of funds to run the machinery of the go
vernment. The government has to resort to debt financing, money financing and fi
nancing from external sources, which put upward pressures of different magnitude
s 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 revenue
s 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 b
udget making a very unpleasant task for the government every year. The governmen
t has to borrow to service the existing debt. Due to this, the debt pool is infl
ating day by day. As getting unlimited funds from abroad is not possible (althou
gh least inflationary in nature) the government has to resort to note printing w
hich 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 offeri
ng more than a 17 per cent rate of return on its securities leaving banks in a l
iquidity crunch and putting upward pressure on the lending rate to the private s
ector. 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 20
04 over February 2003 shows how difficult life has become for the poor: Wheat (2
2 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); t
ea 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 fu
lfill its commitments of achieving macro economic targets. Almost all targets, s
uch as GDP growth, price inflation, bank borrowing, trade deficit, budget defici
t, are violated. This hurts the credibility of the government. Costs of developm
ent 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, d
epositors are getting negative real rates of return on their deposits. Income of
the individuals is being diverted from saving to consumption and non- productiv
e channels like purchase of real estate and conspicuous consumption leaving savi
ng at a very low level of 11 per cent in the country.
Redistribution of income takes place during an inflationary regime. Resources ar
e 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 aggravat
ing the already high inequality between the rich and the poor.
A kind of rent seeking culture develops due to inflation where the businessman e
arns lucrative profits by trading existing production. This provides a disincent
ive 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 leve
l 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 an
xiety, unrest and many other social problems in the country.
Dollarization, as defined by the ratio of foreign currency deposits total moneta
ry assets (M2), takes place due the decline in the value of domestic currency. T
his process never reverses until or unless the value of the local currency is no
t restored as is evident from the study of transitional economics of the sociali
st block and other developing countries. Foreign currency deposits in Pakistan h
ave 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 in
flation Pakistan has been caught in the vicious circle of devaluation (devaluati
on inflation loss of competitiveness again devaluation).
As a result of inflation real money balances (M/P) decline and we need more mone
y 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. T
his 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 m
onetary measures, primarily through reducing the money supply or currency in cir
culation. It will suck up the excess money in the market by offering better yiel
ds, as it had done recently in the case of the six-monthly treasury hills. It so
ld such bills for Rs. 29.5 billion instead of the Rs 15 billion it had originall
y sought and at a yield of 1.72 per cent instead of a lower percentage it had of
fered 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 i
n 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 u
sed for production but as consumer banking, particularly to buy imported luxurie
s or consumer durables, like cars. While the official figures of inflation has r
isen 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 pric
es have shot up, far exceeding the previous record of Rs 200 a kilo and the onio
n prices have risen high, inflation in food prices is bound to be heavy. The tra
ders are always ready to exploit shortages or create shortages and push up the p
rices unconscionably.
61
Causes of Inflation in Pakistan Petrol and other oil prices have been rising eve
ry 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 oth
er energy prices rise pushing up the cost of industrial production and transport
ation, 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 me
at or fish prices rise in Karachi that does not mean the same kind of increase h
as 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, electrici
ty rates, wheat prices, etc does affect all the consumers.
62
CHAPTER 5
CONCLUSIONS & RECOMMENDATIONS
63
Conclusions
Consensus has developed among the economists that the inflation and output growt
h 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 inf
lation of 3 to 4 per cent is also identified. On the basis of these findings a l
ow inflation of 2-3 per cent is desirable. It can be achieved through curtailmen
t of monetary expansion, lowering budget deficit, promoting efficiency by educat
ion and skill, enhancing agriculture production through research and credit avai
lability, promoting national savings by offering positive rate of return on depo
sits and identifying profitable avenues of investment and revival of the economy
by solving the problems of sick industrial units and quick and transparent priv
atizations of public sector enterprises. During the first seven months of the cu
rrent financial year ending January 30, the Federal Bureau of Statistics says in
flation (consumer price index) was 3.38 per cent, while the Sensitive Price Inde
x, which covers largely food items, was 4.78 per cent and the wholesale price in
dex 6.43 per cent.
If the prevailing price push continues, as seems likely, the consumer price inde
x 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, particula
rly of essential items, the hardships of the people can be enormous.
64
The fact that CPI inflation has risen by 4.31 per cent in February 2003 primaril
y owing to increase in the items falling in food and beverages bring home a cruc
ial 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-hi
kes 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 i
s 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 a
n 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 gove
rnor Dr. Ishrat Husain stated at the midterm review of meeting national credit c
onsultative 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 th
e last fiscal year. In July-Feb 2002/03, CPI had risen by 3.54 per cent over Jul
y-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 enhanc
ement of agricultural production. There is need to provide credit to small farme
rs. His weak financial position and skill level prevent him from employing moder
n equipment and inputs to his farm. It is no easy task for mall farmers in Pakis
tan to obtain credit. It is
66
Causes of Inflation in Pakistan possible only after several visits to the bank a
nd 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 Pakist
an due to huge intermediation costs and stuck up loans. Implementation of recent
ly approved laws by the parliament will help cure this situation. Process of pri
vatization of the nationalized commercial banks (NCBs) should be speeded up keep
ing in view the transparency of this process.
As a long-term policy measure, human capital must be equipped with skill and kno
wledge to enhance its productivity and efficiency, and ultimately tame inflation
. The standard of living and the level of education have a strong bearing on pop
ulation growth and other matters of social and economic well being. Autonomy gra
nted 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 driv
e, controlling monetary expansion to public sector for budgetary support and red
ucing the lending rate by lowering the intermediation cost of the banking system
. Fiscal policy should be made instead of monetary policy.
67
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 Anal
ysis Of Recent Trends In Pakistan
•
1999-2000, Economic Survey Of Pakistan
68
Causes of Inflation in Pakistan • 2000-2001, Economic Survey Of Pakistan
•
•
References From Quaid E Azam University Islamabad
•
Pakistan Institute Of Development Economics (PIDE)
•
Dawn Newspaper, www.Dawn.Com
69
70
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 Anal
ysis Of Recent Trends In Pakistan
•
•
•
•
References From Quaid E Azam University Islamabad
•
Pakistan Institute Of Development Economics (PIDE)
•
Dawn Newspaper, www.Dawn.Com
71

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