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Presented By Shaheen Ali Reg No # 1431-209009 Yasir Hussein Reg No # 1431-209002 Naeem Anwar Reg No # 1431-209007
Table of Contents:• • •
1 History 2 Related definitions 3 Measures
3.1 Issues in measuring 4.1 General 4.2 Negative 4.3 Positive 5.1 Keynesian view 5.2 Monetarist view 5.3 Rational expectations theory 5.4 Austrian theory 5.5 Real bills doctrine 5.6 Anti-classical or backing theory 6.1 Monetary policy 6.2 Fixed exchange rates 6.3 Gold standard 6.4 Wage and price controls 6.5 Cost-of-living allowance
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6 Controlling inflation
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Inflation:In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.
Inflation can have positive and negative effects on an economy. Negative effects of inflation include loss in stability in the real value of money and other monetary items over time; uncertainty about future inflation may discourage investment and saving, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include a mitigation of economic recessions, and debt relief by reducing the real level of debt.
History:Inflation originally referred to the debasement of the currency. When gold was used as currency, gold coins could be collected by the government, melted down, mixed with other metals such as silver, copper or lead, and reissued at the same nominal value. By diluting the gold with other metals, the government could increase the total number of coins issued without also needing to increase the amount of gold used to make them, when the cost of each coin is lowered in this way, the government profits from an increase in seignior age. This practice would increase the money supply but at the same time lower the relative value of each coin. As the relative value of the coins decrease, consumers would need more coins to exchange for the same goods and services. These goods and services would experience a price increase as the value of each coin is reduced.
By the nineteenth century. the term "inflation" started to appear as a direct reference to the currency depreciation that occurred as the quantity of . and currency depreciation resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency. a change in the price of money which then was usually a fluctuation in metallic content in the currency. economists categorized three separate factors that cause a rise or fall in the price of goods: a change in the value or resource costs of the good. Following the proliferation of private bank note currency printed during the American Civil War.
and services (such as entertainment and health care). metals). Related definitions:The term "inflation" usually refers to a measured rise in a broad price index that represents the overall level of prices in goods and services in the economy. The term inflation then referred to the devaluation of the currency. Asset price inflation is a rise in the price of assets. The term inflation may also be used to describe the rising level of prices in a narrow set of assets.redeemable bank notes outstripped the quantity of metal available for their redemption. bonds and real estate). and Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. The Reuters-CRB Index (CCI). Core inflation is a measure of price fluctuations in a sub-set of the broad price index which excludes food and energy prices. and not to a rise in the price of goods. such as commodities (which include food. . the Producer Price Index. fuel. financial assets (such as stocks. The Consumer Price Index (CPI). goods or services within the economy. the Personal Consumption Expenditures Price Index (PCEPI) and the GDP deflator are some examples of broad price indices. eliminating food and energy prices to mitigate against short term price fluctuations that could distort estimates of future long term inflation trends in the general economy. as opposed to goods and services. The Federal Reserve Board uses the core inflation rate to measure overall inflation.
Inflation is usually estimated by calculating the inflation rate of a price index.Measures:- Annual inflation rates in the United States from 1666 to 2004. The inflation rate is the percentage rate of change of a price index over time. . usually the Consumer Price Index. The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer".
28%. and in January 2008 it was 211.S.080.S.416. meaning the general level of prices for typical U. the U. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is The resulting inflation rate for the CPI in this one year period is 4. consumers rose by approximately four percent in 2007.For instance. Consumer Price Index was 202. . in January 2007.
represent general inflation in an overall economy. with no change in quality. and distinguishing them from those price shifts resulting from changes in value such as volume. or performance. A weighted price is calculated by multiplying the unit price of an item to the number of those items the average consumer purchases.Issues In Measuring Measuring inflation in an economy requires objective means of differentiating changes in nominal prices on a common set of goods and services. . then this price difference represents inflation. quality. The combined price is the sum of the weighted average prices of items in the "basket". This is the purpose of a price index.90 to $1. can of corn changes from $0. To measure overall inflation. For example. This single price change would not. the price change of a large "basket" of representative goods and services is measured. if the price of a 10 oz. however.00 over the course of a year. Weighted pricing is a necessary means to measuring the impact of individual unit price changes on the economy's overall inflation. which is the combined price of a "basket" of many goods and services.
Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. especially for those with fixed payments. The effect of inflation is not distributed evenly. with inflation lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings. while their borrowers benefit. For example. That is. and as a consequence there are hidden costs to some and benefits to others from this decrease in purchasing power. when the general level of prices rises.General An increase in the general level of prices implies a decrease in the purchasing power of the currency. each monetary unit buys fewer goods and services. Increases in payments to workers and pensioners often lag behind inflation. .
and make it difficult for companies to budget or plan longterm. hurting its ability to supply. In the case of collective bargaining. And inflation can impose hidden tax increases. In a sense. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation. it can grossly interfere with the normal workings of the economy. signaling to buyers and sellers that they should re-allocate resources in . They add inefficiencies in the market. Hyperinflation If inflation gets totally out of control (in the upward direction). as inflated earnings push taxpayers into higher income tax rates. wages will be set as a factor of price expectations. Cost-push inflation Rising inflation can prompt employees to demand higher wages. inflation begets further inflationary expectations. This can cause a wage spiral.Negative High or unpredictable inflation rates are regarded as harmful to an overall economy. Hoarding People buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued. to keep up with consumer prices. Uncertainty about the future purchasing power of money discourages investment and saving. creating shortages of the hoarded objects. Allocative efficiency A change in the supply or demand for a good will normally cause its price to change. which will be higher when inflation has an upward trend. Rising wages in turn can help fuel inflation.
But often changing prices is itself a costly activity whether explicitly. speculative borrowing. inflation sets off the business cycle. which eventually have to be liquidated as they become unsustainable. or implicitly. 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. However. as with the need to print new menus. Austrian economists hold this to be the most damaging effect of inflation. resulting in clusters of malinvestments. But when prices are constantly changing due to inflation. Business cycles According to the Austrian Business Cycle Theory. The result is a loss of allocative efficiency. According to Austrian theory. artificially low interest rates and the associated increase in the money supply lead to reckless.response to the new market conditions. proverbially wearing out the "shoe leather" with each trip. 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. so agents are slow to respond to them. Positive Labor-market adjustments Keynesians believe that nominal wages are slow to adjust downwards. firms must change their prices often in order to keep up with economy wide changes. Menu costs With high inflation. This can lead to prolonged . genuine price signals get lost in the noise.
A moderate level of inflation tends to ensure that nominal interest rates . the real interest rate that you are paying for the loan is 3%. 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 at a variable rate. Keynesians argue that some inflation is good for the economy.disequilibrium and high unemployment in the labor market. The “real” interest on a loan is the nominal rate minus the inflation rate. as it would allow labor markets to reach equilibrium faster. Since inflation would lower the real wage if nominal wages are kept constant. the rate at which banks can borrow from the central bank.[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%. If an economy finds itself in a recession with already low. 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%. nominal interest rates. then the 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. Room to maneuver The primary tools for controlling the money supply are the ability to set the discount rate. or even zero. and open market operations which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. 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.
This is due to the fact that inflation lowers the return on monetary assets relative to real assets. susceptible to inflation. investors would switch from holding their assets as money (or a similar.stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate. form) to investing in real capital projects. To avoid inflation. 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. such as physical capital. Causes:- . See Tobin monetary model.
Adam Smith and David Hume proposed a quantity theory of inflation for money. Most can be divided into two broad areas: quality theories of inflation and quantity theories of inflation. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favorable market conditions will stimulate investment and expansion. and that visible inflation is the result of pressures in the economy expressing themselves in prices. etc. monitors causes and attempts to control inflation. cause of inflation. The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer. as part of what Robert J. Gordon calls the "triangle model": • Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending. central bank of the United Kingdom. its velocity. . The supply of money is a major. Keynesian view Keynesian economic theory proposes that changes in money supply do not directly affect prices. There are three major types of inflation.The Bank of England. a great deal of economic literature was concerned with the question of what causes inflation and what effect it has. and the nominal value of exchanges. The quantity theory of inflation rests on the quantity equation of money that relates the money supply. but not the only. Historically. There were different schools of thought as to the causes of inflation. and a quality theory of inflation for production.
leading to increased oil prices. It involves workers trying to keep their wages up with prices (above the rate of inflation)." Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. as ineffective in controlling inflation. According to the famous monetarist economist Milton Friedman. can cause cost-push inflation. This may be due to natural disasters. This theory begins with the identity: . The quantity theory of money. Monetarist view For more details on this topic. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. see Monetarists. Built-in inflation reflects events in the past. "Inflation is always and everywhere a monetary phenomenon. a sudden decrease in the supply of oil. For example. or increased prices of inputs.• • Cost-push inflation. Built-in inflation is induced by adaptive expectations." is caused by a drop in aggregate supply (potential output). simply stated. and is often linked to the "price/wage spiral". They consider fiscal policy. or government spending and taxation. and firms passing these higher labor costs on to their customers as higher prices. leading to a 'vicious circle'. and so might be seen as hangover inflation. says that the total amount of spending in an economy is primarily determined by the total amount of money in existence. Monetarists believe the most significant factor influencing inflation or deflation is the management of money supply through the easing or tightening of credit. also called "supply shock inflation.
. and do not respond solely to immediate opportunity costs and pressures. In this view. The formula is an identity because the velocity of money (V) is defined to be the ratio of final expenditure ( ) to the quantity of money (M).Where M is the quantity of money. the general price level is affected by the level of economic activity (Q). Rational expectations theory Main article: Rational expectations theory Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their wellbeing. P is the general price level. while generally grounded in monetarism. rising prices are merely consequences and this semantic difference is important in defining inflation. future expectations and strategies are important for inflation as well. see The Austrian view of inflation The Austrian School asserts that inflation is an increase in the money supply. Q is an index of the real value of final expenditures. V is the velocity of money in final expenditures. Austrian theory For more details on this topic. In this formula. the quantity of money (M) and the velocity of money (V).
which permits or allows an increase in the money supply. quantity theory applies to the level of fractional reserve accounting allowed against specie. This interpretation of inflation implies that inflation is always a distinct action taken by the central government or its central bank. primarily of . the Austrian School also maintains that the effects of increasing the money supply are magnified by credit expansion. which is "real bills" that they buy from merchants. as a result of the fractional-reserve banking system employed in most economic and financial systems in the world. RBD has remained a minor topic. Real bills doctrine Main article: Real bills doctrine Within the context of a fixed specie basis for money. Currency and banking schools of economics argue the RBD that banks should also be able to issue currency against bills of trading. Within this context.Austrian economists believe there is no material difference between the concepts of monetary inflation and general price inflation. and the move towards deficit financing of government. In the wake of the collapse of the international gold standard post 1913. Austrian economists measure monetary inflation by calculating the growth of new units of money that are available for immediate use in exchange. generally gold. and in the formation of the Federal Reserve. held by a bank. In addition to state-induced monetary expansion. that have been created over time. This theory was important in the 19th century in debates between "Banking" and "Currency" schools of monetary soundness. one important controversy was between the quantity theory of money and the real bills doctrine (RBD).
a governor of the Federal Reserve going so far as to say it had been "completely discredited. Monetary policy Main article: Monetary policy . Controlling inflation:A variety of methods have been used in attempts to control inflation. even though almost all libertarian economists are opposed to the RBD." Even so. Unlike the Quantity Theory of classical political economy. particularly those that see restrictions on a particular class of credit as incompatible with libertarian principles of laissez-faire. or "backing theory". the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions. such as currency boards. It is generally held in ill repute today. The backing theory argues that the value of money is determined by the assets and liabilities of the issuing agency. it has theoretical support from a few economists. Anti-classical or backing theory Another issue associated with classical political economy is the anti-classical hypothesis of money.interest in limited contexts. with Frederic Mishkin.
Today the primary tool for controlling inflation is monetary policy.S. somewhere from about 2% to 6% per annum. Most central banks are tasked with keeping the federal funds lending rate at a low level. as deflationary conditions are seen as dangerous for the health of the economy. effective federal funds rate charted over fifty years.The U. A low positive inflation is usually targeted. . and within a targeted low inflation range. normally to a target rate around 2% to 3% per annum.
There are a number of methods that have been suggested to control inflation. For instance. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. whether express or implied. some follow a symmetrical inflation target while others only control inflation when it rises above a target. Fixed exchange rates .S. though they have different approaches. Central banks such as the U.
It can also be used as a means to control inflation. so does the currency pegged to it. a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value. a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. as the value of the reference currency rises and falls. vis-à-vis the currency it is pegged to. However. Gold standard Main article: Gold standard . This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition. A fixed exchange rate is usually used to stabilize the value of a currency.Main article: Fixed exchange rate Under a fixed exchange rate currency regime. such as gold).
S. fixed quantities of gold. silver certificate. A U. including the amount of specie per currency unit.Under a gold standard. The currency itself has no innate value. for example. could be redeemed for an actual piece of silver. fixed quantities of gold. but is accepted by traders because it can be redeemed for the equivalent specie. paper notes are convertible into preset. . The standard specifies how the gold backing would be implemented. The gold standard is a monetary system in which a region's common media of exchange are paper notes that are normally freely convertible into pre-set.
More successful examples include the Prices and Incomes Accord in Australia and the Wassenaar Agreement in the Netherlands. as were seen in some countries during the Great Depression. divisibility. The Bretton Woods system broke down in 1971. However. and ease of identification. Representative money and the gold standard were used to protect citizens from hyperinflation and other abuses of monetary policy. causing most countries to switch to fiat money – money backed only by the laws of the country. Wage and price controls Main article: Incomes policies Another method attempted in the past have been wage and price controls ("incomes policies"). However. Austrian economists strongly favor a return to a 100 percent gold standard. fungibility. Notable failures of their use include the 1972 imposition of wage and price controls by Richard Nixon. their use in other contexts is far more mixed. Wage and price controls have been successful in wartime environments in combination with rationing. and so were partially abandoned via the international adoption of the Bretton Woods System.Gold was a common form of representative money due to its rarity. which itself was tied to gold at the rate of $35 per ounce. . Under this system all other major currencies were tied at fixed rates to the dollar. they were not without their problems and critics. durability.
winning the war being fought. only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime. They often have . for example.In general wage and price controls are regarded as a temporary and exceptional measure.
In many countries. A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-living index. Artificially low prices often cause rationing and shortages and discourage future investment. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments or cost-of-living increases because of their similarity to increases tied to externally-determined indexes.perverse effects. due to the distorted signals they send to the market. and too little investment in bread making by the market to satisfy future needs. resulting in yet further shortages. average wages have increased . there will be too little bread at official prices. if the official price of bread is too low. The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant. They may also be tied to a cost-of-living index that varies by geographic location if the employee moves. For example. The usual economic analysis is that any product or service that is under-priced is over consumed. and government entitlements (such as social security) are tied to a cost-of-living index. Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. Many economists and compensation analysts consider the idea of predetermined future "cost of living increases" to be misleading for two reasons: (1) For most recent periods in the industrialized world. employment contracts. pension benefits. typically to the consumer price index. Salaries are typically adjusted annually. see Cost of living. Cost-of-living allowance For more details on this topic. thereby exacerbating the problem in the long term.
sugar etc. chicken farm. the inflation in Pakistan has depicted downward rigidity. reflecting the influence of rising productivity and worker bargaining power rather than simply living costs.faster than most calculated cost-of-living indexes.3 percent in August 2008. WPI inflation is following international declining trend but non-food component of the CPI showed some stubbornness till February 2009. The inflation rate as measured by the changes in Consumer Price Index (CPI) after reaching peak at 25. and (2) most cost-ofliving indexes are not forward-looking. WPI and SPI witnessed a clear downtrend in recent months. All price indices like CPI.9 percent in the comparable period of last year [See . but instead compare current or historical data. The CPI inflation averaged 23.1 percent in February 2009 mainly because of spike in the prices of some food items like onion. Inflation Rate of Pakistan:In sheer contrast to significant abatement in the inflationary pressures across the globe.5 percent in July-February 2008-09 as against 8. showing easing since November 2008 but bounced back to 21.
4 19. milk.1 32.91 18.0 33. against 5. fresh vegetables and fruits.8 25.0 SPI 33. wheat. pulses.7 December 23.9 percent in JulyFebruary 2008-09 as against 13.9 18.3 18.0 November 24. the food inflation is still quite high and is attributable to stubbornness of prices of edible oil.7 33. The non-food inflation stood at 19.6 15.1 Inflation Situation in Pakistan Core Inflation 14.3 January 20.8 20.4 The food inflation is estimated at 28.8 18. sugar. it is expected that the average inflation for .Table-4: (%) CPI July 24.3 September 23.3 18. The downward adjustment of petroleum prices in the month of November is neutralized by frequent hikes in electricity and gas prices.9 percent in the corresponding period of last year.9 17. poultry.85 WPI 34. The relative slowdown in domestic inflation since September 2008 is mainly driven by the deceleration in food inflation whereas non-food component has generally remained stubborn. rice.7 29.3 percent.7 15.9 October 25.2 28. The non-food inflation is also high because of hike in transport group.0 35.3 August 25. wheat flour.0 percent in the comparable period of last year.4 17.7 16.8 23. On current trends and barring any adverse shocks. fuel and lighting group and house rent index. meat.9 31.5 February 21. Notwithstanding recent downward trajectory.
ghee/ cooking oil will be crucial in determining the fate of the SPI.the year (2008-09) as measured by CPI will be close to 20 percent.7 percent in August 2008 to 15. The month of February witnessed fractional decline in the core inflation. wheat.8 percent in February 2009. It has declined from as high as 35.7 percent in the comparable period of last year. Going forward.9 percent for the last four consecutive months. This downturn is contributed by both food and non-food components. the prices of edibles like sugar. the prices of edibles like sugar.0 percent in February 2009.9 percent. Food component has decelerated from 33.0 percent in February 2009. . The non-food component fell more steeply from 37.7 percent to 17.8 percent in this period.7 percent. as against 11. all demand compression. onions will be crucial in determining the fate of the SPI. The Wholesale Price Index (WPI) during first eight months of 2008-09 has increased by 24.5 percent in August 2008 to 22. meets. the core inflation resisted all downward pressures and remained sticky at around 18. The core inflation which represents the rate of increase in cost of goods and services excluding food and energy prices also went up from 5. reflecting a marked downward correction in the last six months. wheat. Notwithstanding.1 percent during this period (Jul-February 2008-09) as against 9. Notwithstanding all monetary tightening during May 2007 to December 2008.4 percent in August 2008 to 9. the core inflation has also depicted first deceleration since May 2007 in December 2008 but hovered around 18. The Sensitive Price Indicator (SPI) has recorded an increase of 26. Going forward.9 percent in the same period of last year.
which is more evident in the demand for consumer durables. In fact.4 percent in FY05 not only surpassed the 6. and (4) a robust financial sector. and increased remittances from abroad. a sustained rise in international oil prices and a gradual monetary tightening in efforts to contain inflationary pressures. (3) continuity of policies. Moreover. but is also the highest during the last two decades. the growth in consumer credit also facilitated the rise in private consumption. (2) good luck in terms of timely winter rains.Executive Summary:Economic Growth.6 percent target by a wide margin for the third consecutive year. The acceleration in domestic economic growth looks even more impressive since it was achieved despite an evident slowdown in major economies around the globe. . The rise in consumption expenditure was probably due to rising consumer confidence as a result of huge capital gains in the equity and real estate markets. Savings and Investment The real GDP growth of 8. this exceptional growth was due to a combination of (1) strong domestic demand. The soaring private consumption expenditure in FY05 in particular provided impetus to strong domestic demand for the second year in a row.
Large-scale manufacturing (LSM) recorded a growth of 15.5 percent growth during FY05.Agriculture The agriculture sector staged a strong performance by recording 7. The record production of cotton (14. which saw a deceleration in growth) contributed toward this improved performance. All subsectors (except livestock. helping spur economic activity in the rural areas. A host of factors were responsible for this improved showing. down from the 12.2 percent growth in FY04.0 percent but is also well above the 2. which not only surpassed the annual target of 4.6 million bales) and a bumper harvest of wheat (21.0 percent YoY recorded during the preceding year. wheat. The strongest contribution to LSM growth during FY05 came from the textile sector that witnessed a remarkable . and the sharp rise in the availability of institutional agric edit that encouraged use of improved seeds. and strong maize and rice harvest probably led to rise in farm incomes during FY05.2 percent growth recorded in FY04.2 percent YoY.1 million tons) during FY05 pushed up the share of major crops in agricultural value addition to 37.1 percent in FY05 from 34. pesticides and fertilizers. including good fortune (in the form of favorable conditions and timely rainfall).0 percent during the previous year. Industry Provisional estimates place the FY05 industrial growth at 10.6 percent in FY05 as compared to 18. The record level of production of cotton. reduce rural poverty.
0 percent actual growth witnessed in FY04.2 percent growth of FY04 owing to higher domestic demand (reflecting expansion in the construction industry) as well as external demand (exports to Afghanistan and Iraq). Furthermore. this was mainly due to disruptions in gas distribution during the year.2 percent target as well as the 6. The growth rate of 7. Other LSM sectors that made significant contribution in value addition include automobiles (particularly trucks. The electricity generation sector recorded a slowdown. local cement dispatches also showed a growth of 18.9 percent during FY05 is significantly above the 6.8 percent in FY04. witnessing a growth of 4. The major contributions came from the .9 percent in FY05 as compared to 6. Finally.2 percent over 14. growth in mining & quarrying saw a modest dip. motorcycles & auto rickshaw) and electronics.5 percent in the preceding year.YoY growth of 24.8 percent growth witnessed during FY04.8 percentage points. falling to 11. compared to an increase of 9.7 percent compared to 6. Services The services sector also kept pace with the higher growth realized in the commodity producing sectors. This drop is mainly attributed to the enhanced capacity. mainly driven by the availability of consumer financing. As with LSM.4 percentage points in FY04.5 percent in FY05 as against the 12. capacity utilization4 during FY05 fell marginally by 0. contributed equally by domestic (private) as well as foreign direct investments in LSM.
Moderate growth has been witnessed in the transport.5 percent in total services sector) registered a strong growth of 12 percent during FY05 on top of the 8. after . This reflects the robust performance of the industry. This increase was well supported by the growth in the insurance business. and foreign direct investment flows in this sector. wholesale & retail trade. The value addition in finance & insurance was mainly on account of a sharp increase in SBP’s profits during FY05 as well as higher volume and efficiency gains realized by the banks and non-bank financial institutions. Moreover. automobiles. industrial chemicals.1 percent rise in FY04. However. petroleum refining. fertilizer. storage and communication sector. the transport segment is adversely affected by the sharp rise in oil prices during FY05. agriculture and foreign trade sectors of the economy. Saving and Investment The national savings deteriorated for the second successive year.5 percent fall in FY05.finance & insurance. largely on account of developments in the telecom sector. storage & communication sub-sectors. and transport. cement. paper & paper board and electronics sub-sector. recording a 4. 4 This represents the average of capacity utilization in vegetable ghee & cooking oil. the wholesale & retail trade sub-sector (with a share of 36.
.2 percent in FY04. Disaggregated data reveals that the FDI is concentrated in a few sectors. which was more than offset by an exceptionally large jump in public savings.g. national savings dropped from the FY03 peak of 20. It may be noted that despite the rise in nominal investment during the preceding three years. The FY04 deceleration in national savings was contributed by the decline in private savings.6 percent. As a result.5 billion during FY05. during FY05 not only have private savings continued to decline (albeit at a lesser pace). such as telecommunication. As far as foreign direct investment is concerned.witnessing a deceleration in growth to 3. as evident in the level of the food and house rent index (HRI). remaining well above the 5-year average of 10. During H1-FY05. and was largely insulated . the investment to GDP ratio has continued to hover around 15. with the annualized CPI inflation remaining high throughout the year.8 percent of GDP to 15. Prices Inflationary pressures that were visible in the economy since H2-FY04. increased availability of credit and significant rise in foreign direct investment (FDI). public savings have also declined. e. Nominal investment grew strongly during FY05. registering a healthy growth of 60. finance & insurance and oil & gas exploration.1 percent of GDP in FY05.5 percent in the last three years. Unfortunately. it reached US$ 1. strengthened significantly during FY05.5 percent. CPI inflation was principally driven by domestic factors. on the back of robust macroeconomic fundamentals.
However. helping to raise the aggregate revenues slightly above the Rs 590 billion revised target. . the cause of concern is the weakness in tax effort and overall revenue mobilization despite the collection of Rs 900 billion in FY05. annualized average CPI inflation rose to 9.5 In H2-FY05 however.from the high international oil prices. The evident slowdown in inflation is probably a combined result of a more aggressive monetary tightening as well as measures taken by the government to ensure the better availability of major food items. the influence of these factors was compounded somewhat by the impact of the hike in domestic prices of petroleum. pushing the overall budgetary deficit to 3.3 percent by end-June 2005̣ – the highest level since 1997. the weak FY05 growth in tax receipts is in part due to the loss of the PDL revenues. and higher than the deficit of 3.3 percent of GDP.7 Public Finance and Fiscal Policy The Central Board of Revenue (CBR) achieved its revenue targets for the third successive year in FY05.6 As a result. which was slightly above the target of 3. However. expenditure exceeded the target substantially.0 percent of GDP realized in FY04. Admittedly. The weak buoyancy is reflected in the continuing fall in the tax-toGDP ratio. oil and lubricant (POL) as well as the associated rise in inflationary expectations. at the same time. However.2 percent of GDP. it may be noted that the marginal YoY CPI inflation peaked off in April 2005 and showed visible weakening in the subsequent months.
Also. Tax voidance and evasion have weakened the tax buoyancy. A related weakness in the revenue structure is an almost total dependence of all tiers of government on Federal taxes. The taxation of agricultural income has already received considerable attention at the policy level. More than half of the increase in government revenues during FY05 over the preceding year is from a swift rise in non-tax revenues. but the tax yields remain low. it is instructive to note that the FY05 tax-to-GDP figure shows a decline even when adding back the full budgeted PDL revenue for the year. The fiscal developments in FY05 have exposed weaknesses in our tax systems that need to be addressed if the improvement in fiscal indicators is to be sustained. In particular. However.following the government’s decision to buffer the economy from at least a part of the rise in international oil prices. a significant contribution is from non-recurring items. enforcement and penal actions to check non-compliance. Another area of concern is the structure of the government revenues. Surprisingly. within non-tax revenues. the lacks of effective audit. Given that these flows are uncertain and unlikely to repeat themselves in the future to the same extent. . the importance of raising revenues from sectors that have traditionally remained under-taxed cannot be overemphasized. Moreover. however. there has been a little debate on the poor growth in the services sector taxes. the concerns over the trend of the overall budgetary deficit in the years ahead are quite legitimate.
was still quite low. but their share in total revenues remains negligible. The provinces will have to significantly enhance their tax collecting capacity to meet their financing requirements. the responsibility for this cannot lie solely with the CBR or.Sustainable growth will depend heavily on tapping resources from all economic activities equitably. while increasing. as also meet the objective of fiscal decentralization. but this increase was very gradual until January FY05. The moderate rise was driven by the fact that inflation. Provinces enjoy the constitutional authority in respect of agriculture income tax and sales tax on services – these two sectors contribute over 75 percent of GDP. and therefore the central bank was more concerned about derailing the momentum of the economy. which had only just started gathering pace after an extended period of . Finally. (21.7 percent YoY) increase in expenditure needs to be contained. while it is encouraging to contribution to the FY05 expenditure large rise in development spending. switching from a broadly accommodative stance (that had continued from recent years) to an aggressive tightening in the second half of the fiscal year. However. and the efficient usage of these resources. note that a strong growth is through a the apparent sharp the FY05 current Money and Banking Monetary policy witnessed an important transition during FY05. indeed the Federal government. Such efforts will greatly improve the tax-GDP ratios. It should be noted that SBP had begun to raise the benchmark interest rates early in FY04.
All of this militated against an aggressive hike in interest rates. Moreover. consequently.8 billion. SBP therefore opted to raise interest rates moderately throughout the period. industrial production registered an impressive growth and the capacity utilization in a .weak growth. (2) More importantly. and are therefore better tackled through administrative and fiscal measures. net credit rose by a record Rs 428. SBP’s reluctance to tighten monetary policy aggressively during H1-FY05 was supported by a number of considerations. As a result. this gradual rise in the benchmark interest rates had no significant impact on the lending rates. SBP forecasts had suggested that the supply-side inflation would decelerate by Q3-FY058 and CPI inflation was indeed weakening (though very gradually) early in H1-FY05. Moreover. These are typically less responsive to monetary policy. This consideration guided the monetary policy throughout H1-FY05. including: (1) The significant contribution of supply-side and structural components to inflationary pressures. but kept the benchmark rates well below the inflation. This suggests that SBP could actually defer an aggressive monetary tightening for some time before negative growth implications would be visible. However research findings are inconclusive for the impact on growth of the inflation rates lower than the threshold level of 8-12 percent. this stance was supported by the fact that monetary research with regard to the trade-off between growth and inflation indicates that inflation in excess of an 8-12 percent (threshold level) 9 hurts growth in the long run.
Together with higher government borrowings during FY05. especially in electronics and automobiles. it also fed a gradual and continuous rise in core inflation which raised the pressure for a significant rise in interest rates. SBP raised the discount rate (for the first time after June 2001) in April 2005. In response to the signs that the economy may overheat in the absence of corrective measures as well as to curb cost push inflation. As a result. the transmission of monetary signal was far more effective during H2-FY05. This rise in interest rates was supported by high liquidity absorptions through OMOs and a slow down in reserve money growth. and increased pressure on the government’s fiscal resources forced the government to retract on its commitment to keep a cap on the oil prices.number of industries increased. The performance of the banking sector also shows continued improvement during FY05. food prices also bounced back despite improved supplies. Although this monetary expansion led to increased industrial activity. A disaggregation of . where the increased activities are mainly credit driven. coupled with a higher acceptance ratio in T-bill auctions during these months compared with the initial nine months of the fiscal year further drained the inter bank liquidity. The inflationary expectations hardened further as the increase in oil prices turned out to be a permanent rather than a transient phenomenon. mainly due to a rise in transportation cost and hoarding. by 150 basis points. private sector credit growth resulted in acceleration in the monetary expansion. This. As a consequence of government’s decision to pass on the impact of oil prices to the consumers.
10 Domestic and External Debt Although the country’s total debt and liabilities (TDL) witnessed a small increase of 5.e. the country’s debt bearing capacity improved during FY05. Furthermore other key indicators (such as the public debt servicing to GDP ratio. i. this growth was comfortably outpaced by the nominal growth rate of 18. However.9 percent during FY05. The major performances indicators till recent have shown an improvement in the financial health of banking institutions. the average maturity of Pakistan’s TDL . raising its share in the country’s TDL to 50.9 percent in FY05. In fact. SME and consumer finance are relatively riskier financing products and thus yield higher returns compared with corporate finance.3 percent recorded by the economy. the TDL as a percentage of GDP fell to its lowest level for the last 20 years. enhancing the country’s capacity to carry debt and reducing its vulnerability to external shocks.1 percent in the preceding year.the credit data by type of bank reveals that all major banking groups contributed to the tremendous FY05 credit. For instance. although the largest share was accounted for by domestic private banks. In particular. the major contribution to the FY05 growth in TDL came from domestic debt. for the fourth successive year. banks’ earnings have improved due to the large credit expansion especially given the rise in interest rates and the trend in diversified deployment of credit across sectors. As a result. public debt servicing to tax revenue ratio) have also improved over the last five years. As in the preceding year. by the end of FY05. up marginally from 50. to 64 percent in FY05 from 71 percent a year ago and 93 percent in FY01.
The major factors contributing to the rise taking place in FY05 were fresh inflows from multilateral creditors and IDB.9 percent of the increase in domestic debt during the year constituted short-term issues. In terms of the external debt and liabilities (EDL).11Indeed. A direct consequence of the shortening of the average maturity profile of the domestic debt is that the vulnerability of debt servicing cost to interest rates shocks increased somewhat in FY05.shortened a little during FY05 as over 156. This rise was realized despite a fall of US$ 154 million in external liabilities as well as the US$ 495 million debt relief provided by the USA during the year. The sharp jump in trade deficit is clearly caused by the strong growth in import payments together with a rise in shipment freight charges during FY05. which .3 billion during the preceding year. Pakistan’s exports performed fairly well during FY05 despite the rising global competitive challenges in the post MFA regime. its stock witnessed a marginal rise of US$ 576 million (1. and the issuance of an Islamic bond – sukuk in the international capital market.6 percent YoY) during FY05. Balance of Payments The major highlight of Pakistan’s external sector is the record high trade deficit of US$ 4.5 billion during FY05 compared to a deficit of US$ 1. In fact. reversing the steady downtrend visible since FY99. In fact the extraordinary 38 percent growth in imports overshadowed the impact of the 16 percent jump in exports during FY05. the stock of longterm debt instruments declined. and had only a negligible contribution from exchange rate fluctuations. since FY05 also saw substantial maturities of long tenor debt.
despite the unprecedented YoY deterioration in trade account in FY05. However. As a result.8 billion during FY04. Encouragingly.6 billion in FY05 as compared to a surplus of US$ 1.were compounded by (1) loss of duty free access to the EU since January 2005. the deficit in the current account balance to some extent was offset by the significant capital flows in the financial account. data shows that the trade deficit during FY05 was primarily caused by higher imports of machinery. raw material (which may be helpful in improving the capacity use as well as in expanding the productive capacity of the economy. the overall balance . Hence.335 million in the previous year. These capital flows mainly include (1) one-off inflows (such as US$ 364 million through privatizations and US$ 600 million through sovereign debt issued internationally) and (2) a jump in concessional long-term loans from the World Bank & ADB. thereby leading to a broad-based increase in economic activities) and petroleum products (reflecting the impact of persistently higher oil prices in the international market and rising consumption in the growing economy). (2) the imposition of antidumping duty by the EU on its bed wear imports from Pakistan. Thus. The strong growth in remittances from expatriates and gains from the lower interest payment on external debt & liabilities partially offset the impact of the large trade gap. the substantial deterioration in trade balance did not completely translate into the current account deficit of US$ 1. and (3) relatively higher inflation compared to the trading partners and competitors. the financial account registered a surplus of US$ 568 million during FY05 in contrast to a deficit of US$ 1.
76 billion.6 billion. . the rupee quickly weakened by 5. On the other hand. In fact. Importantly. while commercial banks’ reserves increased by US$ 1. this gradual slide of the rupee against the US dollar led to a generalized market panic. However. SBP reserves fell mainly on the back of payments for loans and oil imports. This immediately led to a rally by the rupee. even through the SBP had been quietly injecting foreign exchange into the system. This suggested that at least a part of the August-October 2005 pressure on the rupee was due to the demand generated by the expectations of the rupee deprecation alone. The significant point here was that SBP quickly became a net buyer in the market by December 2004.41 billion during the period compared to a surplus of US$ 0. A notable change is witnessed in the composition of overall reserves. SBP reserves scaled down by US$ 0. Pakistan’s overall foreign exchange reserves during FY05 increased by US$ 289 million. the reserves reached a historic high of US$ 13 billion in mid-April 2005 before closing the year at US$ 12. the pressure on the rupee during the initial months of FY05 was not surprising. The magnitude of the pressure on the rupee solely due to expectations became evident only when SBP made a public (and quantifiable) commitment to smooth (the lumpy) oil payments.05 billion. Given the deterioration in the external account.78 billion in FY04. wiping out much of its losses during the initial months. commercial banks’ reserves increased due to both fresh inflows in FE25 deposits as well as net retirement of forex loan.2 percent by end-October 2005.recorded a deficit of only US$ 0. even as the currency appreciated.
However. it is important to speed up the progress on human development in Pakistan. the improvement in the fiscal position. most of the social indicators show high regional and gender disparity. education and other social sector areas. the sustainability of macroeconomic stability and maintaining the current growth momentum remain essential. even the decline was not broad based. Moreover. the government should significantly augment development spending. the positive trends in most of the social indicators have gathered pace during FY02-05 compared to the FY99-02 period. In particular. education indicators are also not very encouraging and a majority of the population still does not have access to basic facilities such as sanitation and safe drinking water.Socio Sector Development Macroeconomic stability and strong economic growth during the last few years enabled the country to show some progress in social sector development as well. increase efficiency of . Similarly. As a result. Unemployment. despite a faster growth in the labor force. etc. has allowed the government to substantially increase spending in health. Similarly. through sustained efforts in recent years. is still very high and.7 percent by FY04. despite declining to 7. Thus. The mortality rates in Pakistan for infants and children under 5 year of age are the worst amongst SAARC members. and the acceleration has to continue consistently to catch up with the backlog and meet the needs of new entrants. the rising trend of the rate of unemployment since FY93 has been reversed during FY02-04. moreover. In this regard. the social indicators still do not show a satisfactory picture. Moreover.
expenditures. The government’s efforts could be complemented by the increased access to financial services of the populace (as especially to the hitherto neglected SME and microfinance sectors). . and foster better partnerships with the private sector to improve delivery of services.