PUNJAB ECONOMIC RESEARCH INSTITUTE

How change in money supply effects inflation

Presented to Dr Muhammud A. Quddus and Ms Bushra
Muhammud Rashid Hussain 8/20/2011

This article is a very crude effort to explain the effects of money supply growth on inflation. For this purpose year wise analysis is made and in order to get more precise results velocity of the M2 is also incorporated.

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Introduction
Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man. Ronald Reagan (American 40th US President (1981- 89), 1911-2004)

No doubt a small increasing number of inflation is good for economys health but it is like a genie which gets easily uncontrolled and makes itself free from the bottle. As soon as this genie got free the trouble starts for the country. Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair. Sam Ewing quotes Definition Starting with the definition of the inflation, we cant say that there is some formal definition of inflation. It has different definition according to different school of thoughts and different perspectives. One definition is given below:

Inflation is an economic condition wherein the price of the goods and services increase steadily measured against standard level of purchasing power, whereas the supply of the goods and services decline along with the devaluation of money.

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Types When the types of inflation are considered then the following list is gathered. Due to the limited space there is only birds eye view is given for the following types of inflation: There are many types of inflation most famous or it is better to say infamous types are mentioned below. Most crippling type is hyperinflation in this situation the prices of the commodities rises more than hundred percent in a very less time period. Another type is stagflation this is the condition in which all the measures to control to the inflation go down the drain and it is very difficult to control the turmoil of the country. This is the also situation contained by the Pakistan. There is another type which is called disinflation it is strange kind in this situation prices instead of increasing starts to decrease., but this is not the good thing either it will also set the stage for the devastation of the country if it is not cured at the initial stages. Reasons If the description of reason is required which is responsible for making this genie out of the bottle then it can be explained in a one word which is money supply. It all depends on the supply of the money made available by the central bank of the country. Higher the money supply implies that currency is being devalued which means that now the same money buying less goods as it was before the inflation. This will greatly affect the purchasing power of the people and it will lead to increments in the price. But this does not imply that growth of money supply is the sole factor which is responsible for the inflation. There are also other factors that matters but they are of puny status compared to the money supply growth and that explains why only this factor is considered throughout the paper.

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Literature review
The interest rate is considered as one of the building block of all this macroeconomic set up. Therefore a small change in interest rate inflicts huge changes in the field like economic growth, inflation and foreign exchange. Before indulging into deep discussion there is a brief highlighting of the present scenario of the country called Pakistan. All the blood line products of the economy had their prices hiked up in the current year. This implies that there would be more adjustments to prices and when the price adjustments become more costly then firms tend to avoid adjustment to small shocks and leave the decision in changing prices to large shocks this small action piles up to a huge disproportionate implication on the price level. This indicates that aggregate inflation also depends upon the relative price changes. If we have to describe the economic condition of the country in one line that it would not be lie to said that Pakistan is under the very tight grip of the inflation in fact not inflation but stagflation. Stagflation has much more crippling effects then the inflations. This takes the toll from the common people in the form of increased unemployment prices and it worsened off the living standard of the masses to the great extent. Now thinking about the reasons and who should be considered liable to all this, then all the evidence indicates towards the money supply that is growing like crazy by every day. And this is done to pay off the international debts and to meet the budget deficits for that purpose loan is being taken from the banks in the form of printing money and at the end of the day we stand at the same place that amount of international debt that is being retired in fact pumps up the debt that was taken internally. This does not imply that private sector should not be given the loans its the government sector which is the culprit and putting pressure on money supply and inflation There is a trend seen in many countries that reducing the pricing power of the firms will lead to the fall in the inflation level in the countries under consideration. This trend has pivotal effects on money supply because it not only affects the forecasts of the inflation but also effects the change in inflation due to the change in the monetary policies. Strikingly in the recent years inclination of banks moved toward price stability from the money and its role. Now maintaining smooth prices seems to be the agenda of the banks. No doubt both of them are interrelated and both effects inflation hugely. Therefore in order to cure the disease of inflation state bank should stand up for the development and establishment of such polices which are targeted to increase economic growth and reducing the inflation and will also lead to create stability in balance of payments. In short instead of focusing on minor issues like changes in interest rate it should broad its horizon and solves the bigger issues at the hand.

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Methodology
This research paper is totally based upon the secondary data this implies that the experience of collecting first hand data and evaluating is missing from this research paper. This does not mean that the quality of the paper is compromised. Therefore all the efforts are incorporated which are required for a comprehensive and articulate piece of work. For the theory part of the paper mostly online articles, newspapers and human resources of the form of experts of this field were consulted. And the resulting paper is the amalgamation of all the three resources. Again for the data collection on inflation and growth of money supply is collected from the internet. After that a very comprehensive yearly analysis is given. This analysis not only incorporate the data on money supply, velocity of M2 and inflation of the respective years but also considered the other economic factors of the event that could also influence growth of money supply and which again effect the inflation in the economy After that results and findings of this paper were stated with a comprehensive explanation of the dynamics behind this. Then paper leads towards the heading of the limitations. This heading basically talks about the problems and factors which were proved to be binding during the completion process of the paper. This automatically connects the paper from the heading of suggestion which talks about the solution to the problem which was discussed in the limitation heading. The paper tidied up with appendices which contains the data on inflation growth of money supply and velocity of M2 in a very comprehensive manner also the data was represented graphically in this part so that it will give the idea about the relationship between money supply and inflation in pictorial form. The last part of the paper is of references it contains all the sources of all the data which was incorporated and used in this paper.

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Analysis
Data on which this analysis is based is given in more detail in appendix I and the unit which is used is percentage, also the pictorial representation is available in appendix II. As we know that its not the money supply which effects the inflation, therefore yearly analysis of money supply effects on inflation is given with the consideration of important events happened during the subsequent years. 2000 During this year we have money supply growth of 9.40, velocity of M2 is 2.20 and percentage in inflation is -37.52. Also during this year Nawaz Sharif was sentenced to life imprisonment on hijacking and terrorism charges not only that he was also sent to exile in Saudi Arabia after being pardoned by military authorities. Being part of the huge macroeconomic model these events do have some implications on increased inflation. 2001 This is the year which holds the five major events which inflicts serious impacts on the inflation rate. First of all Gen Pervez Musharraf names himself president while remaining head of the army. He replaced the figurehead president, Rafiq Tarar, who vacated his position earlier in the day after the parliament that elected him was dissolved. Secondly, in July Musharraf meets Indian Prime Minister Atal Behari Vajpayee in the first summit between the two neighbors in more than two years. The meeting ends without a breakthrough or even a joint statement because of differences over Kashmir. Thirdly, again Musharraf swings in behind the US in its fight against terrorism and supports attacks on Afghanistan. US lifts some sanctions imposed after Pakistan's nuclear tests in 1998, but retains others put in place after Musharraf's coup. Fourthly, India imposes sanctions against Pakistan, to force it to take action against two Kashmir militant groups blamed for a suicide attack on parliament in New Delhi. Pakistan retaliates with similar sanctions. Lastly, India, Pakistan mass troops along common border amid mounting fears of a looming war. All these events explain why there was a positive change in inflation of 23.05 points and value for money supply is of 9 points, though velocity increased to 2.60.

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2002 In this year money supply fairly picked up to almost four points and reached to 14.80 whereas velocity fell two points and reduced t 2.50. On the other hand inflation went to -43.22. Other major economic events are as follows; it started with President Musharrafs act of banning two militant groups - Lashkar-e-Toiba and Jaish-e-Mohammad - and takes steps to curb religious extremism. Then, President Musharraf wins another five years in office in a referendum criticized as unconstitutional and fraught with irregularities. After that, Pakistan test fires three medium-range missiles capable of carrying nuclear warheads, amid rumors of impending conflict with India. President Musharraf says Pakistan does not want war, but is ready to respond with full force if attacked. In retaliation Britain and US maintain mount offensive to avert war. Then in August President Musharraf grants himself sweeping new powers, including the right to dismiss an elected parliament, prompting opposition anger. October holds the event of first general election since the 1999 military coup results in a hung parliament. And year ended when National Assembly elects Mir Zafarullah Jamali - a member of a party close to General Musharraf - to head a coalition government as the first civilian prime minister since the 1999 military coup. 2003 Mainly this year proved to be slow regarding the economic events, basically there are three important activities to note on. Firstly North-West Frontier Province votes to introduce Shariah law. Secondly, Pakistan declares a Kashmir ceasefire; India follows suit. Lastly, in December Pakistan and India agree to resume direct air links and to allow over flights of each other's planes from beginning of 2004, after a two-year ban. On the money supply side there is a slight increase and it went to 18.60 this time velocity also increased slightly and went to 2.30 and inflation reached to 23.88.

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2004 In 2004 money supply grew to 19.60 and velocity maintains itself to 2.30 and inflation depicts an upward trend and end up at 47.26. Other economic events are explained under; it started when in February leading nuclear scientist Dr Abdul Qadeer Khan admits to having leaked nuclear weapons secrets, reportedly to Libya, North Korea and Iran. Then, in April Parliament approves creation of military-led National Security Council, institutionalizing role of armed forces in civilian affairs. After that Pakistan mounts military offensive against suspected al-Qaeda militants and their supporters near Afghan border after attacks on checkpoints, resulting in high casualties. Then, in May Pakistan readmitted to Commonwealth. Lastly this year ends with President Musharraf say he will stay on as head of the army, having previously promised to relinquish the role. 2005 This year has a very bleak start and it remained gloomy throughout the year. In January Tribal militants in Baluchistan attack facilities at Pakistan's largest natural gas field, forcing closure of main plant. In April for the first time in 60 years the bus services started to operate between Muzaffarabad (in Pakistani-administered Kashmir) and Srinagar in (Indian-controlled Kashmir). Then in august Pakistan tests its first, nuclear-capable cruise missile. October was the worst it contained the event of an earthquake, with its epicenter in Pakistani-administered Kashmir, kills tens of thousands of people. The city of Muzaffarabad is among the worst-hit areas. This does it with the events for this year while bringing the following values of money supply, velocity and inflation 19.10, 2.40 and 103.06 respectively.

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2006 In 2006 money supply growth is at 15.10, velocity is 2.40 and inflation is -14.61. Now as far as the economic events are concerned then they are as follows; firstly, in a US missile strike Up to 18 people are killed, apparently targeting senior al-Qaeda figures, in the northwest. Secondly, Security forces kill prominent Baluchistan tribal leader, Nawab Akbar Bugti. Protests over his death turn violent. Thirdly, a raid on an Islamic seminary in the tribal area of Bajaur bordering Afghanistan kills up to 80 people, sparking anti-government protests. The army says the madrassa was a training camp for militants. Lastly, Pakistan says it has successfully test-fired a short-range missile capable of carrying a nuclear warhead. 2007 This year is pregnant with the following events; first of all Islamabad rejects an assertion by the head of US National Intelligence that al-Qaeda leaders are hiding out in Pakistan. Secondly, tension mounts between the government and the radical Red Mosque in Islamabad. Thirdly, sixty-eight passengers are killed by bomb blasts and a blaze on a train travelling between the Indian capital New Delhi and the Pakistani city of Lahore. Also Pakistan and India sign an agreement aimed at reducing the risk of accidental nuclear war. Fourthly, President Musharraf suspends the Chief Justice Iftikhar Mohammed Chaudhry, triggering a wave of anger across the country. First joint protests held by the parties of exiled former Prime ministers Benazir Bhutto and Nawaz Sharif. Fifthly, Officials say around 250 people have been killed in fighting between South Waziristan tribesmen and foreign militants said to be linked to al-Qaeda. Sixthly, several killed in Karachi during rival demonstrations over dismissal of Chief Justice Chaudhry. Subsequent strikes paralyze much of the country. Seventhly, President Musharraf extends media controls to include the internet and mobile phones amid a growing challenge to his rule. Eighthly, Security forces storm the militant-occupied Red Mosque complex in Islamabad following a week-long siege. Supreme Court reinstates Chief Justice Chaudhry. Ninthly, Ms Bhutto, President Musharraf holds a secret meeting in Abu Dhabi on a possible power-sharing deal. Tenthly, Musharraf wins most votes in presidential election. The Supreme Court says no winner can be formally announced until it rules if the general was eligible to stand for election while still army chief. Nearly 200 people die in fighting with Islamic militants in North Waziristan, stronghold of pro-Taliban and al-Qaida groups. Ex-prime minister Benazir Bhutto

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returns from exile. Dozens of people die in a suicide bomb targeting her homecoming parade in Karachi. Eleventh, Gen Musharraf declares emergency rule while still awaiting Supreme Court ruling on whether he was eligible to run for re-election. Chief Justice Chaudhry is dismissed. Ms Bhutto is briefly placed under house arrest. Caretaker government sworn in. New Supreme Court - now staffed with compliant judges - dismisses challenges to Musharraf's re-election. Nawaz Sharif returns from exile. Musharraf resigns from army post and is sworn in for second term as president. Twelfth, State of emergency lifted. 27 December - Benazir Bhutto assassinated at election campaign rally in Rawalpindi. During this year money supply, velocity and inflation were 19.30, 2.30 and -1.89 respectively. 2008 Following is the situation on the money supply, velocity and inflation side 15.30, 2.40 and 54.39. On the other hand following economic events occur during year 2008; first of all Up to 90 fighters killed in clashes in the tribal region of South Waziristan, near the Afghan border, where militants have been openly challenging the army. Secondly, Parliamentary elections hand the two main opposition parties gain a clear majority. They later agree to form a coalition government. Thirdly, Pakistan People's Party (PPP) nominee Yusuf Raza Gilani becomes prime minister. Fourthly, the disgraced Pakistani nuclear scientist, Dr Abdul Qadeer Khan, says allegations he passed on nuclear secrets are false and that he was made a scapegoat. Fifthly, the two main governing parties agree to launch impeachment proceedings against President Musharraf, who resigns soon after. Senate Speaker Muhammad Sumroo becomes acting president. PPP leader Asif Ali Zardari - Benazir Bhutto's widower - says he will be the party's candidate in the presidential election set for 6 September. Former PM Nawaz Sharif pulls his PML-N out of the coalition government, accusing the PPP of breaking its promise to approve the reinstatement of all judges sacked by former President Pervez Musharraf. Sixthly, Asif Ali Zardari elected by legislators as Pakistan's new president. Marriott Hotel in Islamabad devastated in a suicide truck bombing which leaves at least 50 dead. An Islamist militant group claims responsibility. Seventhly, the government borrows billions of dollars from the International Monetary Fund to overcome its spiraling debt crisis. Lastly, India says militants who carried out the Mumbai terrorist attacks in November had Pakistani links, and demands Pakistani action. Islamabad denies any involvement but promises to co-operate with the Indian investigation.

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2009 This year is famous for the following major events. First of all Government agrees to implement Shariah law in north-western Swat valley in effort to persuade Islamist militants there to agree to permanent ceasefire. Secondly, Gunmen in Lahore attack a bus carrying the Sri Lankan cricket team. Five policemen are killed and seven players injured. After days of protests, government gives in to opposition demands for reinstatement of Chief Justice Iftikhar Chaudhry and other judges dismissed by former President Pervez Musharraf. At least 40 people are killed when gunmen storm a police academy in Lahore. Thirdly, Swat agreement breaks down after Taliban-linked militants seek to extend their power-base. Government launches offensive lasting months to wrest control of north-western districts from militants. Fourthly, The Pakistani and Indian prime ministers pledge to work together to fight terrorism at a meeting in Egypt irrespective of progress on improving broader relations. The Supreme Court acquits opposition leader Nawaz Sharif of hijacking charges, removing the final ban on his running for public office. Fifthly, Pakistan issues a global alert for 13 suspects over November's attacks in the Indian city of Mumbai. President Zardari orders the suspension of judges appointed under emergency rule in 2007, after the Supreme Court ruled the emergency declared by former President Musharraf to have been unconstitutional. Sixthly, the leader of Pakistan's Taliban, Baitullah Mehsud, is killed in US drone attack in South Waziristan. Seventhly, New Taliban leader Hakimullah Mehsud pledges revenge for the drone attack that killed Baitullah Mehsud. Suicide bombing in northwestern city of Peshawar kills 120 people. Eighthly, President Asif Ali Zardari hands control of Pakistan's nuclear arsenal to PM Yusuf Raza Gilani, in apparent attempt to ease political pressure. Lastly, Supreme Court rules that amnesty decree protecting President Zardari and several of his allies against corruption charges was illegal. On the other hand growth of money supply is 9.60, velocity is 2.6 and inflation is 73.15.

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2010 In the last year of the analysis money supply is 12.45, velocity is 2.7 and inflation is -43.54. Following events were occurred during this year. Firstly, Suicide attack on a volleyball match in north-west kills more than 100 people. Secondly, Parliament approves package of wide-ranging constitutional reforms. Measures include transferring key powers from office of president to prime minister. Thirdly, Worst floods in 80 years kill at least 1,600 people and affect more than 20 million. Government response widely criticized. Fourthly, Pakistan temporarily suspends NATO supply route into Afghanistan after series of US drone strikes in northwest. Fifthly, Exmilitary ruler Musharraf apologizes for "negative actions" while in power, launches political party from exile in UK. Rise in targeted political killings, bombings in commercial hub of Karachi. And lastly, 50 killed in a double suicide attack in Mohmand, near the Afghan border, during a gathering of tribal elders.

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Results
All this research and comprehensive analysis above leads us to one simple fact that inflation and supply of money are directly related. This implies that greater the supply of the money greater the inflation in the country whereas smaller the money supply the lower number will be the result in case of inflation. Lower inflation make the people better off because they would be able to buy more goods with the same amount of money compared to the time periods when the inflation is comparatively higher. Reason for this direct relation can be explained by one simple and worldwide phenomenon that whenever the higher amount or supply of any commodity is available at disposal then it will lose its value. And money is not the exception to this rule. Therefore as the supply of money increased it will lose its value and this is known as the devaluation. This implies that when the money is devalued it is now buying fewer goods than before and as a result prices of the commodities goes up and this all boils down to the phenomenon called inflation. All this process explains direct relationship between inflation and supply of money. The condition is no different for our beloved country Pakistan. That is in the years when the supply of money is greater in the country there is also the time of high inflation and people are worse off because their money is buying less commodities compared the to the low inflation time period. On the other hand, during the years when the money supply is available to people in relatively lower amounts, the inflation is also comparatively lower than the periods when the money supply is greater. During this period people are also better off because now their money is buying more goods compared to the time period when the inflation is high. No doubt there are also other factors which are responsible for creating inflation -- like demand push inflation or cost pull inflation -- in the country but this money supply effect is considered to be most important of them all because it has the most crippling effect on the countrys economy. This factor very swiftly turned the economy from riches to rags. And in no time country is struggling to get itself free from the curse of inflation and the harmful effects which it has inflicted upon the country. It is like the cancerous disease for countrys economy which has very painful remedies.

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Limitations
As far as the constraints regarding this project are concerned then they are explained below; y First of all the most binding factor is the shortage of the time available for the research regarding this paper. Abundance of time would contribute to more comprehensive research and it will also allow having some room for the collection of some first hand and total dependence on the secondary data would be avoided to some extent. y Secondly, the availability of some data proved to be bit challenging. One prominent example is the data on the supply of the money for Pakistan from the year 2000 to 2010 is really difficult to get. y Thirdly, authenticity or credibility of the data is also a great problem. As we know that getting the data is not the problem it is the getting the correct data is important because faulty data may lead to imprecise decisions and this would make a huge impact in the practical world. And all the research is heavily based upon the secondary data therefore it is very essential to question the authenticity and credibility of the data. Otherwise inaccurate data will lead to different results and this will bring wooliness to the research paper. y Fourthly, not only the credibility of data is concerned it is also the authenticity of the author that matters. Most of the time people who are not well informed about the present condition write about things related to the topic and considering such type of data would be amiss. Also the people having biased thoughts would not be able to provide appropriate form of data. Therefore its not the authenticity of the data that matters only its also the credibility of the author that makes an impact.

Lastly but most crippling factor that falls on the state bank side is that there is an event called outside lag and state bank is the victim of this disease. Basically the outside lag is the time between corrective authority action responding to a shock to the economy and the resulting affect on the economy. Therefore this implies that by the time action was made the situation in economy changes and this will sometimes lead to instead of improving the economy worsens off further. The good thing in the case of state bank is that it is free from the disease of inside lag and inside lag is the time between a shock to the economy and corrective government action responding to the shock.

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Suggestions
Now putting some light on the remedies of the above mentioned limitations; y First of all more availability of time assigned to this research paper would lead to a relatively better and more comprehensive paper. This will also allows some space for the collection of the primary data and this provide with a more precise and accurate analysis. y Secondly, an easy accesses to some of the important data would result in the betterment and comprehension of the research paper y Lastly, establishment of the websites that act as the benchmark and will be reliable enough to provide authentic and credible data would save the day. Thats all for now and most important factors that proved to be major bindings and how they should be tackled are explained above under the heading of limitations and suggestions respectively.

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Appendix I
Data on inflation Following is the data on inflation in the tabular form:

Year Inflation, average consumer prices Percent Change 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 3.584 4.41 2.504 3.102 4.568 9.276 7.921 7.771 11.998 20.775 11.73 -37.52 % 23.05 % -43.22 % 23.88 % 47.26 % 103.06 % -14.61 % -1.89 % 54.39 % 73.15 % -43.54 %

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Data on money supply Following is the data on money supply growth and velocity of M2: Narrow Money End June Stock 1999-2000 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 M1 739.03 1275.61 1494.14 1797.36 2174.74 2512.21 2720.68 3155.63 4689.14 Monetary Assets (M2) 1,400.63 1,526.04 1,751.88 2,078.48 2,485.49 2,960.64 3,406.91 4,065.16 4,689.14 5,137.20 5,777.20 Growth Percentage 9.40 9.00 14.80 18.60 19.60 19.10 15.10 19.30 15.30 9.60 12.45 Income Velocity of Monetary Assets (M2) 2.20 2.60 2.50 2.30 2.30 2.40 2.40 2.30 2.40 2.6 2.7

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Appendix II
Money supply This graph shows the trend of money supply growth over the ten years. It shows that from 2000 to 2010 money supply keep on growing upward.

Money supply
2012 2010 2008 2006 2004 2002 2000 1998 0 2 4 6 8 10 12 Money supply

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Inflation Following is the graph which shows the inflation trend over the past ten years that is from 2000 to 2010:

Inflation
2012 2010 2008 2006 2004 2002 2000 1998 -100.00% -50.00% 0.00% 50.00% 100.00% 150.00% Inflation

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Inflation vs. Money supply This is the pictorial representation of the relation between inflation and growth of money supply. It also shows that as the money supply goes up inflation also goes up and as the money supply goes down inflation also goes down. Therefore this implies that there is a direct relationship between money supply growth and inflation.

Inflation
120.00% 100.00% 80.00% 60.00% 40.00% Inflation 20.00% 0.00% -20.00% -40.00% -60.00% 0 2 4 6 8 10 12

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References y http://thinkexist.com/quotation/inflation_is_as_violent_as_a_mugger-as/223581.html y http://thinkexist.com/quotation/inflation_is_when_you_pay_fifteen_dollars_for_the/2190

97.html

y y y y y y y

http://glossary.econguru.com/economic-term/outside+lag http://news.bbc.co.uk/2/hi/south_asia/country_profiles/1156716.stm http://www.economywatch.com/inflation/definition.html http://www.cairn.info/article.php?ID_ARTICLE=ECOI_088_0111 http://qje.oxfordjournals.org/content/110/1/161.short http://www.sciencedirect.com/science/article/pii/S0014292100000374 http://www.indexmundi.com/pakistan/inflation_rate_(consumer_prices).html