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DATE OF SUBMISSION: March, 10, 2012



What is Inflation?
Inflation is a rise in the general price level and is reported in rates of change. Essentially what this means is that the value of your money is going down and it takes more money to buy things. Therefore a 4% inflation rate means that the price level for that given year has risen 4% from a certain measuring year. The inflation rate is determined by finding the difference between price levels for the current year and previous given year. The answer is then divided by the given year and then multiplied by 100. To measure the price level, economists select a variety of goods and construct a price index such as the consumer price index (CPI). By using the CPI, which measures the price changes, the inflation rate can be calculated. This is done by dividing the CPI by the beginning price level and then multiplying the result by 100.


Inflation is one of the key factors in any nations economy. Inflation shares relationships with many other factors that greatly affect the business and trading community in a nation. 1. Inflation and Interest Rates: If the local currency loses purchasing power then possible earnings by the lender might go down as well, therefore; as inflation rises, interest rates rise as well. 2. If interest rates increase, most of the security markets will see their prices affected as well. 3. Stock, Bonds, and the local Economic Indicators will see their numbers affected simply by money losing its purchasing power.

In this era of globalization, inflation crosses borders and affect to both developing and developed countries and now inflation is a major problem of todays world including Pakistan. It is generally felt that for several years, Pakistan has had double digit inflation.

Why does inflation matter? The impact of inflation on trade and businesses depends in part on whether inflation is anticipated or unanticipated:

Anticipated inflation: When people are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects. For example, trade unions may exercise their collective bargaining power to negotiate with employers for increases in money wages so as to protect the real wages of union members. In this way, people can help to protect the real value of their financial wealth. Companies can adjust prices and lenders can adjust interest rates. Businesses may also seek to hedge against future price movements by transacting in forward markets. For example, most of the major airlines buy their aviation fuel several months in advance in the forward market, partly as a protection against fluctuations in world oil prices.

Unanticipated inflation: When inflation is volatile from year to year, it becomes difficult for traders and businesses to correctly predict the rate of inflation in the near future. Unanticipated inflation occurs when economic agents (i.e. traders, businesses and governments) make errors in their inflation forecasts. Actual inflation may end up well below, or significantly above expectations causing losses in real incomes and a redistribution of income and wealth from one group in society to another.

Money Illusion It is a fact of life that people often confuse nominal and real values in their everyday lives because they are misled by the effects of inflation. For example, a worker might experience a 6 per cent rise in his money wages giving the impression that he or she is better off in real terms. However if inflation is also rising at 6 per cent, in real terms there has been no growth in income. Money illusion is most likely to occur when inflation is unanticipated, so that peoples expectations of inflation turn out to be some distance from the correct level. When inflation is fully anticipated there is much less risk of money illusion affecting both individual employees and businesses.

Effects of Inflation in Pakistan As described by the institute of Development Economics in Pakistan, inflation has had some of the following broad effects in the Pakistani living quality.

1. Increasing vulnerability and fall in real income of lower, middle and fixed income segments of the society. 2. uncertainty about future scenario of the business environment and instability of the financial system 3. Erosion of business and investors confidence 4. Slowing down of real economic activities 5. Investment 6. Economic growth 7. Employment 8. Businesses and Trade

IMPACT OF INFLATION ON TRADE & BUSINESS 1. Disrupt Business Planning: More generally, inflation can disrupt business planning. Budgeting becomes difficult because of the uncertainty created by rising inflation of both prices and costs and this may reduce planned capital investment spending. Lower investment then has a detrimental effect on the economys long run growth potential.

2. Reduces the value of domestic output: An increase in the rate of monetary expansion generally reduces the value of domestic output and alters the composition of domestic production. The result is a change in the pattern of international comparative advantage and trade flows. The initial depreciation of the exchange rate following an increase in the rate of monetary expansion is accompanied by a trade surplus and capital outflow, while the subsequent depreciation is accompanied by a trade deficit. 3. Layoff workers: A destabilizing effect of inflation on businesses is that it can cause consumers and investors to changer their speeding habits. When inflation occurs, people tend to spend less meaning that factories have to lay off workers because of a decline in orders. 4. Speculation by some businesses to take advantage: Another destabilizing effect of inflation is that some people choose to speculate heavily in an attempt to take advantage of the higher price level. Because some of the purchases are high-risk investments, spending is diverted from the normal channels and some structural unemployment may take place. 5. Inflation alters the distribution of income: Businesses that deal in providing loans are generally hurt more than borrowers during long inflationary periods which mean that loans made earlier are repaid later in inflated rupees.

6. Difficulties in obtaining raw material: Many entrepreneurs have never had to do business in an age of inflation. Recently, many small business owners have begun to feel the pinch of inflation. Health care costs, fuel costs, and many raw material costs due to the many hurricanes of last season are pushing up prices on almost everything. So it make difficult for businesses to obtain raw material on reasonable or affordable prices. 7. Difficulties in maintaining positive cash flows: Because of inflation businesses laid people off, shrunk inventories, and tight supplies then pushed up prices. Small businesses are always tight on cash flow. And if their inputs of raw materials and other direct operating expenses go up, they may not be able to pass along these costs quickly enough to keep their cash flow positive. Managing cash flow is only one issue for small business owners. 8. Loosing Customers: Raising prices is a difficult process for many small businesses. But, every increase potentially makes the businesses less competitive, and raises the possibility that customers might go elsewhere. 9. Huge price disadvantage as compared to foreign competitors: Inflation is quite variable around the world, and therefore foreign competitors might not face the same inflation rates that we do in the Pakistan. That would put us at a huge price disadvantage.

Other important IMPACTS: If inflation looks to be getting too high, then they will raise interest rates. This affects businesses and consumers. Consumers will find it more attractive to save more and spend less. They will find it more expensive to borrow money for spending. Most consumers also have mortgages. The repayments become more expensive so their disposable income falls and they spend less. Overall, spending in the economy falls. Businesses find it more expensive to borrow money for investment and growth. Investment spending is also spending in the economy, and this falls. Of course, there is a cost to this, because growth and employment are reduced, so the Bank has to weigh this up carefully. If inflation looks too low, it cuts interest rates with the opposite effect, and growth and employment are increased.

CONCLUSION: Inflation is a burning issue in Pakistan; it is generally felt that for several years, Pakistan has had double digit inflation. We can see then that inflation can be regarded as the enemy of long-term growth and it is true to say that one of the main causes of the decline in international competitiveness of Pakistans trade over the period has been high inflation especially in comparison to our major competitors. But its not an end, even when the economy seems hopeless, there are many things that we can do to combat its effects. Knowing how to predict economic changes is a very important financial tool. We can use investment tools and business strategies to combat the impact of inflation and keep our personal financial portfolios and small businesses intact.

RECOMMENDATIONS/ TIPS TO COMBAT INFLATION: Here are some important tips for business owners to do to combat inflation: Keep overhead low. Build cash reserves to buffer short term price increases. Watch your margins carefully. Worry about growing profits, not sales. Don't lock into long-term contracts that have narrow margins with large customers. If you notice an increase in inflation, begin making small price increases instead of large increases all at once. Eliminate or pay down any variable interest loan. These payments will increase with inflation.