ESSAY: MA ECONOMICS EXTERNAL,FINAL, INFLATION AND UNEMPLOYMENT

'INFLATION'

The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.

In economics, inflation is a sustained increase in the general price level 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 reflects a reduction in the purchasing power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the consumer) over time.  The opposite of inflation is deflation.

Inflation affects an economy in various ways, both positive and negative. Negative effects of inflation include an increase in the opportunity cost of holding money, uncertainty over future inflation which may discourage investment and savings, and if inflation were rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future. Positive effects include ensuring that central banks can adjust real interest rates (to mitigate recessions) and encouraging investment in non-monetary capital projects.

Economists generally believe that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. However, money supply growth does not necessarily cause inflation. Some economists maintain that under the conditions of a liquidity trap, large monetary injections are like "pushing on a string". Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth.

Today, most economists favor a low and steady rate of inflation. Low (as opposed to zero or negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduces the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control monetary policy through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.

CAUSES OF INFLATION

Inflation is a generalized and persistent increase in price level over a certain period of time.

Before going into macroeconomic details, some preliminary understanding can be developed by simple microeconomic demand and supply analysis. An increase in price of a good will always take place due to its excess demand (shortage).  Shortage will occur when either its demand rises above supply or supply falls below demand. Diagrammatically, price rises when demand or supply curve shifts upward.

 

On the same basis inflation can be classified into Demand side inflation and Supply side inflation. On the demand side one explanation is Keynesian, Demand Pull theory and the other is Monetarists approach, referred as monetary inflation. On the supply side it is Cost push inflation.

Demand Pull Inflation:

It takes place when aggregate demand (AD = C + I + G + X – M) increases rapidly, in a situation where economy is already close to or at full employment level. It is a condition where aggregate demand increases persistently when all the firms are already working at full capacities and can’t increase production. We already know that production involves a time lag, so if rate of increase of demand will be greater than rate of increase of supply, shortage and thus a price hike will take place.

Keynesian long run aggregate supply curve shows that starting from ample spare capacity how an economy reaches to full employment level. Horizontal part shows that due to spare capacity initially output can increase without an increase in price level. Later on every increase in aggregate demand will increase output lesser and price level greater and ultimately will increase only price level without any increase in output level.      

 In most of the cases excessive government expenditure without precautions is blamed for rapid increase in aggregate demand. If a government, spending at large during a recession, does not realizes that its effect will involve a time lag and keeps on spending to get quick results, it may soon result in over expansion which will show in the form of inflation.

Monetary Inflation:

According to Monetarists, inflation is always and every where a monetary phenomenon. They believe that inflation is always caused by an excess of money supply over the value of GDP.

Let’s talk about it in detail. Firstly it must be understood that demand for money is derived demand, which means that money is not demanded for its own sake, it is demanded to purchase goods and services. So it is simple to understand that money supply should be dependent on money demand which is itself dependent on demand for goods & services. However if money supply will exceed money demand, people and banks will have extra money balances which will be spent or lent. An increase in money supply will cause a decline in interest rates which will boost borrowing and then spending by firms and also consumers. In both the cases aggregate demand will increase above the value of GDP, resulting in a shortage of goods & services leading to an increase in price level.

Diagram shows that an increase in AD from AD1 to AD2 to AD3 is directly resulting in an increase in price level because LRAS curve is perfectly inelastic.

Monetary inflation can be explained by using Fischer’s Equation of Exchange in its Cambridge version; M V = P Y. Here M stands for money stock, V for velocity of circulation (the frequency at which money changes hands), P is price level and Y is national output. Monetarists on the basis of their observations believe that V usually remains stable. They also believe that LRAS curve is a vertical line therefore in long run Y stays constant (at full employment level). AS a result any increase in money supply will directly result in an increased price level.

Changing places in the above mentioned equation, we can make it equation for inflation. P = M V / Y. Now V & Y treated as a constant in equation therefore P is a function of M. When money supply rises price level rises and when money supply falls price level falls.                                                           

P = f (M).

Cost Push Inflation:

Is an absolutely different phenomenon, where the cause of inflation lies on supply side rather than demand side. We already know that when cost of production increases; firms are unable to maintain their production level as a result supply of the specific good falls. Same applies in macroeconomic model, when there is an increase in prices of factors of production, costs of production rise generally. Firms respond by cutting back their outputs hence aggregate supply falls leading to a situation where AD > AS, price level starts to rise.

It can be seen from the diagram that a backward shift in aggregate supply curve continuously is causing price level to rise, which is happening due to an increase in cost of production.

Usual causes of Cost Push Inflation:

An increase in world oil prices is a major contribution in cost push in oil importing countries.

Devaluation or persistent depreciation will increase cost of imported factors of production.

An increase in import duties will also increase cost.

If there is inflation in exporting country, cost of imports will increase in importing country.

In all above four cases inflation takes place due to an increase in costs of imports that’s why it can be separately classified as imported inflation. One more important point is that in all of the four cases we are assuming that demand for imports is inelastic which is not that unrealistic. Apart from above mentioned reasons, most of the reasons are local;

Lack of competition in the market between firms; we know that existence of monopoly power either being a single large firm or due to cartelization, will give price making ability. This will result in higher costs of other firms.

Trade Unions one of the major contributor increase costs by demanding a wage increase without increasing productivity. As a result costs of production increase which increase price level further and a wage price spiral starts.

Indirect taxes imposed; by including them into the price of a good also increases costs of production.

During a boom too much profiteering by some large firms increase costs of production of other firms often referred as profit push inflation.

Sometimes artificial shortage (hoarding) or genuine shortage of an essential good can create a generalized increase in costs.

Demand pull inflation will lead to cost push inflation. If prices of factors of production increase due to demand pull it will push costs of the firms up.

EFFECTS OF INFLATION

Effects of inflation will vary depending on its rate, acceleration and its predictability. Effects will be more dangerous if rate of inflation is higher, it is accelerating and it was not already anticipated. On the contrary if the rate is low and is stable it will influence positively depending on the rates of inflation of country’s trading partners. Moreover if the rate of inflation is anticipated, it will be less devastating. In coming paragraphs we will initially deal with the negative influences of inflation. Later on we will deal with zero rate of inflation, negative inflation (deflation) and finally low and stable rate of inflation.

Inflation and Common man:

A common man is one of the most badly influenced, the one with least or zero bargaining power for any wage increase to compensate for decline in buying power due to inflation. Hence people with fixed incomes will face hardships and will be forced to live a lower standard life. The persistent hardships faced can create other personal and social disorders.

Saving, lending and borrowing:  

During hyper inflation money is losing its value at such a higher rate that rate of interest offered on savings can’t even compensate for the loss of real value and a real positive return is out of question. For instance bank is offering a 10 % interest per annum and rate of inflation is 20 % per year, this shows that after a year of savings your money will earn a negative 10 % return. As a result people will prefer either to consume their savings or will buy fixed assets.

Lending will be discouraged and borrowing will be encouraged. If inflation rate is accelerating banks will not be able to adjust their rate of interest that promptly and will earn a negative real return on their lending. Borrower will benefit because at the time of receipt of the loan its buying power is greater as compared to the time when it will be returned. It means in real terms borrower is borrowing more and returning lesser. Due to the same reason credit sales will not be made, when the payment of the sold good will be received at a later time, the amount received by the seller will not be even able to repurchase the good for further sales.      

Inflation and functions of money:

 Inflation actually attacks its main function of being a medium of exchange.  When there will be inflation buying power of money will decline, during hyper inflation decline in buying power will take place at such a tremendous rate that its acceptability will become zero. People will start barter and money will no longer serve as a medium of exchange.

Secondly when money is losing its value due to inflation, especially when rate is very high, then there is no point in saving it. Money will no longer perform as a store of value. If a bank is offering a 10 % interest and inflation rate is 50 % then actually there is negative savings of 40 %.

Thirdly when people have started to barter due to extreme inflation then value of goods will be quoted in terms of other goods instead of money and money will not serve as a measure of value.

When money is not a measure of value then it is not a unit of account also. This is because now people are not using money for transactions and therefore they can’t do their accounting in money.

Money will not be used as a means of deferred payment also. Since people know that money is losing its value continuously therefore when payment will be made at a later date it will have a lower real value. What was sold at credit will be impossible to replace from the returned money.

Inflation and business:

Inflation increases cost of doing business in many ways. First of all, factors of production being expensive now, cost of production will increase and rate of return will fall, mainly for those businesses which have a week price making ability.

 Secondly persistently changing prices will require continuous changes in price lists, labels, software, menus and advertisements. This additional cost during inflation is known as Menu Costs.

 Apart from this, firms as well as consumers will incur Shoe leather cost also, which is a cost in terms of more time spent and efforts in search of lower price substitutes.

Inflationary noise is another problem faced by firms. An increase in market price of a good may be taken as a signal of an increase in demand for the good and individual firms may plan to increase output. However sometimes the price increase is just due to a generalized increase in price level, there was actually no increase in demand.

The above mentioned problems faced by firms during high rates of inflation will cause local as well as foreign investments to fall.

Inflation and external economy:

Due to higher cost push inflation, country may lose its comparative cost advantage and its exportability will decline. On the other side local goods being expensive imports of the country will increase. Declining exports and increasing imports will negatively influence trade balance and balance of payment position of the country. Apart from this capital and financial account of balance of payment will worsen because inflation will discourage foreign investments which are recorded in these accounts of balance of payments.  

Inflation and government:

Due to inflation nominal value of tax revenues will increase while real value will fall. On the other hand because of the same inflation real value of government’s expenditure will be falling and to maintain that expenditure government will be increasing taxes.

Secondly to solve the problem of inflation government will have to adopt expenditure dampening policies. Steps taken by government will be an increase in direct taxes; cutting government expenditure on non productive areas and increasing the rate of interest. All these measures will make life further difficult for a common man for instance if government cuts its expenditure on public hospitals, schools and other social security expenses only a common man will suffer. This won’t be wrong to say that inflation occurs due to the actions of higher income groups but its costs are mainly borne by lower income groups.

So!

When there are so many problems associated with inflation, then is zero rate of inflation desirable?

An absolutely zero rate of inflation means that market has become stagnant; there is no growth in output. This is because zero inflation is only possible when demand for goods and services is not at all increasing therefore firms do not have any reason to produce goods & services and employ factors of production. In other words firms do not need to increase its capacity and therefore no further capital formation (investments) is required. In such a situation we do not expect economic growth and a reduction in unemployment to take place. Taking Phillips curve in consideration zero inflation is only achievable at higher rates of unemployment and lower economic growth rates. However zero rate of inflation maintained for short period of time after a long spell of high rates of inflation will eliminate people’s anticipation of inflation which will help to keep inflation controlled in future when economy expands again.

Then! What about negative inflation (deflation)?

A generalized and persistent decline in price level means that economy is undergoing a period of deflation. This is a time when buying power of money is increasing but the effect is off set because sources of income are diminishing. Deflation is only possible due to demand deficiency. This usually occurs due to a financial crises, for instance 2007’s sub-prime mortgage crisis in USA, financial system collapsed and liquidity became scarce due to which aggregate demand fell. Due to a fall in demand firms will have unsold stocks which is a matter of worry for them therefore in order to get rid of those unsold stocks firms will reduce prices. A generalized fall in price level and decline in profitability will force firms to cut their outputs and make workers redundant, dragging the economy into a recession. Falling prices means, it is better for consumers to buy later and take advantage of lower prices, this will create a further slowdown of economy. So we can see that a period of deflation will be followed by a recession soon. Recession means mass human sufferings due to which it is never welcomed and so a period of deflation.

The Best!

All economists agree that a low and stable rate of inflation is for the benefit of all the stakeholders of the economy. A positive and low rate of inflation is an indication that market is expanding at a sustained rate. Therefore firms have a reason to expand their capacities and also to acquire greater quantities of workers and other factors of production. All this will lead to higher GDP growth rate and lower unemployment rate.

When inflation is under control, exportability will improve and potential for higher imports will decline solving the balance of payment problem. Therefore now government can focus on the problem of higher unemployment, lower economic growth and low development. Government can bravely spend on growth and development projects and can afford to cut taxes which will further improve economic conditions.

A common man’s buying power will remain almost intact and with more employment and earning opportunities standard of living will improve. When buying power of money is constant almost economy will take full advantages of functions of money in modern economies.

In short whatever was worst in hyper inflation will be best in low and stable rate of inflation.  

Unemployment vs Inflation

Unemployment and inflation are two economic determinants that indicate adverse economic conditions. Economic analysts use these rates or values to analyze the strength of an economy. It’s been found that these two terms are interrelated and under normal conditions have a negative relationship between two variables.

What is Unemployment

The unemployment rate is the percentage of employable people in a country’s workforce. The term employable refers to workers who are over the age of 16; they should have either lost their jobs or have unsuccessfully sought jobs in the last month and must be still actively seeking work. The formula used to calculate unemployment rate is:

Unemployment rate = number of unemployed persons / labor force.

If the unemployment rate is high, it shows that economy is underperforming or has a fallen GDP. If the unemployment rate is low, the economy is expanding. Unemployment rate sometimes changes according to the industry. Expansion of some industries creates new employment opportunities resulting in a drop in the unemployment rate of that industry. There are few types of unemployment.

Structural unemployment: the unemployment that occurs when changing markets or new technologies make the skills of certain workers obsolete.

Frictional unemployment: the unemployment that exists when the lack of information prevents workers and employers from becoming aware of each other. This is usually a side effect of the job-search process, and may increase when unemployment benefits are attractive.

Cyclical unemployment: type of unemployment that occurs when there is not enough aggregate demand in the economy to provide jobs for everyone who wants to work.

Employment is often people’s primary source of personal income. So employment impacts the consumer spending, standard of living and overall economic growth.

 

What is Inflation

Inflation can be defined simply as the rate of increase in prices for goods and services. We use different measures to calculate inflation. Currently, most used indicators are CPI (Consumer price index) and RPI (Retail price index). The following formula is used to calculate inflation.

Inflation rate = [(P2-P1) / P1] * 100

P1     =       Price for the first time period (or the starting number)
P2     =       Price for second time period (or the ending number)

There are two types of inflation:

Cost-push inflation: this occurs when there is a rise in the price of raw materials, higher taxes, etc.

Demand-pull inflation:  this occurs when the economy grows quickly. Aggregate demand (AD) will be increasing faster than aggregate supply. Then automatically create the inflation.

Relationship between Unemployment and Inflation

As mentioned above, the relationship between Unemployment and Inflation was initially introduced by A.W. Philips. Phillips curve demonstrates the relationship between the rate of inflation with the rate of unemployment in an inverse manner. If levels of unemployment decrease, inflation increases. The relationship is negative and not linear.

Graphically, when the unemployment rate is on the x-axis, and the inflation rate is on the y-axis, the short-run, Phillips curve takes an L-shape. It can be shown by a graph as below.

When unemployment rises, the inflation rate will possible to fall. This is because:

·         If the unemployment rate of a country is high, the power of employees and unions will be low. Then, it is hard for them to demand their labor power and wages because employers can rent other workers instead of paying high wages. Thus, wage inflation is likely to be subdued during the period of rising unemployment. This will reduce the cost of production and reduce the price of goods and services. This causes a decrease in the demand pull inflation and cost push inflation.

·         High unemployment is a reflection of the decline in economic output. thus, businesses experience an increase in increase in volume goods not sold and spare capacity. In a recession, businesses will experience a greater price competition. Therefore, a lower output will definitely reduce demand pull inflation in the economy.

Conclusion

Unemployment and inflation are two economic concepts widely used to measure the wealth of a particular economy. Unemployment is the total of country’s workforce who are employable but unemployed. On the other hand, inflation is the increase in prices of goods and services available in the market. There is a considerable relationship between unemployment and inflation. This relationship was first identified by A.W.Philips in 1958. Low unemployment rate and low inflation rate are ideal for the development of a country; then the economy would be considered stable.

PHILLIP’S CURVE

Definition of 'Phillips Curve'

Definition: The inverse relationship between unemployment rate and inflation when graphically charted is called the Phillips curve. William Phillips pioneered the concept first in his paper "The Relation between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957,' in 1958. This theory is now proven for all major economies of the world.

Description: The theory states that the higher the rate of inflation, the lower the unemployment and vice-versa. Thus, high levels of employment can be achieved only at high levels of inflation. The policies to induce growth in an economy, increase in employment and sustained development are heavily dependent on the findings of the Phillips curve.

However, the implications of Phillips curve have been found to be true only in the short term. Phillips curve fails to justify the situations of stagflation, when both inflation and unemployment are alarmingly high.

The Phillips curve suggests there is an inverse relationship between inflation and unemployment.

This suggests policy makers have a choice between prioritising inflation or unemployment. During the 1950s and 1960s, Phillips curve analysis suggested there was a trade-off, and policy makers could use demand management (fiscal and monetary policy) to try and influence the rate of economic growth and inflation. For example, if unemployment was high and inflation low, policy makers could stimulate aggregate demand. This would help to reduce unemployment, but cause a higher rate of inflation.

In the 1970s, there seemed to be a breakdown in the Phillips curve as we experienced stagflation (higher unemployment and higher inflation). The Phillips Curve was criticised by monetarist economists who argued there was no trade-off between unemployment and inflation in the long run.

However, some feel that the Phillips Curve has still some relevance and policymakers still need to consider the potential trade-off between unemployment and inflation.

Origins of the Phillips Curve

The Phillips curve originated out of analysis comparing money wage growth with unemployment. The findings of A.W. Phillips in The Relationship between Unemployment and the Rate of Change of Money Wages in the United Kingdom 1861–1957 suggested there was an inverse correlation between the rate of change in money wages and unemployment. For example, a rise in unemployment was associated with declining wage growth and vice versa.

Original Phillips Curve Diagram

This analysis was later extended to look at the relationship between inflation and unemployment. Again the 1950s and 1960s showed there was evidence of this inverse trade-off between unemployment and inflation.

Why is there a trade-off between unemployment and inflation?

·         An increase in aggregate demand (AD to AD2) causes higher real GDP (Y1 to Y2). Therefore firms employ more workers and unemployment falls.

·         However, as the economy gets closer to full capacity, we see an increase in inflationary pressures. With lower unemployment, workers can demand higher money wages, which causes wage inflation. Also, firms can put up prices due to rising demand.

·         Therefore, in this situation, we see falling unemployment, but higher inflation.

Monetarist View of Phillips Curve

However, Monetarists have always been critical of this Phillips curve trade-off. They argue that in the long run there is no trade-off as Long Run AS is inelastic. Monetarists argue that if there is an increase in aggregate demand, then workers demand higher nominal wages. When they receive higher nominal wages, they work longer hours because they feel real wages have increased. (their price expectations are based on last year)

However, this increase in AD causes inflation, and therefore, real wages stay the same. When they realise real wages are the same as last year, they change their price expectations, and no longer supply extra labour and the real output returns to its original level. Therefore, unemployment remains unchanged, but we have a higher inflation rate. The short-run Phillips curve shifts upwards to SRPC 2

Monetarist view of AD / AS

The increase in AD only causes a temporary increase in real output to Y1. After inflation expectations increase, SRAS shifts to left (SRAS2), and we end up with higher inflation (P3) and output of Yf. This AD/AS model explains why we only get temporary fall in unemployment.

·         Adaptive expectation monetarists argue there is only a short-term trade-off between unemployment and inflation.

·         Rational expectation monetarists argue there is no trade-off, even in the short term. The rational expectation model suggests that workers see any increase in AD as inflationary and so predict real wages will stay the same.

Summary of Monetarist v Keynesian view

A monetarist would argue unemployment is a supply side phenomena. Monetarists argue using demand-side policies can only temporarily reduce unemployment by an ever-accelerating inflation rate. Monetarists argue that unemployment is determined by the natural rate of unemployment

Keynesians argue there can be demand deficient unemployment, and during a recession demand-side policies can reduce unemployment in the long term (with perhaps some inflation)

Pakistan and inflation

Inflation in Pakistan,

its causes and its remedies.

Introduction:

                               According to official statistics, price inflation in Pakistan, as measured by the consumer price index (CPI), remained on average 11.1% per annum between 1990-91 and 1995-96 but more than 20% as believed by most of the economists. Price inflation, defined as the persistent rise in general price level in a country, may be described as creeping, running or galloping depending on its pace of rise in a country. Inflation in Pakistan has entered into the regime of ‘running inflation’ intimating to the managers of the economy the seriousness of unmanageable feature of macro-economics variables in the country.  Several studies have been conducted to explore the causes of inflation during the 1990’s. Generally, monetary growth, public policy, administered prices, rise in the prices of imported goods, inflationary expectations and output growth are termed as the determinants of inflation in Pakistan. However, their actual contribution towards inflation is debatable. One group of economists considers inflation a monetary phenomenon, while the other assigns more weightage to rise in administered prices and increase in prices of imported goods as determinants of inflation. Overall, host of factors from both the demand and supply side are responsible for the recent price spiral in Pakistan. The following is a brief review of the factors responsible for inflation during this period.

 Causes of Inflation:

                                                The GDP growth has a significant dampening effect on inflation. Pakistan’s GDP has grown at an average rate of more than 6% per annum during the last decade. During the first half of 1990, however, the growth rate remained at an average of 4% per annum which may be attributable to the transition of economy from greater government role to the private sector, inefficiency of public sector enterprises, lower production in large scale manufacturing, poor agriculture sector performance and distortionary public policies. Most public sector enterprises have become inefficient and have been incurring losses for several years. More than 4000 industrial units in the private sector are ‘sick’ due to which performance of the manufacturing sector is poor for the last few years and recorded a negative growth of 1.4% this year. The agricultural sector, which contributes 26% to the GDP also exhibited vulnerability during the last five years’ period. This sector recorded a meager growth of 2.5% per annum during last five years which is even lower than 3.0% population growth rate. The effect of poor agriculture growth is also evident from the fact that ‘food group (weight 49.35%), in CPI recorded 107% inflation from 1990-91 to May, 1997 as compared with overall inflation of 97.57% and non-food inflation of 88.0% during the same period. Furthermore, the country faced a severe wheat shortage this year due to lower than targeted production of wheat in the country, delay in its import and failure of responsible authorities in its prompt distribution in different areas of the country.

        As far as administered prices are concerned the government increased the procurement price of wheat, gram, rice, sugarcane, e.t.c. This year in the range of 10% to 40% to give impetus to the production of these crops. Actual quantities of these crops will come into the market with the time lag of at least 6 months. Prices, however, increased soon after the government’s announcement. Distortionary public policy towards agriculture sector in the past has put us into the situation that, Pakistan, an agricultural country, is bound to import wheat, milk, cooking oil, pulses, meat e.t.c to the tune of $2.0 billion annually. Solution of half of trade deficit problem of the country hinges in self-sufficiency in agricultural production. Similarly, the index of fuel, lighting and lubricants in CPI, which comprises electricity gas and POL products increased 19% during the year from end June, 96 to May, 97 and 98.59% from 1990-91 to May 1997 which caused rise in cost of production and transportation cost. One reason for rise in the prices of POL products in the country is price-hike of POL in the international market determined by demand and supply forces. The other one is the frequent devaluation of domestic currency which is controllable by better economic management in the country. Almost every increase in administered prices adds more and more grieves, miseries and hardships to the consumer life.

                                                                                                 Increases in the world price of imports in the world market and a 40% devaluation/depreciation in the Pakistani rupee from January 1991 to June 1997 fuelled inflation to unmanageable levels. Without removing the causes of devaluation , we are lowering the value of our currency to make our commodities competitive. As devaluation fuel inflation, it becomes necessary to devalue further to keep our market competitiveness intact. This has put the Pakistani rupee in a devaluation spiral.

                                                     Large and persistent levels of trade and current account deficits due to stagnant exports and high level of imports is posting several implications for inflation. More than 60% of our exports consist of cotton and cotton-based products which are facing cut throat competition in the world market. Our major imports are machinery, chemicals and oil which registered a faster growth in price in international market due to the monopolies created by the developed countries.

                                                                                                                          The tax to GDP ratio in Pakistan is only 13 to 14%, leaving the government short of funds to run the machinery of the government. The government has to resort to debt financing, money financing and financing from external sources which put upward pressures of different magnitudes on the price level.

                                                      The ratio of indirect to total tax revenues in Pakistan is more than 70%. It has been the practice of all governments from past to present to tap revenues from indirect taxes, due to which inflation in the country has reached a very high level. The debt burden of Pakistan is almost equal to GDP, which has made budget making a very unpleasant task for the government every year. The government has to borrow to service the existing debt. Due to this, the debt pool is inflating day by day. As getting unlimited funds from abroad is not possible (although least inflationary in nature) the government has to resort to note printing which fuels inflation severely. Borrowing from the banking and non-banking sector also has its limitations. The government has to compete with the private sector and offer attractive rates of return on its securities. The government is offering more than a 17% rate of return on its securities leaving banks in a liquidity crunch and putting upward pressure on the lending rate to the private sector. In the wake of a high lending rate the revival of the economy is looking difficult.

Consequences Of Inflation:

                  During an Inflationary period it becomes very difficult for the government to fulfill its commitments of achieving macro economics targets. Almost all targets, such as GDP growth, price inflation, bank borrowing, trade deficit and budget deficit are violated. This hurts the credibility of the government. Costs of development project and non-development expenditure increase due to which the government needs more funds next year by the amount of inflation to keep economic activity at the level of previous year.

                                                                                              A low saying rate in the country is also one of the causes of rising inflation. In the wake of 14% inflation and an average 10% deposit rates, depositors are getting negative real rates of return on their deposits. Income of the individuals is being diverted from saving to consumption and non-productive channels like purchase of real estate and conspicuous consumption leaving saving at a very low level of 11% in the country.

                                                                                      Redistribution of income takes place during an inflationary regime. Resources are moving from lender to borrower. As in the case of Pakistan, lenders are small deposit holders and borrowers the rich elite. Double digit inflation is aggravating the already high inequality between the rich and the poor.

           A kind of rent seeking culture develops due to inflation where the businessman earns lucrative profits by trading existing production. This provides a disincentive for him to be involved in the production process. An entrepreneurial culture cannot develop in this situation. Trading further raises the price level by manipulation of the market through hoarding and black-marketing by the rent seekers while production eases the upward pressure on price level in an economy.

                                                                     As inflation is a regressive tax on fixed and low income groups, it can cause anxiety, unrest and many other social problems in the country.

               Dollarization; as defined by the ratio of foreign currency deposits to total monetary assets (M2), takes place due to the decline in the value of domestic currency. This process never reverses until or unless the value of the local currency is not restored as is evident from the study of transitional economics of the socialist block and other developing countries. Foreign currency deposits in Pakistan have reached the $9.4 billion mark since their inception in 1992 to date acting as a hanging sword on the head of the government. Inflation expedites this trend further.

                  Devaluation is also one of the consequences of inflation. Due to double digit inflation Pakistan has been caught in the vicious circle of devaluation (devaluation inflation loss of competitiveness again devaluation).

                        As a result of inflation real money balances (M/P) decline and we need more money to exchange the same quantity of goods and services. This puts pressure on the printing press to print more and more currency notes to meet the requirement. This is the extra cost attached to inflation.

 

 Inflation Pressure On The Economy

There has been a significant rise in inflation mainly caused by supply shocks of essential food items and higher crude oil prices in the international market. Some essential items like wheat and meat has witnessed considerable increase during the outgoing fiscal year (2003-2004) mainly spearheaded by supply shocks caused by misadministration and hoarding (rather than actual supply shocks). Even after the stabilization of food items supply, the inflation caused 4% ending with 4.6% surge in price level during 2003-2004. Some prophets of doom and gloom gave an impression that price level is sky rocketing, and the economy would crumble in near future. However, that’s not the case. Some analysts were also of the opinion that inflation would accentuate macroeconomic imbalance and will hurt the poor and the fixed income groups. Some went to the extent of linking recent surge in inflation to imminent rise in the poverty level.

                                                                                                                                The recent surge in inflation is a global phenomenon and cannot be viewed in isolation. Normally inflation is the byproduct of economic growth and economist term it as greasing factor that is necessary for economy to move at a brisk pace. There are always some sort of trade-offs between employment and inflation. The inflation is an integral part of economic activity and it is unavoidable. Higher growth is essentially associated with higher inflation. The economic policy can only influence one part of the inflation while other part is out of the purview of such a policy. For example higher oil prices in the international market are out of the purview of the economic policy making and food supplies are driven by the performance of volatile agriculture sector. The government can hardly influence the performance of the agriculture sector. Core inflation is the true representative of the influence of the economic policy on inflation.

          As far as inflation is concerned, Pakistan is comfortably placed in the camp of developing countries since the last three years. It is a misconception that the statistics released by the government do not fully translate the on ground realities (although it is true that inflation in real terms is much higher in the economy than reported by the government). Generally, people take decrease in inflation rate as decrease in prices of most items but in fact it might represent the declaration of the pace of increase in price level.

                   It is common to criticize statistics provided by the government without going into proper analytical assessment. As a matter of fact the government statistics are based on internationally recognized methodology of collection and processing of information. These methods, in fact are being practiced in both the developed and developing world in general.

          In Pakistan, like most of world economies, the term inflation is generally referred to the upward movement in Consumer Price Index (CPI). The CPI index in Pakistan is based on a basket of 374 consumer items selected on the basis of a Family Budget Survey conducted by Federal Bureau of statistics in 2000-2001. Its objective is to measure the change in cost of living due to changing prices of consumer items. The consumer items are distributed in 10 groups of basket of goods and services. The weight of an item represents the share of expenditure of an average family on the specific item. The CPI is compiled by FBS (Family Budget Survey) on the basis of monthly surveys. Its coverage includes 35 major cities/urban centers across the country. While, all the urban centers have been categorized into four groups by size of population ranging from mega cities to urban areas with less than fifty thousand population. The selection of these urban centers has been made in such a way that ensures geographical and regional representation of all the areas of the country. Each month, more than 100,000 prices are collected on the basis of a stratified random sample covering four markets in these 35 cities. Price quotations are collected for each of the 375 items from different shops in each market.

The stereotype thinking about statistics provided by the government has a historical background. Pakistanis are traditionally accustomed to low inflation (see table-1). Only twice in the country’s history of five decades we touched double-digit inflation as far as average for decades is concerned. The inflationary pressure persisted in the early 1990s due to monetary overhang combined with shortage of essential commodities continued until 1996-97 and the average for the first seven years (1990-97) of the 1990s averaged at 11.4 % but continued its declining trend thereafter. It declined to 7.8 % in 1997-98 and further to 5.7 % in 1998-99. In 2002-03 it reached to 3.1 %, which is lowest ever since 1969. Improved availability of agriculture and food products has kept a firm check on the prices of milk, wheat, rice, beef, mutton and poultry meat. The trend of declaration could not sustain during the outgoing fiscal year and during 2003-04 CPI.

                    Moved up by 4.6 % against a target of 4.0% and actual achievement of 3.1 % last year. The main reason was the shortage of wheat in some parts of the country.

                  Another important contributor to the inflation was higher oil prices in the international market. The Oil Advisory Committee has already passed on major portion of the oil price-hike to the consumers. The oil price-hike is an international phenomenon beyond the control of the government.

                       

The table-2 clearly implies that the inflation in Pakistan is modest as compared to other developing countries. Pakistan’s inflation rate of 4.6% during the outgoing  fiscal year is far below that 1998-99 level. No government in the world can be comfortable with soaring prices but in modern growth centric economic policy making, inflation is unprecedented and any forceful containment of inflation often caused slowdown in growth and rise in unemployment. The government of Pakistan is applying stringent and prudent policy measures to keep a check on inflation.

The government must tolerate around 5% inflation to reach above 6.5% growth during 2004-2005. The government should be vigilant about food supplies and restrict State Bank Of Pakistan from doing any unreasonable like upward adjustment of interest rates. This might hamper the current growth momentum in the economy.

Remedies:

                                           A persistent high level of monetary growth should never be compromised to maintain stability in the external value of currency and to control inflation effectively. The major factor towards excessive monetary growth in the case of Pakistan is high government borrowing as compared to the stipulated credit allocation in the credit plan. This leaves less room for the private sector which is considered more productive as compared to public sector. The Central Bank should not act as the printing press for the government’s finance ministry. For example during 1996-97 the government of Pakistan has taken more than Rs. 80 billion in credit as compared to revised target of Rs. 61 billion from the total domestic credit expansion of Rs. 136 billion. Unlimited injection of credit into the economy will aggravate the already uncontrollable inflation in the country. Quick and transparent privatization of government sector enterprises and use of privatization proceeds towards debt retirement will ease the government’s position by reducing the amount of debt servicing. It will also lower the government’s budget deficit by the amount of losses incurred by these units.

                                           Down-sizing the budget deficit by cutting administrative expenditures and through increases in revenues by broadening the tax base. The government should consult that group of privileged people who is not contributing to government exchequer currently so that it does not have to resort to increasing administered prices to get extra revenue.  Inflation in Pakistan is hard to control efficiently and quickly without enhancement of agricultural production. There is need to provide credit to small farmers. His weak financial position and skill level prevent him from employing modern equipment and inputs to his farm. It is no easy task for small farmers in Pakistan to obtain credit. It is possible only after several visits to the bank and after paying some percentage of the loan to mobile credit officer (MCO) or to other officials. This increases the effective rate of return and multiplies his miseries.

               Banks are unable to offer a positive real rate of return to depositors in Pakistan due to huge intermediation costs and stuck up loans. Implementation of recently approved laws by the parliament will help cure this situation. Process of privatization of the nationalized commercial banks (NCBs) should be speeded up keeping in view the transparency of this process.

               As a long-term policy measure , human capital must be equipped with skill and knowledge to enhance its productivity and efficiency and ultimately tame inflation. The standard of living and the level of education have a strong bearing on population growth and other matters of social and economic well-being. Autonomy granted to State Bank Of Pakistan is also a right step towards financial soundness and the restoration of the value of currency. Performance of the State Bank Of Pakistan hinges on the success of recovery drive , controlling monetary expansion to public sector for budgetary support and reducing the lending rate by lowering the intermediation cost of the banking system.

Conclusion:

                                              Consensus has developed among the economists that the inflation and output growth are negatively correlated specially at the level of double-digit inflation. An unclear trade-off between inflation and unemployment at a very low level of inflation of 3 to 4% is also identified. On the basis of these findings a low inflation of 2 to 3% is desirable. It can be achieved through curtailment of monetary expansion, lowering budget deficit, promoting efficiency by education and skill, enhancing agriculture production through research and credit availability, promoting national savings by offering positive rate of return on deposits and identifying profitable avenues of investment and revival of the economy by solving the problems of sick industrial units and quick and transparent privatization of public sector enterprises.