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Inflation In Pakistan-Macro Economics-Project Report, Study Guides, Projects, Research of Macroeconomics

This is project report for Macro Economics submitted to Ajay Agnehotri at Netaji Subhas Institute of Technology. It includes: Inflation, Demand-pull, Cost-push, Unemployment, Trend, Relationship, Monetary, Fiscal, Policy, Measures

Typology: Study Guides, Projects, Research

2011/2012

Uploaded on 07/06/2012

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Inflation in Pakistan
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EXECUTIVE SUMMARY ______________________________________________________ 4
1. CHAPTER INTRODUCTION TO PROJECT _________________________________ 5
1.1. OBJECTIVES ______________________________________________________________ 5
1.2. PLAN OF THE PROJECT ___________________________________________________ 5
1.2.1. STATEMENT OF PROBLEM 5
1.2.2. METHODOLOGY 6
1.2.3. DATA COLLECTION 6
1.2.4. DATA MANAGEMENT AND ANALYSIS 6
1.2.5. PRESENTATION OF RESULTS 6
1.2.6. DISSEMINATION OF THE RESULTS 7
1.2.7. POSSIBLE CONSTRAINTS 7
1.2.8. REQUIREMENTS 7
1.2.9. MOTIVATION BEHIND THE PROJECT 7
2. CHAPTER LITERATURE REVIEW ________________________________________ 8
2.1. INTRODUCTION ___________________________________________________________ 8
2.2. DEFINITION ______________________________________________________________ 9
2.3. DEMDAND-PULL AND COST-PUSH INFLATION ______________________________ 9
2.4. CAUSES OF INFLATION ___________________________________________________ 10
2.5. RELATIONSHIP OF INFLATION WITH UNEMPLYMENT ____________________ 11
2.6. LINK OF OTHER VARIABLES WITH INFLATION ___________________________ 12
3. CHAPTER DATA COLLECTION OF INFLATION IN PAKISTAN _____________ 12
3.1. PRICE INDICES IN PAKISTAN _____________________________________________ 12
3.2. INFLATION DURING 1990’S _______________________________________________ 14
3.3. INFLATION DURING 2000’S _______________________________________________ 16
3.3.1. INFLATION DURING 2002-03 17
3.3.2. INFLATION DURING 2003-04 18
3.3.3. INFLATION DURING 2004-05 18
3.3.4. INFLATION DURING 2005-06 19
3.3.5. INFLATION DURING 2006-07 20
3.3.6. INFLATION DURING 2007-08 21
3.3.7. INFLATION DURING 2008-09 22
3.4. LINK OF UNEMPLOYMENT AND INFLATION IN PAKISTAN 1995-2006 24
4. CHAPTER DATA ANALYSIS OF INFLATION IN PAKISTAN ________________ 26
TABLE OF CONTENTS
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5.1.6. CONTROL HOARDING TO PREVENT MANIPULATION OF SUPPLY AND DEMAND

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EXECUTIVE SUMMARY

Pakistan has undergone a significant economic growth during last few years, but the core problems of the economy are still unsolved. Inflation remains the biggest of all these problems.

The first part of the research project will present the research layout. It gives the main problem and purpose of doing this research project. The methodology of research is based on secondary data analyses, collected through websites, economic surveys and the journals. Aim is to find the determinants of inflation, its causes, situation in Pakistan, and measures to control it. Limitations are defined as per actual.

The second chapter reviews the literature defining inflation as ―too much money chasing too few goods. This chapter explains the view point of different researchers in determining the causes of inflation and establishing links of different variables with inflation such as fiscal and monetary policies, unemployment, demand pull and cost pull factors that affect inflation. This chapter also identifies monetary shocks, inflation expectations, nominal exchange rate, and price of imports, exogenous supply shocks and fiscal policy shocks as determinants of inflation.

The third chapter gives inflation patterns in Pakistan from 1990‘s to 2008, which reports the last five years as highly inflationary due to expansionary monetary policy and high oil prices. In the end we conclude that sustained level of high economic growth over the year has increased the level of income, which has resulted in a surge in domestic demand. High international oil prices lead to increase in transportation charges as well as energy intensive industry products such as metal commodities. As producers pass on the increased costs to consumers, this leads to an increase in cost of Pakistani imports, which drives up inflation. Government actions are not useful, as we are not seeing any difference in the inflation rates. Domestic production should be encouraged instead of imports; investment should be given preference in consumer goods instead of luxuries, Agriculture sector should be given subsidies, foreign investment should be attracted, and developed countries should be requested for financial and managerial assistance. And lastly a strong monitoring system should be established on different levels in order to have a sound evaluation of the process at every stage.

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1. CHAPTER – INTRODUCTION TO PROJECT

Our study will be focused at the various aspects of inflation in Pakistan from a local and global perspective. Inflation or price inflation is a rise in the general level of prices of goods and services in an economy over a period of time. It can also be described as a decline in the real value of money—a loss of purchasing power. The level of inflation in Pakistan has been persistently rising since Partition. The high levels of inflation reflect a volatile economy in which money does not hold its value for long. Workers require higher wages to cover rising costs, and are disinclined to save. Producers in turn may raise their selling prices to cover these increases, scale back production to check their costs (resulting in lay-offs), or fail to invest in future production. Many such problems have been, and still are, being faced by Pakistan. The factors leading to high levels of inflation include deficit financing, foreign remittances, foreign economic assistance, increase in wages, population explosion, black money, prices of imported goods, devaluation of rupee, etc.

1.1. OBJECTIVES

The main objectives of this project are to:

  1. Present the scenario of inflation in Pakistan and highlight the figures in recent years
  2. Study the measures that have been taken by the government to control inflation
  3. Analyze policies of the State Bank of Pakistan and the tools it is using to control inflation
  4. Give recommendations to control inflation.

1.2. PLAN OF THE PROJECT 1.2.1. STATEMENT OF PROBLEM

―To determine the extent to which monetary policy is able to influence inflation rates in Pakistan through changes in money supply.‖

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1.2.6. DISSEMINATION OF THE RESULTS

The report is going to be submitted to our instructor teaching economics at the end of the semester.

1.2.7. POSSIBLE CONSTRAINTS

The possible limitations in our research would be;

 Time constraint  Knowledge constraint  Data constraint

1.2.8. REQUIREMENTS

The research project will require: Personnel and individual roles of all group members in carrying out the work.

 Paper - for the report etc.  Transport – for gathering data

1.2.9. MOTIVATION BEHIND THE PROJECT

Pakistan has undergone a significant economic growth during last few years, but the core problems of the economy are still unsolved. Inflation remains the biggest of all these problems. Inflation is one of the obstacles on the way of development. In Pakistan, it has squeezed the major part of the population. Specially, during the current year it rose to a very high level creating an alarming situation.

The motivation behind this project is to explore the reasons that caused current price hike in all the commodity prices especially food items. This is an issue that has struck the masses very hard. The poor people living below the poverty line have been affected the most. The poverty level is continuously increasing in the country and the difference between the rich and the poor is on rise. This can create a serious problem for the country‘s economy in future. Therefore, we have decided to work on this issue as a team and take the challenging task to put forward some suggestions which would help control the rising inflation.

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This chapter overviews the concept of inflation, including introduction and definition of inflation. It will tell us if inflation is bad or good for Pakistan‘s economy. It will help us to build links between different variables of economy to identify the reasons and impacts of inflation. This chapter answers the research question one, four and five.

2. CHAPTER – LITERATURE REVIEW

This chapter overviews the concept of inflation, including introduction and definition of inflation. It will help us to build links between different variables of economy with inflation to identify the reasons and impacts of inflation.

2.1. INTRODUCTION

Inflation is a sustained rise in overall price levels. Moderate inflation is associated with economic growth, while high inflation can signal an overheated economy.

As an economy grows, businesses and consumers spend more money on goods and services. In the growth stage of an economic cycle, demand typically outstrips the supply of goods, and producers can raise their prices. As a result, the rate of inflation increases. If economic growth accelerates very rapidly, demand grows even faster and producers raise prices continually. An upward price spiral, sometimes called ―runaway inflation‖ or ―hyperinflation,‖ can result.

The inflation syndrome is sometimes described as ―too many dollars chasing too few goods;‖ in other words, as spending outpaces the production of goods and services, the supply of dollars in an economy exceeds the amount needed for financial transactions. The result is that the purchasing power of a dollar declines.

In general, when economic growth begins to slow, demand eases and the supply of goods increases relative to demand. At this point, the rate of inflation usually drops. Such a period of falling inflation is known as disinflation. Disinflation can also result from a concerted effort by government and policy makers to control inflation; for example, for much of the 1990s, the U.S. enjoyed a long period of disinflation even as economic growth remained resilient.

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side and demand side factors could be responsible for surge in inflation. Inflation can be a result of shocks to the supply of certain food items and to world oil markets. Rising oil prices can pose risk of increase in prices of almost all other commodities of the consumer basket. Such supply- side shocks are very volatile and can cause large fluctuations in food and oil prices. The effects of this on overall inflation at times can be so excessive that these cannot be countered through demand management, including monetary policy. However, greater emphasis in the recent debate on inflation remained on the demand side factors. The demand side pressures were often considered as an outcome of the September 11, 2001 incident in the United States of America (USA) and a combination of expansionary monetary and fiscal policies. First, increased domestic demand due to remittances from abroad and liberal demand-management policies outpaced the domestic production, creating a positive output gap, which in turn put upward pressure on prices. Growth in private consumption remained above 10 percent on average during FY04 and FY06, depicting signs of demand side pressures on price level. Rising import prices were also considered as an important factor in creating inflation. The exchange rate, if depreciating, in this scenario can also put upward pressure on price levels. Similarly, some people blamed indirect taxes for being the main cause of inflation. The wheat support price has also been identified as an important determinant of inflation in Pakistan by Khan and Qasim (1996) and Hasan et al (1995). Inflation that was spurred by increase in aggregate demand was called ‗demand-pull inflation‘ while supply shocks were supposed to cause ‗cost-push inflation‘.

Another competing model advocated by Sunkel (1958), Streeten (1962), Olivera (1964), Baumol (1967) and Maynard and Rijckeghem (1976) is the ‗Structuralist Model‘. This model emphasizes supply-side factors, such as food prices, administered prices, wages and import prices as determinants of inflation. It proposes that inflation in the long run can be explained by the differential rates in productivity growth, wages and elasticity of income and prices between the industrial and services sectors.

2.4. CAUSES OF INFLATION

Press Information Department of Pakistan (2007) states some of the causes of high inflation in Pakistan including:

 decelerating economic growth  Loose monetary policies  Output set-backs  Higher duties and taxes  Depreciating Pak Rupee  Frequent adjustments in the administered prices of  Gas, electricity, POL (Petroleum, Oil and  Lubricants) products  Frequent adjustments in support price of wheat  Political instability

2.5. RELATIONSHIP OF INFLATION WITH UNEMPLOYMENT

Samuelson (1998) explains the relationship between inflation and unemployment. This curve says that there is an inverse relationship between unemployment and inflation i.e. whenever inflation increases, unemployment decreases and vice versa. Inflation is basically affected by many factors mainly the fiscal policy and monetary policy by the government. These two policies are used as tools by the government to control inflation and regulate the economic activity in the country. Unemployment is affected by inflation in many ways. For example when inflation moves in the same direction as the interest rate. This means that if inflation is higher, the interest rate is also higher and vice versa. So when money supply increases in the economy, the inflation rate increases in the economy. The interest rate when increases, the cost of borrowing increases. When the cost of borrowing is higher the producers and the investors will tend to borrow less from the banks because now they have to pay the higher cost for borrowing money. This will result in less investment in the business sector which leads to low production in the economy and when there is low production in the economy there is less employment of human resource in the businesses. So this leads to unemployment and if this situation prevails in the economy the unemployment rate keeps on increasing.

Four different price indices are used in Pakistan over the course of fiscal year, namely: the Consumer Price Index (CPI), the Wholesale Price Index (WPI), the Sensitive Price Index (SPI) and the GDP deflator. The CPI is the main measure of price changes at the retail level. It covers the retail prices of 374 items in 35 major cities and reflects roughly the changes in the cost of living of urban areas. The WPI is designed for those items which are mostly consumable in daily life on the primary and secondary level; these prices are collected from wholesale markets as well as from mills at organized wholesale market level. The WPI covers the wholesale price of 106 commodities prevailing in 18 major cities of Pakistan. The SPI shows the weekly change of price of 53 selected items of daily use consumed by those households whose monthly income in the base year 2000-01 ranged from Rs.3000 to above Rs.12000 per month. The SPI is based on the prices prevailing in 17 major cities and is computed for the basket of commodities being consumed by the households belonging to all income groups combined. In Pakistan, the main focus is placed on the CPI as a measure of inflation as it is more representative with a wider coverage of 374 items in 71 markets of 35 cities around the country.

Table 2: Most Commonly Used Price Indices of Pakistan

Features: Name (^) CPI SPI WPI Cities Covered 35 17 18 Markets Covered 71 53 18 Items Covered 374 53 425 Commodities Covered 92 - 106

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Number of Commodity Groups 10 - 5

3.2. INFLATION DURING 1990’S

Pakistan sustained a double-digit inflation between 9.8 to 13.0 percent during the first seven years of 1990s i.e. from (1990-97). Not surprisingly one of the critical macroeconomic issues in Pakistan‘s policy arena during those periods has been as to how put inflation under effective control. The persistence of the double-digit inflation along with large fiscal deficit (7.0% of GDP) has been the major source of macroeconomic imbalances in the 1990s. There has been a general agreement that lack of fiscal management resulting in the excessive growth of money supply, the supply side bottlenecks, the adjustment in government administered prices the imported inflation (pass through of exchange rate adjustment), escalations in indirect taxes, and inflationary expectations have the major factors responsible for the persistence of the double digit inflation during most periods of 1990s.

Inflation in Pakistan continued to exhibit a declining trend thereafter i:e after 1997. It declined to 7.8 percent in 1997-98 and further to 5.7 percent in 1998-99 (See Table 3).

Table 3: Annual Rate of Inflation (Percentage) in Pakistan for Period 1990-

Period CPI WPI SPI GDP Deflator

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Period Overall CPI Inflation Food Inflation Non-Food Inflation

1993 - 94 1994 - 95 1995 - 96 1996 - 97 Average 1994 - 97 1997 - 98 1998 - 99 Jul-April 1998 - 99 1999 - 2000

Inflationary pressures have continued to diminish over the last three years mainly on account of tight monetary policy, prudent fiscal management, and improved supply of food items in the country. Although the exchange rate adjustment and the rise in international price of POL products have put upward pressures on inflation but these pressures were countered by the tight monetary policy fully supported by fiscal stance and improvement in the supply situation in the country.

3.3. INFLATION DURING 2000’S

The inflation rate, which was at 5.7 percent in 1998-99, was further reduced to 3.1 percent by 2002-03 (the lowest in the last three decades). This low level of inflation was supported by strict fiscal discipline, the lower monetization of the budget deficit, an output recovery, a reduction in duties and taxes, and appreciation of exchange rate. During this time period, the country had very low levels of food inflation, as domestic supply was plentiful as were international stockpiles.

During the first two years (2000-01/2002-03) overall inflation averaged 3.7% as against double- digit inflation during most periods of 1990s. As stated earlier the decline in overall inflation owe heavily to low food inflation (3.1%) compared to non-food inflation, as non food inflation averaged 4.3% during the last three years. Support price (maintenance of prices at a certain level

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usually through public subsidy or government) of wheat was not raised during 2001-02 one factor contributing to low food inflation.

3.3.1. INFLATION DURING 2002-

Inflation averaged at 3.3% during July- April 2002-03. The low level of inflation in the mildest of 12.5% increase in money supply is the result of better supply situation of essential commodities, appreciation of exchange rate, prudent fiscal management and continued sterilization of monetary impact of massive foreign exchange inflows. Food and non-food inflation have been estimated as 3.1% and 3.4% respectively as against 2.1% and 4.4% respectively in the corresponding period of last year. The higher increase in food inflation over the comparable period of last year is attributable to increase in prices of wheat, wheat flour, rice basmati, meat, tea, vegetable ghee and cooking oil. The increase in vegetable ghee and cooking oil is the result of increase in international price of palm oil and imposition of GST on the local manufacturing of ghee in the federal budget 2002-03.

Slower increase in non food inflation as compared with last year resulted mainly on account of lesser increase in fuel and lighting group (8.55% as against 9.6% of last year) and transport and communication group (5.5%as against 7.1% last year). It is important to note that during July 1- May 15 2003-03, 22 adjustments in prices of petrol has taken place – 13 times the prices were raised and 8 times reduced while one time it remain unchanged. On July 1, 2002 the price of petrol was Rest 33.71 per liter and on May 16, 2003 it‘s stood at the Rest 28.88 per liter – a decline of 14.3%. The prices of petroleum products and its various grades including kerosene oil fluctuated moderately during the fiscal year 2002-03.

The contribution of non food inflation is estimated at 61.3%, which is lower than last year (77.5%). Within non-food inflation, almost one half of the contribution has come from fuel and lighting and transport and communication.

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Another important factor is import prices, which explains 13.6 per cent of the inflation in 2004-

  1. In 2004-05, two important factors for inflation were government sector borrowing and support/procurement price of wheat, contributing 17.6 per cent and 11.8 per cent respectively. The government taxes however did not cause any significant rise in prices in 2004-05. This seems logical since there has been no change in the tax to GDP ratio over the last few years. There was no further strong pressure on import costs because of a stable exchange rate. The expansionary monetary policy did contribute in promising GDP growth but it also led to the rise in consumer prices. The phenomenal growth in the flow of loose credit to the private sector played a significant role in disturbing the price mechanism. Availability of money at virtually no cost encouraged speculators and hoarders.

―Strong domestic demand and market structure issues, especially related to the continued supply shortages of some key food staples led a surge in inflationary pressures in the economy during 2004-05, with a smaller but growing contribution from international commodity prices,‖ said the SBP in its annual report for 2004-05.

Assuming that no unexpected sharp jump in domestic oil prices would be allowed, and continued smooth supply of key staples would be maintained, SBP estimates suggest that 2005-6 inflation would range between 7.7 and 8.3 percent. The SBP report blamed international scenario main reason behind such higher inflation rate during 2004-05 amid rising international oil prices, which had been a challenging development for global price stability during 2005.

3.3.4. INFLATION DURING 2005-

Inflation picked up to an average of 8.6 percent per annum during the last two years (2004- and 2005-06) for a variety of reasons. First and foremost was the unprecedented rise in international price of oil which more than doubled during the last two years, reaching an all time high of $78/bbl. The rise in international oil prices therefore contributed to the pick up in inflation during the last two years. Second factor has been the surge in demand, which put pressure on prices. Four years of strong economic growth (on average, 7.0 % per annum) gave rise to the income levels of various segments of the society, which strengthened domestic demand and put upward pressure on prices of essential commodities.

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The government had taken several measures to bring inflation down during 2005-06. These measures included the tightening of monetary policy as well as augmenting the supply of essential commodities through liberalizing of import regime. As a result the overall inflation registered a decline from 9.3 percent in 2004-05 to 7.9 percent in 2005-06. Most importantly, food inflation declined from 12.4 to 6.9 during the same period. Non-food inflation on the other hand registered an increase from 7.1 to 8.6 percent. In 2006 the growth in non-government sector borrowing was 23 per cent. This growth is reflected in the contribution of NGSB in inflation, which was 35 per cent in 2005-06. One important factor is import prices, which explains 26.7 per cent of the inflation in 2005-06.

The government taxes did not cause any significant rise in prices in 2005-06. There was no further strong pressure on import costs because of a stable exchange rate. Such policy cannot be sustained for long since trade deficits set the direction.

3.3.5. INFLATION DURING 2006-

In year 2006, core inflation from 7.1 percent in June 2006 came down to 5.5 percent in December 2006, due to the tighter monetary stance.

The CPI-based inflation during July-April 2006-07 averaged 7.9 percent as against 8.0 percent in the same period last year. The single largest component of the CPI is the food group, which showed an increase of 10.2 percent. This was higher than the 7 percent food inflation observed over the corresponding period of last year. According to the State Bank of Pakistan, the food inflation during the period increased because of supply side constraints. On the other hand, the non-food prices grew at a slower pace compared to last year. The non-food inflation averaged 6.2 percent between July -April 2006- 07 while it stood at 8.8 percent in the corresponding period of last year. The non-food non-energy inflation (core inflation) decelerated sharply to 6.0 percent in first ten months of the fiscal year as against 7.7 percent in the same period last. The tight monetary policy pursued by the SBP has resulted in the sharp reduction in the core inflation. A more detailed analysis of the food group shows a considerable variation in inflation rates of the items included in the group. For example, considering the perishable and non-perishable items in the food group separately shows that nonperishable food prices rose by 9. percent while the perishable items prices grew by 17.6 percent. The estimated contributions to inflation for perishable and non-perishable items are 11.5 percent and 40 percent respectively when their weights are 5.14 percent and 35.2 percent respectively. Clearly, the contribution of perishable items to inflation is