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Pakistan Economy-Macro Economics-Assignment Solution, Exercises of Macroeconomics

This assignment is related to Macro Economics course. It was assigned by Vipin Mehta at Makhanlal Chaturvedi National University of Journalism to cover following points: Inflation, Complex, Process, Price, Controls, Depriciations, Exchange, Rate, Wholesale, Sensitive, Index

Typology: Exercises

2011/2012

Uploaded on 07/06/2012

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Pak economy: Inflation, a complex process
By Aftab Ahmad Khan
Inflation may be suppressed or open; it is open when prices rise without check.
According to the Nobel Laureate, Prof. Milton Friedman open inflation refers to an
“inflationary process in which prices are permitted to rise without being suppressed by
government price controls and similar techniques.” Suppressed inflation refers to those
conditions in which, as a result of avoiding the policies of price control and rationing on
the part of the government, prices are prevented from rising. Wartime controls are an
example of suppressed inflation; post-war inflations are an example of suppressed
inflation developing into open inflations. The word „suppression‟ in the context of
inflation implies: (a) postponement of the present demand to some future date; and (b) the
diversion of demand from one kind of goods to another, from those goods which are
subject to price control to those goods whose prices are uncontrolled and whose supplies
are not rationed.
Inflation is a complex process and it is difficult to find a single empirical model that fits
the circumstances of all countries. There is, however, little disagreement that in the long
run, inflation is a monetary phenomenon; high rates of price increases cannot be
sustained for long periods without monetary nourishment. Monetisation of fiscal deficits
is frequently the major source of excessive monetary expansion in developing countries.
Although sustained rise in inflation is only possible if it is accommodated by monetary
expansion, episodes of high inflation can be triggered by other developments as well.
Large depreciations of the nominal exchange rate are widely regarded as a cause of
inflation. There is indeed some evidence that episodes of accelerating inflation in
countries like Argentina and Brazil have been initiated by devaluations and thereafter
sustained by an accommodating monetary policy. Another potential source of inflationary
impulses is the supply shock that may have inflationary repercussions if financial policies
are accommodating. Structural reforms in developing countries at the behest of
International Monetary Fund (IMF) may create temporary inflationary pressures when
prices are being de-controlled and subsidies cut: wage and salary increases in excess of
productivity gains and infrastructure bottlenecks (e.g. energy shortage and inadequacies
of transport) can also exercise inflationary pressures. The non-monetary sources of
inflation, however, cannot be perpetuated unless these are sustained by inappropriate
monetary policies.
Many economists have frequently emphasised that inflation is more than an economic
problem. This is because of their belief that money supply in a modern economy is a
sociologically determined variable. Behind the excessive expansion of money supply, lie
complex socio-political forces struggling over the distribution of income and wealth.
Various groups, strata and classes in contemporary economies are engaged in an
organized struggle over distributive shares. This distributional struggle is not new but it
has acquired certain new dimensions which compel the state to continuously increase the
supply of money. In a situation of intensified struggle over distributive shares,
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Pak economy: Inflation, a complex process

By Aftab Ahmad Khan

Inflation may be suppressed or open; it is open when prices rise without check. According to the Nobel Laureate, Prof. Milton Friedman open inflation refers to an “inflationary process in which prices are permitted to rise without being suppressed by government price controls and similar techniques.” Suppressed inflation refers to those conditions in which, as a result of avoiding the policies of price control and rationing on the part of the government, prices are prevented from rising. Wartime controls are an example of suppressed inflation; post-war inflations are an example of suppressed inflation developing into open inflations. The word „suppression‟ in the context of inflation implies: (a) postponement of the present demand to some future date; and (b) the diversion of demand from one kind of goods to another, from those goods which are subject to price control to those goods whose prices are uncontrolled and whose supplies are not rationed.

Inflation is a complex process and it is difficult to find a single empirical model that fits the circumstances of all countries. There is, however, little disagreement that in the long run, inflation is a monetary phenomenon; high rates of price increases cannot be sustained for long periods without monetary nourishment. Monetisation of fiscal deficits is frequently the major source of excessive monetary expansion in developing countries. Although sustained rise in inflation is only possible if it is accommodated by monetary expansion, episodes of high inflation can be triggered by other developments as well. Large depreciations of the nominal exchange rate are widely regarded as a cause of inflation. There is indeed some evidence that episodes of accelerating inflation in countries like Argentina and Brazil have been initiated by devaluations and thereafter sustained by an accommodating monetary policy. Another potential source of inflationary impulses is the supply shock that may have inflationary repercussions if financial policies are accommodating. Structural reforms in developing countries at the behest of International Monetary Fund (IMF) may create temporary inflationary pressures when prices are being de-controlled and subsidies cut: wage and salary increases in excess of productivity gains and infrastructure bottlenecks (e.g. energy shortage and inadequacies of transport) can also exercise inflationary pressures. The non-monetary sources of inflation, however, cannot be perpetuated unless these are sustained by inappropriate monetary policies.

Many economists have frequently emphasised that inflation is more than an economic problem. This is because of their belief that money supply in a modern economy is a sociologically determined variable. Behind the excessive expansion of money supply, lie complex socio-political forces struggling over the distribution of income and wealth. Various groups, strata and classes in contemporary economies are engaged in an organized struggle over distributive shares. This distributional struggle is not new but it has acquired certain new dimensions which compel the state to continuously increase the supply of money. In a situation of intensified struggle over distributive shares,

governments are faced with a dilemma of either suppressing or mitigating the conflict which threatens the very foundation of market oriented economies.

Suppressing the distributional dissent requires curbs on trade union activity, imposing of stringent discipline on the workers by means of unemployment, curtailment of hard won political rights of the people and so on. Such a roll back of social progress or suppression of internationally recognised rights is to some extent possible under authoritarian regimes; in a democratic set up it is not feasible. Hence, the other alternative with the government is to expand money supply to meet the claims of every section and group in society. The resulting inflation thus becomes an effective short-run softener of social conflict. It is, however, also a fact that politically motivated inflation if persisted in for a considerable period could assume serious proportions with unwelcome political, social and economic consequences.

Pakistan has been grappling with inflationary pressures during its life of over 60 years. According to official statistics, consumer price index, increased forty-five fold during the period 1949/50 – 2007/8. The pace of inflation, however, has been varying at different periods of history.

Price inflation indicators for 2004-05, 2005-06, 2006-07 and 2007-08 were disturbing. The government visualised an annual inflation target of 6.5 percent during 2007-08, which was raised to 12 per cent for 2008-09.Food inflation in June 2008 soared to a record high of 32 per cent.The core inflation (non-energy and non-food) escalated to 13 per cent in June 2008 as compared with the modest figure of 5.7 per cent in the same month last year.

The Wholesale Price Index (WPI), which is generally used to measure the cost of production, registered a record increase of 16.41 per cent during 2007-08.

The Sensitive Price Index (SPI), which reflects the prices of 53 essential commodities, mostly kitchen items, recorded a disturbing rise of 28-37 per cent in the week ending July 4, 2008 over the corresponding week of 2007.

A worrisome feature of the price situation was the substantial rise of 21.83 per cent in the Consumer Price Index (CPI) in June 2008 over the corresponding month last year.

Inflationary trends have been high due to domestic supply side disturbances and the impact of increase in international prices of oil and some key food items. The costs of inflation to the economy have been considerable. Inflation has tended to accentuate inequalities and caused considerable strains on our balance of payments. It has weakened the external value of our rupee. It pushed a sizable chunk of our resources into such socially wasteful channels such as real estate, luxury housing, speculative inventories, bullion and jewellery and foreign exchange balances held abroad. Inflation has been responsible for enlivening speculation, stimulating inessential consumption and generating a climate of industrial strife in the country. Discrimination against the public

equilibrium level. The causes of inflation have been much discussed in economic literature and policy debates. There is, however, little disagreement that in the long run inflation is primarily a monetary phenomenon. High rates of price increase cannot be sustained for extended periods without corresponding increase in money supply. The link between monetary growth and inflation is empirically well established for high inflation countries but adjustment lags and shifts in money demand functions tend to weaken the short run correlation in countries with more moderate rates of inflation.

Monetisation of the fiscal deficits is frequently the major source of excessive monetary expansion in developing countries. Developing countries resort to monetary financing of fiscal deficits to a greater extent than industrial countries. This is because of the structural weaknesses of public sector financing in developing countries, which are typically characterised, as in our case, by narrow tax bases, low elasticity of public revenue as well as under-developed capital markets and low private savings. Although a sustained rise in inflation is only possible, if it is accommodated by inappropriate fiscal and monetary policies, episodes of high inflation can be triggered by other developments such as large depreciation of exchange rates, adverse supply shocks, rise in import prices, excess of wage claims over productivity growth, and monopolistic/ oligopolistic market structures.

Structural reforms may also create temporary inflationary pressures, for example when prices are being de-controlled and subsidies cut.

Many economists have frequently emphasised that inflation is more than an economic problem. This is because of their belief that money supply in a modern economy is a “sociologically determined variable.” Behind the excessive money supply, lie complex socio-political forces struggling over the distribution of income and wealth. Various groups, strata and classes in contemporary economies are engaged in an organised struggle over distributive shares. This distributional struggle is not new but it has acquired certain new dimensions, which compel the state to continuously increase the supply of money.

In a free polity particularly, a large number of groups and sections of people pressurise the elected government to accommodate their demands. These groups include organised labour, industrialists, traders, defence personnel, civil servants, farmers etc. These groups do not explicitly ask for inflation, but it is their demands, which if fulfilled usually lead to it. These implicit demands for inflation arise from pressures on the government not to pursues an anti-inflationary policy; these may stem from taxpayers who demand lower taxes or exemptions or who resist extension of the tax base; or these many emanate from beneficiaries who resist expenditure reduction or imposition of appropriate charges or these could be ignited by groups attempting to obtain an increase in their share of national income. Thus, in the short-run, acceleration in money supply and prices represent politically rational response to the various pressures exercised by the beneficiaries of inflation or by those who are going to suffer as a consequence of dis- inflationary measures. It is, however, also a fact that politically motivated inflation if persisted in for a considerable period could assume serious proportions with unwelcome political consequence.

Pakistan has been grappling which inflationary pressures of varying intensity during its entire life of over 60 years as an independent country. According to official statistics, consumer price index (CPI) increased forty fold during the period 1949/50 – 2006/7. The pace of inflation has, however, been varying at different periods of history. Inflationary pressures in the economy during the 1950s and 1960s, were quite moderate; the average annual price increase during the 1950, was 3.0 per cent, while it was 3.2 per cent during the 1960s. During the decade of the 1970s there was worrisome acceleration in inflation attributable to heavy devaluation of the rupee, sharp-rise in oil prices and large monetary expansion (average annual increase of 21 per cent as against average annual growth of 4.8 per cent in Gross Domestic Product). There was deceleration of inflationary pressures during the 1980s with higher real domestic growth of 6.5 per cent on an average basis and a marked reduction in the annual average growth of monetary assets to 13.2 per cent. During the decade of the 1990s, inflationary trends witnessed acceleration with an annual average growth of 9.7 per cent in consumer price index (CPI); monetary assets also witnessed a sharp average annual rise of 21.7 per cent in this decade as against an annual average increase of 4.6 per cent in GDP. There was a welcome decline in inflation rate to 3.6 per cent in 1999-2000. During 2000-2001 to 2003-04, the average annual rate of rise in consumer price index was a modest 3.9 per cent. This impressive performance on the inflationary front was quite remarkable especially in view of the fact that monetary assets expanded at an annual average rate of 15.5 per cent during this period. The low level of inflation during 1999-2000 to 2003-04 can be attributed to improved supply position stemming from output recovery, strict monetary measures leading to lower monetisation of fiscal deficits, depressed international market prices and appreciation of the exchange rate.

Price inflation indicators for FYs 2004-05, 2005-06 an 2006-07 were somewhat disturbing. Inflation as measured by CPI increased by 9.3 per cent in 2004-05, 7.9 per cent in 2005-06 and 7.8 per cent in 2006-07; monetary assets during these fiscal years increased at an annual average rate of 17.9 per cent. During the first nine months of the current FY08, the average CPI based inflation has been estimated at 9.5 per cent period compared to 8 per cent in the same period last year. Food inflation, however, jumped to 13.8 per cent as compared with 10.3 per cent in the corresponding period last year. The wholesale price index (WPI) and sensitive price index (SPI) during July-March FY registered increases of 12.59 per cent and 12.87 respectively.

Inflationary trends in recent years have remained uncomfortably high on account of domestic supply side disturbances and the impact of increase in international prices of oil and some key food items. To control inflation, the State Bank of Pakistan has been pursuing a tight monetary policy during the last three years. It has raised its discount rate to 10.5 per cent. It quite appropriately emphasised in its 2Q Report for FY08, the importance of controlling growing macro-economic imbalances reflected in the widening fiscal and current account deficits which add to inflationary pressures.

The costs of inflation to the economy have been considerable. Inflation has tended to accentuate inequalities and caused strains on our balance of payments. It pushed a sizeable chunk of our resources into socially wasteful channels such as real estate, luxury

Inflation in pakistan — who to blame?

By Hasaan Khawar and Dr Zafar Iqbal

The State Bank of Pakistan has recently released the second quarterly report for FY 2007- 08, unveiling the skyrocketing inflation figures. These figures came as no surprise to the masses, who are already crippled under soaring prices and severe shortage of essential food items.

Crude oil prices touching record high peaks are adding fuel to the fire. Under the circumstances one wonders who to blame for this massive price hike.

According to State Bank, high food inflation, owing to the rising international commodity prices as well as „factors related to domestic economy‟, are the main culprits. This situation, besides exposing the vulnerability of our economy to international price shocks, has also bewildered people about what benefit, if any, they have extracted from the so- called phenomenal economic growth of the last five years.

Is our economy that vulnerable to external economic shocks? Are there any other factors responsible for this high inflation, besides the surge in international prices? And what can the government do to prevent such an untoward situation?

As experts are predicting one of the worst global food crises in history, the prices for food items are hitting a record high in the international commodity market. These prices coupled with an unprecedented hike in crude oil prices are further compounding the global inflationary pressures.

These factors however, are only responsible for part of the crisis that Pakistan is facing right now. After analysing the current economic situation, one cannot ignore such factors as government‟s expansionary fiscal policy, the prevalent anti-competitive market practices, inefficient law and order situation resulting in supply disruptions and administrative decisions like the delay in passing on the oil price increase to the consumers.

The oil prices have been on the rise since last year. However, the caretaker government, apparently under political pressure, failed to pass on these increases to the public, fearing a political backlash in the upcoming elections. This delay, in turn, failed to check the consumer demand, which could have been substantially rationalised, if the price increase was passed on to the consumers. Such a demand rationalisation could possibly have resulted in significantly lower oil import bill and consequent reduction in current account deficit.

The anti-competitive market structure facilitated a few elements in cornering the wheat market and was hugely responsible for the increase in the flour price. Right before the elections, when people were waiting in long lines just to get a sack of flour and the

government was desperately trying to import wheat at phenomenally high prices, the administration miserably failed to check the hoarders.

Not even n a single case was made public, where a hoarder of wheat was taken to task. The hoarding of essential food items like wheat therefore, pushed up the flour prices tremendously, resulting in a huge increase in food inflation.

The increase in food inflation is now responsible for 59 per cent increase in the CPI. Interestingly, in a country where agriculture is the backbone of the national economy and the main source of livelihood for 66 per cent of the population and accounting for 20. per cent of the GDP, it is surprising that why the local supply is so vulnerable that we cannot even meet our local demand.

Our fiscal deficit currently stands at around more than Rs359 billion, much more than what the government had expected. Most of this deficit has been funded by nothing else but the cheapest and easiest financing source available to the government, through expansion of M2 assets. This is in sharp contrast to the SBP‟s recommendation to the government last year to retire debt of around Rs62 billion. This expansion in monetary assets apparently has played a key role in boosting aggregate demand and pushing the inflation further up.

The new government has also to deal with the dirty laundry of the last government. A case in point is the recent heavy oil subsidy, which was given in terms of issuing guarantees to oil companies, against which they borrowed the unpaid price differentials from the commercial banks, shifting the financial burden to a future date.

Most of the subsidy amount, if not all, is still to be paid and will have its adverse impact probably in the next financial year. Under this situation, the government has limited options to deal with the current crisis. On one hand, any decision to tighten the monetary policy runs the risk of generating a recessionary trend and on the other, the widening fiscal deficit is giving little room to the government to grant any relief to the consumers.

There is no single remedy for this chaotic situation and the government should adopt a multi-pronged strategy to tackle this issue. In the short term, the government should strengthen the administrative machinery, to check anti-competitive market practices, such as hoarding, as well as to ensure supply of essential food items.

In the long run, however, the focus should be on enhancing agricultural productivity, careful agricultural planning and maintaining strategic reserves of essential food items. The situation also highlights the need to thoroughly examine the prevalent market structures in the domestic food market, by organizations like Competition Commission of Pakistan, and design appropriate interventions to prevent these monopolistic trends in future.

On the energy front, the government must seriously explore alternative options including ethanol-based fuel. While this option has been tried on a limited scale, the minimal price

living and they may have no choice but to cut down their expenditures on health and children‟s education.

Rising inflation is also making it more difficult for pensioners and low-income people living on nominal incomes to make both ends meet. It is interesting to note that the high inflation trend in food has been noticed since the start of the last fiscal 2006. Food inflation was in double digits, averaging more than 10 per cent, during fiscal year 2006-

  1. During July 2006, it stood at 7.44 per cent, August 11.08 per cent, September 11. per cent, October 10.54 per cent, November 8.07 per cent, December 12.71 per cent, January 2007, 8.70 per cent, February 9.99 per cent, March 10.74 per cent, April 9.41 per cent, May 11.31 per cent and June 9.68 per cent.

Likewise, at the start of the new financial year 2007-08, it kept the same trajectory and during July 2007, food inflation stood at 8.47 per cent, August 8.62 per cent, September 12.97 per cent, October 14.67 per cent, November 12.47 per cent, December 12.21 per cent, January 2008 18.25 per cent, February 16.05 per cent, March 20.61 and April 10. per cent.

More worrisome was the Wholesale Price Index (WPI) which during April rose to 23. per cent from only 6.03 per cent in the same month of the last fiscal, which indicates further increase in general prices in the coming months.

The main concern is that in the basket of WPI, food prices in percentage terms increased by 10.96, fuel, lighting and lubricants 7.48, manufactures 2.67 per cent and building materials 1.41 over April 2007.

The CPI covers retail prices of 374 items in 35 major cities and reflects roughly the changes in the cost of living of urban areas. In the CPI basket, during April 2008, food and beverages showed 10.46 percentage points increase over April 2007, house rent 2. percentage points, transport and communication charges 1.33 percentage points, cleaning, laundry and personal appearance 0.94 percentage point, apparel, textile and footwear 0. percentage point, household furniture and equipment 0.28 percentage point and fuel and lighting charges 0.63 percentage point over the same month of the last fiscal.

In a span of just one month, egg prices were up by 27 per cent, fresh fruits 26 per cent, wheat flour 26 per cent, chicken farm 16 per cent, potatoes 10 per cent, wheat 9 per cent, gram pulse 7 per cent, basin 7 per cent, onions 6 per cent, cooking oil, masoor pulse, milk products, fresh milk three per cent over March 2008. Likewise, transport charges were up 14.72 per cent, diesel 13.53 per cent and petrol 9.51 per cent over the previous month.

Source: The News, 13/5/

http://www.opfblog.com/2241/pakistan-inflation-stands-at-all-time-high/