Effects of Inflation in Pakistan

ABSTRACT

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 aim of this report is to find the determinants of inflation in Pakistan, its causes and measures to control it.In this report the literature review explains the view point of Rafia Ehsan and Dr. Humayun Dar who is an economist and PhD from Cambridge University 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. The report highlights patterns in Pakistan from 2008 to 2012, which reports the last five years as highly inflationary due to expansionary monetary policy and high oil prices. 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. 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. 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.

INTRODUCTION

Inflation

Inflation refers to a rise in prices that causes the purchasing power of a nation to fall. Inflation is a normal economic development as long as the annual percentage remains low, once the percentage rises over a pre-determined level, it is considered an inflation crisis. The term "inflation" once referred to increases in the money supply (monetary inflation), however, economic debates about the relationship between money supply and price levels have led to its primary use today in describing price inflation. Inflation can also be described as a decline in the real value of money.

Economic Growth

We define economic growth in an economy by an outward shift in its Production Possibility Curve (PPC). Economic growth is measured by the increase in a country’s total output or real Gross Domestic Product (GDP) or Gross National Product (GNP). The Gross Domestic Product (GDP) of a country is the total value of all final goods and services produced within a country over a period of time. Therefore an increase in GDP is the increase in a country’s production.

Economic growth is one of the most important indicators of a healthy economy. One of the biggest impacts of long-term growth of a country is that it has a positive impact on national income and the level of employment, which increases the standard of living. As the country’s GDP is increasing, it is more productive which leads to more people being employed. This increases the wealth of the country and its population.

Relationship between Inflation and Economic growth.

Economic growth of a country is the result of monetary, fiscal and other economic policies undertaken by its policy makers. Economic growth is affected by a number of factors, one of which is inflation. The relationship between economic growth and price growth is complex one. The complexity of relationship between inflation and economic growth has been investigated in the course of many studies. Empirical studies conducted for industrial and developed countries found a negative relationship between inflation and economic growth. In contrary, studies focusing on developing countries sample found a positive relationship between inflation and economic growth. Inflation and economic growth are parallel lines and can never meet. Inflation reduces the value of money and makes it difficult for the common people. Inflation and economic growth are incompatible because the former affects all sectors.

CAUSES AND IMPACTS

CAUSES OF INFLATION

There are many causes for inflation, depending on a number of factors.

EXCESS MONEY PRINTING

Inflation can happen when governments print an excess of money to deal with a crisis. As a result, prices end up rising at an extremely high speed to keep up with the currency surplus. In which prices are forced upwards because of a high demand.

HIGH PRODUCTION COST

Another common cause of inflation is a rise in production costs, which leads to an increase in the price of the final product. For example, if raw materials increase in price, this leads to the cost of production increasing which in turn leads to the company increasing prices to maintain steady profits. Rising labor costs can also lead to inflation. As workers demand wage increases, companies usually chose to pass on those costs to their customers.

INTERNATIONAL LENDING AND NATIONAL DEBTS

Inflation can also be caused by international lending and national debts. As nations borrow money, they have to deal with interests, which in the end cause prices to rise as a way of keeping up with their debts. A deep drop of the exchange rate can also result in inflation, as governments will have to deal with differences in the import/export level

FEDERAL TAXES

Finally, inflation can be caused by federal taxes put on consumer products such as cigarettes or fuel. As the taxes rise, suppliers often pass on the burden to the consumer; the catch, however, is that once prices have increased, they rarely go back, even if the taxes are later reduced. For example, arise in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an extension to the range of products to which VAT is applied. These taxes are levied on producers (suppliers) who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden of the tax onto consumers. For example, if the government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push inflation.

EFFECTS OF INFLATION

Most effects of inflation are negative, and can hurt individuals and companies alike, below is a list of some of the effects.

1.    Unemployment

The inverse correlation between inflation and unemployment should be intuitively easy to grasp. Based on the fundamental principles of supply and demand, inflation ought to be low when unemployment is high, and vice versa.

However, this relationship is more complicated than it appears at first glance, and has broken down on a number of occasions over the past 45 years. As inflation and (un)employment are two of the most important economic variables that affect us in our daily lives, it is important to gain an understanding of their association.

Now consider the reverse situation where unemployment is low, which means that the demand for labor (by employers) exceeds supply. In such a tight labor market, employers will not hesitate to offer higher wages to attract employees, leading to rising wage inflation.

Phillips Curve

A.W. Phillips was one of the first economists to present compelling evidence of the inverse relationship between unemployment and wage inflation. Phillips studied the relationship between unemployment and the rate of change of wages in the United Kingdom over a period of almost a full century (1861-1957), and discovered that the latter could be explained by (a) the level of unemployment, and (b) the rate of change of unemployment.

Phillips hypothesized that when demand for labor is high and there are few unemployed workers, employers can be expected to bid wages up quite rapidly. However, when demand for labor is low and unemployment is high, workers are reluctant to accept lower wages than the prevailing rate, and as a result, wage rates fall very slowly.

A second factor that affects wage rate changes is the rate of change of unemployment. If business is booming, employers will bid more vigorously for workers, which means demand for labor is increasing at a fast pace (i.e. percentage unemployment is decreasing rapidly), than they would if demand for labor is either not increasing (i.e. percentage unemployment is unchanging) or is only increasing at a slow pace.

The tradeoff between inflation and unemployment led economists to posit that Phillips Curves could be used to fine-tune monetary or fiscal policy options so as to meet desired economic outcomes. Since a Phillips Curve for a specific economy would show an explicit level of inflation for a specific rate of unemployment and vice versa, it should be possible to aim for a balance between desired levels of inflation and unemployment.

Unemployment rate in Pakistan decreased to 5.70 percent in the second quarter of 2010 from 6.10 percent in the first quarter of 2010. This unemployment rate in Pakistan is reported by the Pakistan Bureau of Statistics. Historically, from 1985 until 2010, Pakistan’s unemployment rate averaged 5.31 Percent reaching an all-time high rate of 7.80 percent in June 2002 and a record low of 3.10 percent in December 1987. In Pakistan, the unemployment rate measures the number of people actively looking for a job as a percentage.

The effect of inflation on unemployment

The Phillips curve shows the inverse trade-off between inflation and unemployment. As one increases, the other must decrease.

This examined the impact of inflation on GDP and unemployment rate in Pakistan. The study concludes that inflation insignificantly influences GDP and unemployment and the correlation is negative.

2.    Rupee depreciation

The concept enables the estimation of the exchange rate between one currency (say the rupee) and another currency (say the dollar) for the exchange to be at par with the domestic purchasing powers of these two currencies – the technique helps determine the relative value of these two currencies.

Inflation and Purchasing Products

Price inflation decreases people's ability to pay for goods. The concept at a basic level says if an employee's wages remain steady, but the cost of goods increases, then the employee can afford less goods. As wage inflation occurs, people will be able to buy more products. A general misconception is that when wages rise, prices also rise and according to the Federal Reserve Bank of Cleveland, there is little support that wage inflations cause price inflation.

Inflation and Debt

Price inflation is a debtor's best friend and a creditor's worst enemy. As the prices increase, the amount borrowed will deteriorate in value so the debtor is paying back less money and the creditor is receiving less money. For example, a student borrows $100,000 in 2005, then inflation occurs over the next couple years. Inflation then makes that $100,000 comparatively worth only $80,000 due to the increase in prices. When wages inflate, both the borrowers and the creditors win. The borrowers can repay their loans quicker due to higher income. The borrowers then should receive loan payments quicker if the borrowers pay back their loans with the increased wages.

Pakistani rupee can buy more goods and services in Pakistan than the US dollar in the USA.

The Indian and Pakistani rupees are highly undervalued on the basis of PPP

It argues that if a basket of goods is bought in India and the same basket is bought abroad the exchange rate would be approximately Rs17.7 while in our case the exchange rate would be roughly Rs41.33, making the rupee undervalued by more than one and half times – 155 percent!

The most well-known PPP indicator for laypersons is The Economist’s Big Mac Index, referring to a product that is literally similar but being sold at different prices worldwide. The exchange rate would be computed such that it would make the price of this identical product the same the world over. If a Big Mac is sold for $4.79 and its cost in Pakistan today is Rs350, the equivalent dollar price of the Big Mac in Pakistan is 3.31 suggesting that the Pakistani rupee is undervalued by 31 percent, giving an equivalent PPP exchange rate of Rs73. If this is indeed the case why hasn’t Pakistan been unable to expand its exports?

A major reason for this could be Pakistan’s weak competitiveness owing to matters other than price. For example: a) government policies and tax and regulatory regimes that discourage the development of an environment for export expansion while protecting and incentivizing import-substituting industries; and b) the low productivity of our labor and other factors and inputs of production used per unit of output-our productivity being substantially lower than that of China, etc.

How it affected Pakistan                                                                                                              

The depreciation of the rupee has multiple impacts on the economy and its cost-benefit ratio needs to be examined thoroughly before making any move via the managed float route. For this the proper forum is the Monetary and Fiscal Policies Coordination Board. Any sharp currency devaluation would have at least two serious implications: a surge in the cost of debt servicing as well as on investment based on imported capital goods, particularly for long-term infrastructures.                                                                                                                         Mr Dar blamed the free fall of the rupee for an almost Rs230 billion increase in public debt within just a few hours. There is a difference between a weak market exchange rate and strong purchasing power parity of the rupee versus the dollar. This difference hides a major abnormality: a weaker rupee makes imports costlier and exports cheaper, perpetuates adverse terms of trade and transfer of resources abroad, and aggravates the balance of payments position                                                                                                                        In Pakistan, banks prefer to invest in Treasury bills and Pakistan Investment Bonds, the stock market and currency trading rather than cater to potentially more productive sectors of the economy. Looking at the big picture, the continuous depreciation of the rupee since the early 1970s, to boost exports, has delivered an import-oriented and not an exported led economy. Trade and current account deficits have been a perpetual problem, managed by huge workers’ remittances, ballooning foreign debt and fluctuating capital and financial inflows with worsening external sector.                                                               And in a fast changing global, trade and investment environment many of the existing policies have been put to a critical test. There are limits to the excessive use of devaluation to reduce the trade deficit.                                                                                                                                                    The rupee depreciation does temporarily help boost exports by making goods and services cheaper for foreign buyers. To cut imports by making them expensive for domestic buyer’s, the external sector has to hit the edge of a precipice. Since the cost of imported capital goods and other industrial inputs, including raw materials, becomes expensive as a result of currency depreciation, the cost of production of exportable goods ultimately goes up and loses much of its competitiveness. The problem is that costly imports have not encouraged enough of import substitution nor have external sector pressures convinced the country’s policymakers to mobilise, increase dependency on domestic resources and reduce reliance on foreign money. This leads to the trade and current account deficits becoming a perpetual problem with the external sector in a virtually unending crisis.                                                                                                                                                                                                   

Exchange Rate Average ( US Dollar, Pakistani Rupees)

YEAR

US DOLLAR

2010

84.5

2011

85.6

2012

90.2

2013

97.5

2014

105.4

2015

100.7

2016

104.8

2017

104.7

2018

115.6

3.    Trade

The price of exports relative to the price of imports is called the terms of trade (TOT), which indicates a quantitative relationship between two products traded between two countries. An increase in the price of exports relative to that of imports indicates an improvement in the country’s TOT. This means that more foreign exchange is coming into the country than going out, which has a favorable impact on the balance of payments (BOP), foreign investment, and economic growth (see Mendoza, 1995; Bleaney & Greenway, 2001; Blattman, Hwang, & Williamson, 2003). Conversely, a larger increase in the price of imports than that of exports indicates a deterioration in the TOT, which adversely affects the BOP and output growth of the country.

Any volatility in the TOT also has adverse effects on economic growth because an increase in volatility increases risk, which discourages investment by making current investment unprofitable. The TOT is more volatile in developing countries (such as Pakistan), whose exports are ? Graduate student, Allama Iqbal Open University, Islamabad, Pakistan. ?? Assistant Professor, COMSATS Institute of Information Technology, Islamabad, Pakistan. ??? Assistant Professor, Modern College of Business and Science, Muscat, Oman. 112 Kiran Ijaz, Muhammad Zakaria, and Bashir A. Fida likely to be concentrated in primary commodities with fluctuating prices. This can, potentially, seriously disrupt the output growth of these countries (Broda & Tille, 2003). Mendoza (1995), for instance, shows that TOT volatility accounts for up to half of the output volatility in developing countries.

Other than output, TOT volatility is also considered a major source of inflation fluctuations (volatility) in developing countries. Theoretically, the TOT can affect inflation both positively and negatively. Under a fixed exchange rate system, the literature posits a positive relationship between TOT shocks and inflation; under a flexible exchange rate system, this relationship is reversed, at least in the short run.

The relevant literature on Pakistan is limited: although studies such as Khan, Bukhari, and Ahmed (2007) and Abdullah and Kalim (2012) have tried to identify the determinants of inflation in this context, they do not consider TOT volatility as an inflation determinant. Our aim is to fill this gap by evaluating the effect of TOT volatility on inflation in Pakistan, using annual data

TOT and Inflation in Pakistan Pakistan’s TOT has worsened continuously over the years because its main exports comprise agricultural products whose prices are relatively low and tend to fluctuate over time. The country also depends heavily on imported machinery, the price of which has increased over time. Other key reasons for the high fluctuation in TOT include the oscillating world demand for domestic exports, domestic political instability, and local drought/flood conditions (Fatima, 2010; Baxter & Kouparitsas, 2000). Figure 1 illustrates Pakistan’s TOT and inflation rate—measured by the consumer price index (CPI) While the TOT has declined over time, the inflation rate has increased exponentially. In other words, we see a negative association between TOT and inflation, both of which have moved in opposite directions throughout this period. The TOT and inflation rate are negatively correlated both during Pakistan’s fixed exchange rate period. This is because the TOT has deteriorated under the flexible regime, causing both the nominal and real exchange rates to depreciate. As a result, inflation has increased.

The results show that TOT volatility has a significant negative effect on inflation in Pakistan. Output growth has a negative effect on inflation while foreign export prices have a positive effect on inflation. Both the depreciation of the nominal exchange rate and money supply increase the inflation rate.

4.    Food

When there is higher (than average) food inflation in the country, it is important to see how wide spread is the inflation in the basket of food items. For this purpose, an index called Inflation Diffusion Index (IDI) is constructed (for the first time in Pakistan). IDI is the difference between the share of items with increasing prices and the share of items with decreasing prices in the group we are interested in. In case IDI is zero, it means the share of commodities with increasing prices equals the share of items with decreasing prices in the group. Since IDI measures the spread of inflation amongst commodities, wider is the spread of inflation amongst the commodities when higher is the inflation levels based on an established phenomenon of positive relation between the level and dispersion of inflation. Higher food and oil price rise in 2008 (than recent historic levels) resulted in above (historical) average food inflation in Pakistan in subsequent months. Pakistan was worst hit by the global food and oil price rise of 2008. We had to import wheat at historical high prices. Generally, Pakistan is not a net wheat importer, especially after 2000.

Much of the inflation in Pakistan is caused by the increase in food prices. It might be due to less productivity of agriculture sector or could be the result of ‘so called’shortage of goods and services in the economy developed by manufacturing sector’s “giants”. Several supply side and demand side factors could also be responsible for the increase in inflation in Pakistan. Inflation could be the result of shocks to the supply of certain food items and to world oil markets. In addition, fluctuating oil prices in world market could also be, due to rigid wage and price structure, another cause of rise in general price level of almost all other commodities.

Food inflation hurts poor more than rich as poor spend higher proportion of their income on food items as compared to rich. Higher global food and crude oil prices in 2008 resulted in higher (than historical average) food inflation in Pakistan. Global food inflation caused food inflation in Pakistan. However, food inflation diffusion has been lower as compared to non-food inflation in Pakistan. Wheat support price has also been estimated as an important determinant of inflation in Pakistan. Inflation, result of any factor, hurts the poor more since more than half of the budget of the low income persons is spent for food.

MAIN OBJECTIVES

INFLATIONARY FACTORS IN PAKISTAN

Several supply and demand factors could be responsible for this surge in inflation.

SUPPLY-SIDE SHOCKS

Can cause large fluctuations in food and oil prices, effects of which on overall inflation, at times, can be so excessive that these cannot be countered through demand management, including monetary policy.

INCREASED DOMESTIC DEMAND

First, increased domestic demand created an output gap, putting upward pressure on prices. Growth in private consumption on the average remained over 10 per cent between FY04 and FY06, depicting signs of demand side pressures on price level. The relationship between growth and inflation depends on the state of the economy. High growth, without an increase in inflation, impossible if the productive capacity or potential output of the economy is growing enough to keep pace with demand. This is also possible if the actual output is below the potential output and there is sufficient spare capacity available to cope up with the demand pressures. When the actual output catches up with the potential output, there remains no spare capacity and the economy is working at full employment level, any further gain in growth comes at the cost of rising inflation. If demand continues to grow at this stage, and the productive capacity does not expand, there is a serious threat of rapid inflation in the long run without any additional growth in the output. A prolonged phase of rising inflation in such a case can have severe consequences for the economy.

INCREASE IN NET IMPORTS

Second, the growing gap between domestic demand and production was filled by a sharp increase in net imports, which grew by above 40 per cent in FY05 and by 24 per cent in FY06. As compared to imports, exports increased by only around 10 per cent in FY05 and by 13 per cent in FY06. This resulted in a record trade deficit.

RISING TRADE DEFICIT

The expectations effect is very important since there is a danger that the current high rate of inflation can get locked into expectations of inflation. People expect higher salaries to compensate for expected increase in prices, speculation in asset prices increases, credit meant for manufacturing sector diverts to real estate and stock markets, and hoarders, profit and rent seekers become active in expectation of high price in the future. All this can have devastating effect for the prices.

FISCAL POLICY REMAINED EXPANSIONARY

Third, fiscal policy has remained expansionary in the last few years. Expansionary fiscal policy fuels domestic demand and puts pressure on the current account deficit. It widens the investment-saving gap, which has to be financed externally. Financing of fiscal deficit through money creation adds to inflationary pressures. Increased government borrowing from central bank can have serious consequences for general price level.

EXPANSIONARY MONETARY POLICY

Fourth, the expansionary monetary policy- high growth in money supply and loose credit policy- was believed to be contributing to high inflation. Although expansion of credit is usual in expanding economies, excessive credit growth can have adverse effects on real variables.

RISING IMPORT PRICES

Rising import prices are also considered an important factor for inflation. Exchange rate, if depreciating can also put upward pressure on price level. Increase in prices of goods, such as petrol, raw material etc. makes our imports costlier, impacting on cost of production.

INDIRECT TAXES

Similarly, indirect taxes are also blamed as the main cause of inflation. The indirect taxes, such as sales tax and excise duties raise the prices of consumer goods. This creates inflationary pressure. On the other hand, direct taxes reduce the take-home income and have anti-inflationary effect. Substantial increase in support price of wheat is estimated to have an inflationary effect on consumer prices, particularly food prices. This effect is due to the fact that wheat and wheat-related products account for 5.1 per cent of the CPI basket.

PRICE INDICES IN PAKISTAN

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 in35 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 Siphons the weekly change of price of 53 selected items of daily use consumed by those households Thespis 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 represents more with a wider coverage of 374 items in 71 markets of 35 cities around the country. As such, the change in CPI becomes an indicator of the inflation that affects all of us. WPI indicates the change in wholesale prices which affects businesses and industries. And SPI that covers a limited number of essential items of daily use including food and fuel can be termed as the inflation for the poor.

FLAWS IN MEASURING INFLATION IN PAKISTAN

In their fight against poverty our economic managers need to know a bit more precisely, how inflation is affecting the poor people. But they use CPI to evaluate the impact of inflation on the cost of living of the poor and the rich alike. The reason why they do not use the SPI for this purpose is that the basket of items for calculating SPI is too small although it includes most essential food and fuel items that the poorest people consume.

CONCLUSION

Inflation effects the different sectors of the economy (Effects on the distribution of income and wealth, Effects on production, Effects on the Government, Effects on the Balance of Payment, Effects on Monetary Policy, Effects on Social Sector, Effects on Political environment) and different classes of the people (Debtors & Creditors, Salaried Class, Wages earners, Fixed income group, Investors and shareholders, Businessmen, Agriculturists).A reasonable rate of inflation--around 3- 6 per cent-- is often viewed to have positive effects on the national economy as it encourages investment and production and allows growth in wages. When inflation crosses reasonable limits, it has negative effects. It reduces the value of money, resulting in uncertainty of the value of gains and losses of borrowers, lenders, and buyers and sellers. The increasing uncertainty discourages saving and investment. Not only can high inflation erode the gains from growth, it also makes the poor worse off and widens the gap between the rich and the poor. If much of the inflation comes from increase in food prices, it hurts poor more since over half of family budget of the low wage earners goes for food. Second, it redistributes income from fixed income earners (for instance pensioners) to owners of assets and earners of large and variable income, such as profits. For Pakistan’s economy, inflation can be bad if it crosses the threshold of six per cent, and can be extremely harmful if it crosses the double digit level. Several supply and demand factors could be responsible for this surge in inflation. Supply-side shocks can cause large fluctuations in food and oil prices, effects of which on overall inflation, at times, can be so excessive that these cannot be countered through demand management.