- What is Inflation?
Inflation
is the rate at which the general level of prices for goods and services is
rising and, consequently, the purchasing power of currency is
falling. Central banks attempt to limit inflation, and
avoid deflation, in order to keep the economy running smoothly. In
economics, inflation is a rise in the general level of prices of
goods and services in an economy over a period of time. When the general price
level rises, each unit of currency buys fewer goods and services.
Because the
term inflation is such a generic term used in many contexts, there is
no commonly accepted definition of inflation, nor is there a common
agreement on what constitutes acceptable levels of inflation, bad inflation, or
hyperinflation.
Generally it can be said
that inflation is a measure of a general increase of the price level in an
economy, as represented typically by an inclusive price index, such as the
Consumer Price Index (CPI). The term indicates many individual prices rising
together rather than one or two isolated prices, such as the price of gasoline
in an otherwise calm price environment.
- Some Types of Inflation:
When the rise in prices is very low
like that of a snail or creeper, is called Creeping Inflation. Running
inflation has inflation rate between 8-10 %. A sense of urgency needs
to be shown in controlling the running inflation. Hyper
Inflation, Latin American countries like Argentina and Brazil had
inflation rates of 50 to 700 percent per year in the between 1970 and 1980. Many
developed and industrialized countries like Italy and Japan still do. Pricing
Power administered price inflation. When the business houses and
industries decide to increase the price of their respective goods and services
to increase their profit margins.
- Causes of Inflation:
Historically,
a great deal of economic literature was concerned with the question of what
causes inflation and what effect it has. There were different schools of
thought as to the causes of inflation. Most can be divided into two broad
areas: quality theories of inflation and quantity theories of inflation. The
quality theory of inflation rests on the expectation of a seller accepting
currency to be able to exchange that currency at a later time for goods that
are desirable as a buyer. The quantity theory of inflation rests on the
quantity equation of money that relates the money supply, its velocity and the
nominal values of exchanges. Adam
Smith and David Hume proposed a quantity theory of inflation for
money, and a quality theory of inflation for production.
Keynesian View:
Keynesian economics proposes
that changes in money supply do not directly affect prices, and that visible
inflation is the result of pressures in the economy expressing themselves in
prices.
There are three major types of
inflation, as part of what Robert J. Gordon calls the "triangle
model”
- Demand-pull inflation is caused by increases in aggregate demand due to increased private and government spending, etc. Demand inflation encourages economic growth since the excess demand and favorable market conditions will stimulate investment and expansion.
- Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. Another example stems from unexpectedly high Insured losses, either legitimate (catastrophes) or fraudulent (which might be particularly prevalent in times of recession).
- Built-in inflation is induced by adaptive expectations, and is often linked to the "price/wage spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and so might be seen as hangover inflation.
Demand-pull
theory states that inflation accelerates when aggregate
demand increases beyond the ability of the economy to produce
(its potential output). Hence, any factor that increases aggregate demand
can cause inflation. However, in the long run, aggregate demand can be
held above productive capacity only by increasing the quantity of money in
circulation faster than the real growth rate of the economy. Another (although
much less common) cause can be a rapid decline in the demand for
money, as happened in Europe during the Black Death, or in
the Japanese occupied territories just before the defeat of Japan in
1945.
The
effect of money on inflation is most obvious when governments finance spending
in a crisis, such as a civil war, by printing money excessively. This sometimes
leads to hyperinflation, a condition where prices can double in a month or
less. Money supply is also thought to play a major role in determining moderate
levels of inflation, although there are differences of opinion on how important
it is. For example, Monetarist economists believe that the link is
very strong; Keynesian economists, by contrast, typically emphasize the role
of aggregate demand in the economy rather than the money supply in
determining inflation. That is, for Keynesians, the money supply is only one
determinant of aggregate demand.
Some
Keynesian economists also disagree with the notion that central banks fully
control the money supply, arguing that central banks have little control, since
the money supply adapts to the demand for bank credit issued by commercial
banks. This is known as the theory of endogenous money, and has been
advocated strongly by post-Keynesians as far back as the 1960s. It
has today become a central focus of Taylor rule advocates. This
position is not universally accepted – banks create money by making loans, but
the aggregate volume of these loans diminishes as real interest rates increase.
Thus, central banks can influence the money supply by making money cheaper or
more expensive, thus increasing or decreasing its production.
A
fundamental concept in inflation analysis is the relationship between inflation
and unemployment, called the Phillips curve. This model suggests that
there is a trade-off between price stability and employment.
Therefore, some level of inflation could be considered desirable in order to
minimize unemployment. The Phillips curve model described the U.S. experience
well in the 1960s but failed to describe the combination of rising inflation
and economic stagnation (sometimes referred to as stagflation) experienced
in the 1970s.
Thus,
modern macroeconomics describes inflation using a Phillips curve
that shifts (so the trade-off between inflation and unemployment
changes) because of such matters as supply shocks and inflation becoming built
into the normal workings of the economy. The former refers to such events as
the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary
expectations implying that the economy "normally" suffers from
inflation. Thus, the Phillips curve represents only the demand-pull component
of the triangle model.
Another
concept of note is the potential output (sometimes called the
"natural gross domestic product"), a level of GDP, where the economy
is at its optimal level of production given institutional and natural
constraints. (This level of output corresponds to the Non-Accelerating
Inflation Rate of Unemployment, NAIRU, or the "natural" rate of
unemployment or the full-employment unemployment rate.) If GDP exceeds its
potential (and unemployment is below the NAIRU), the theory says that inflation
will accelerate as suppliers increase their prices and built-in
inflation worsens. If GDP falls below its potential level (and unemployment is
above the NAIRU), inflation will decelerate as suppliers attempt to
fill excess capacity, cutting prices and undermining built-in inflation.
However,
one problem with this theory for policy-making purposes is that the exact level
of potential output (and of the NAIRU) is generally unknown and tends to change
over time. Inflation also seems to act in an asymmetric way, rising more
quickly than it falls. Worse, it can change because of policy: for example,
high unemployment under British Prime Minister Margaret
Thatcher might have led to a rise in the NAIRU (and a fall in potential)
because many of the unemployed found themselves as structurally
unemployed, unable to find jobs that fit their skills. A rise in structural
unemployment implies that a smaller percentage of the labor force can find jobs
at the NAIRU, where the economy avoids crossing the threshold into the realm of
accelerating inflation.
Unemployment:
A connection
between inflation and unemployment has been drawn since the emergence of large
scale unemployment in the 19th century, and connections continue to be drawn
today. However, the unemployment rate generally only affects
inflation in the short-term but not the long-term. In the long term, the velocity
of money supply measures such as the MZM ("Money Zero Maturity,"
representing cash and equivalent demand deposits) velocity is far more
predictive of inflation than low unemployment.
During the Great Depression, the classical theory
attributed mass unemployment to high and rigid real wages.
To Keynes, the
determination of wages was more complicated. First, he argued that it is not real but nominal wages that are set in negotiations
between employers and workers, as opposed to a barter relationship. Second, nominal wage
cuts would be difficult to put into effect because of laws and wage contracts.
Even classical economists admitted that these exist; unlike Keynes, they
advocated abolishing minimum wages, unions, and long-term contracts, increasing labour market flexibility. However, to
Keynes, people will resist nominal wage reductions, even without unions, until
they see other wages falling and a general fall of prices.
Keynes rejected the
idea that cutting wages would cure recessions. He examined the explanations for
this idea and found them all faulty. He also considered the most likely
consequences of cutting wages in recessions, under various different
circumstances. He concluded that such wage cutting would be more likely to make
recessions worse rather than better.
Further, if wages
and prices were falling, people would start to expect them to fall. This could
make the economy spiral downward as those who had money would simply wait as falling
prices made it more valuable – rather than spending. As Irving Fisher argued in 1933, in his Debt-Deflation
Theory of Great Depressions, deflation (falling prices) can make a depression
deeper as falling prices and wages made pre-existing nominal debts more
valuable in real terms.
- Inflation Thresholds:
Table 1 shows somewhat
arbitrary thresholds. Other economists would have thresholds a little more
strident than this, yet others a little looser. When you look at Table 1
it is clear that a nominal amount of inflation, typically less than 3%, is
accepted and might even be good for the economy.1 But any sustained level above
2.5% or 3% will be seen as a potential problem, and the higher the rate, the
more serious and dangerous the problem. Part of the reason for this is because
once inflation moves up into the high single-digit range and then double-digit
range, it begins to self-compound into a higher rate. In other words, once it
reaches a certain rate, it sets in motion a series of forces that tend to move
it automatically to a higher rate (explained later). More bluntly, a 12%
inflation will automatically become a 15% inflation and then a 20% inflation if
not dealt with using severe and relentless anti-inflation policies. Once
inflation moves above the 20% range, lessons from history tells us that the
tendency to self-compound is so great that the inflation becomes explosive and
potentially ruinous to an economy.
- Controlling Inflation:
Monetary Policy:
Governments and
central banks primarily use monetary policy to control inflation. Central
banks such as the U.S. Federal Reserve increase the interest
rate, slow or stop the growth of the money supply, and reduce the money supply.
Some banks have a symmetrical inflation target while others only
control inflation when it rises above a target, whether express or implied.
Most central banks
are tasked with keeping their inter-bank lending rates at low levels, normally
to a target annual rate of about 2% to 3%, and within a targeted annual
inflation range of about 2% to 6%. Central bankers target a low inflation rate
because they believe deflation endangers the economy.
Higher interest
rates reduce the amount of money because fewer people seek loans, and loans are
usually made with new money. When banks make loans, they usually first create
new money, then lend it. A central bank usually creates money lent to a
national government. Therefore, when a person pays back a loan, the bank
destroys the money and the quantity of money falls. In the early 1980s, when
the federal funds rate exceeded 15 percent, the quantity
of Federal Reserve dollars fell 8.1 percent, from $8.6 trillion down
to $7.9 trillion.
Monetarists
emphasize a steady growth rate of money and use monetary policy to
control inflation by increasing interest rates and slowing the rise in the
money supply. Keynesians emphasize reducing aggregate demand during
economic expansions and increasing demand during recessions to keep inflation
stable. Control of aggregate demand can be achieved using both monetary policy
and fiscal policy (increased taxation or reduced government spending
to reduce demand).
Fixed Exchange Rates:
Under
a fixed exchange rate currency regime, a country's currency is tied in value to
another single currency or to a basket of other currencies (or sometimes to
another measure of value, such as gold). A fixed exchange rate is usually used
to stabilize the value of a currency, vis-a-vis the currency it is pegged to.
It can also be used as a means to control inflation. However, as the value of
the reference currency rises and falls, so does the currency pegged to it. This
essentially means that the inflation rate in the fixed exchange rate country is
determined by the inflation rate of the country the currency is pegged to. In
addition, a fixed exchange rate prevents a government from using domestic
monetary policy in order to achieve macroeconomic stability.
Under the Bretton Woods agreement, most countries around the
world had currencies that were fixed to the US dollar. This limited inflation
in those countries, but also exposed them to the danger of speculative
attacks. After the Bretton Woods agreement broke down in the early 1970s,
countries gradually turned to floating exchange rates. However, in the
later part of the 20th century, some countries reverted to a fixed exchange
rate as part of an attempt to control inflation. This policy of using a fixed
exchange rate to control inflation was used in many countries in South America
in the later part of the 20th century (e.g. Argentina (1991–2002),
Bolivia, Brazil, and Chile).
Gold Standard:
The gold standard
is a monetary system in which a region's common media of exchange are paper
notes that are normally freely convertible into pre-set, fixed quantities of
gold. The standard specifies how the gold backing would be implemented,
including the amount of specie per currency unit. The currency itself
has no innate value, but is accepted by traders because it can be
redeemed for the equivalent specie. A U.S. silver certificate, for
example, could be redeemed for an actual piece of silver.
The gold standard
was partially abandoned via the international adoption of the Bretton
Woods System. Under this system all other major currencies were tied at fixed
rates to the dollar, which itself was tied to gold at the rate of $35 per
ounce. The Bretton Woods system broke down in 1971, causing most countries to
switch to fiat money – money backed only by the laws of the country.
Under a gold
standard, the long term rate of inflation (or deflation) would be determined by
the growth rate of the supply of gold relative to total output. Critics
argue that this will cause arbitrary fluctuations in the inflation rate, and
that monetary policy would essentially be determined by gold mining.
Wages and Price Control:
Another method
attempted in the past have been wage and price
controls ("incomes policies"). Wage and price controls have been
successful in wartime environments in combination with rationing. However,
their use in other contexts is far more mixed. Notable failures of their use
include the 1972 imposition of wage and price controls by Richard Nixon.
More successful examples include the Prices and Incomes Accord in
Australia and the Wassenaar Agreement in the Netherlands.
In general, wage
and price controls are regarded as a temporary and exceptional measure, only
effective when coupled with policies designed to reduce the underlying causes
of inflation during the wage and price control regime, for example, winning the
war being fought. They often have perverse effects, due to the distorted
signals they send to the market. Artificially low prices often cause rationing
and shortages and discourage future investment, resulting in yet further
shortages. The usual economic analysis is that any product or service that is
under-priced is over-consumed. For example, if the official price of bread is
too low, there will be too little bread at official prices, and too little
investment in bread making by the market to satisfy future needs, thereby
exacerbating the problem in the long term.
Temporary controls
may complement a recession as a way to fight inflation: the
controls make the recession more efficient as a way to fight inflation
(reducing the need to increase unemployment), while the recession prevents the
kinds of distortions that controls cause when demand is high. However, in
general the advice of economists is not to impose price controls but to
liberalize prices by assuming that the economy will adjust and abandon
unprofitable economic activity. The lower activity will place fewer demands on
whatever commodities were driving inflation, whether labor or resources, and
inflation will fall with total economic output. This often produces a severe
recession, as productive capacity is reallocated and is thus often very unpopular
with the people whose livelihoods are destroyed.
Stimulating Economic Growth:
If economic
growth matches the growth of the money supply, inflation should not occur
when all else is equal. A large variety of factors can affect the rate of
both. For example, investment in market production, infrastructure,
education, and preventative health care can all grow an economy in
greater amounts than the investment spending.
Cost-of-living Allowance:
The real
purchasing-power of fixed payments is eroded by inflation unless they are
inflation-adjusted to keep their real values constant. In many countries,
employment contracts, pension benefits, and government entitlements (such as social
security) are tied to a cost-of-living index, typically to the consumer
price index. A cost-of-living allowance (COLA) adjusts
salaries based on changes in a cost-of-living index. It does not control
inflation, but rather seeks to mitigate the consequences of inflation for those
on fixed incomes. Salaries are typically adjusted annually in low inflation
economies. During hyperinflation they are adjusted more often. They may
also be tied to a cost-of-living index that varies by geographic location if
the employee moves.
Annual escalation
clauses in employment contracts can specify retroactive or future percentage
increases in worker pay which are not tied to any index. These negotiated
increases in pay are colloquially referred to as cost-of-living adjustments
("COLAs") or cost-of-living increases because of their similarity to
increases tied to externally determined indexes.
The latest figures of SPI are for 24 April 2014. When
compared to the prices of items in SPI basket from the one week before i.e. 17
April 2014,
Given
the persistent downward trend in inflation over the last ten months, CPI
inflation for the year 2012-13 is forecast-ed to hover around 8.0%. The
availability of food items and any adverse external hike in prices. Seems
unlikely, therefore, the upside risk to inflation for one remainder of FY13 is
minimal. However the revision of any energy tariffs and imposition of taxes may
pose risk to inflation beyond FY13. Food supply at affordable price is the
focal point of food security policy of Pakistan and the four dimensions of food
security also include food availability, food accessibility, food utilization
and food stability which have always been on the high agenda of food policy. It
is hoped that implementations of the policy in letter and spirit will to
further contain the inflation and ensure secure food environment for the
growing population.
- Inflation Trend in Pakistan:
The latest figures of SPI are for 24 April 2014. When
compared to the prices of items in SPI basket from the one week before i.e. 17
April 2014,- 7 items prices have increased while 17 items prices decreased in one week period.
- Following are the figures from “Monthly review on Price Indices” Mar 2014, Base 2007-2008.
- Economic Condition of Pakistan:
High
inflation is contributing to:
- Increasing vulnerability and fall in real income of lower, middle and fixed
income segments of the society.
- Uncertainty
about future scenario of the business environment and instability of the
financial system
- Erosion
of business and investors’ confidence
- Slowing
down of real economic activities
- Investment
- Economic growth
- Employment
Inflation Rate Year-Wise:
Inflation By Consumer Income Group:
Regional Inflation Trend:
Whole Price Index:
Pakistan's and Bangladesh's Inflation Rate:
- Conclusion:
Given
the persistent downward trend in inflation over the last ten months, CPI
inflation for the year 2012-13 is forecast-ed to hover around 8.0%. The
availability of food items and any adverse external hike in prices. Seems
unlikely, therefore, the upside risk to inflation for one remainder of FY13 is
minimal. However the revision of any energy tariffs and imposition of taxes may
pose risk to inflation beyond FY13. Food supply at affordable price is the
focal point of food security policy of Pakistan and the four dimensions of food
security also include food availability, food accessibility, food utilization
and food stability which have always been on the high agenda of food policy. It
is hoped that implementations of the policy in letter and spirit will to
further contain the inflation and ensure secure food environment for the
growing population.
- Some Recommendations:
- Proper taxation system.
- Increase export.
- Increase foreign reserves.
- Control corruption.
- Devaluation of money.
- Produce Electricity.
- Broaden tax collection.