The inflation crisis prevalent in Pakistan

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The purpose of this research paper is to study the inflation crisis prevalent in Pakistan. On one hand, the monetarist school of thought follows the assumption that "Inflation is always and everywhere a monetary phenomenon" (Milton Friedman, 1963). The monetarists argue that variation in the money supply has major influences on national output in the short run and the price level in the long run and that the objectives of monetary policy are best met by targeting the growth rate of the money supply". However, the way inflation is rising in Pakistan cannot be attributed to variations in monetary aggregates alone. Factors such as import price level(s) and petroleum prices also play a vital role in determining the rate/level of inflation in Pakistan's economy. This paper is set to test the correlation between inflation, measured in terms of CPI variations, and its various determinants, in order to determine which factors are most relevant in influencing price levels in the developing economy of Pakistan. The study conducted uses secondary data to carry out an econometric analysis in order to explore the practical and feasible means controlling inflation for Pakistan.

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ACKNOWLEDGEMENT

I am heartily thankful to my supervisor, Anam Tahir, whose encouragement, guidance and support from the beginning to the end of thesis enabled me to develop an understanding of the subject. I would also like to offer my regards and blessings to all of those who supported me in any respect during the completion of the project.

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1 - INTRODUCTION

1.1: Inflation: A conceptual overview:

Inflation is a global and persistent phenomenon since the invention and introduction of money. There are three primary variables, namely money supply, and the demand and supply for goods and services decide which cause this phenomenon to appear in every economy. The following paragraphs identify and explain the most important concepts and terms involved in this thesis, so that one can easily understand the concepts and their implications.

Inflation is the rise in the prices of goods and services in an economy over a period of time. When the general price level rises, each unit of the functional currency buys fewer goods and services. Consequently, inflation is a decline in the real value of money - a loss of purchasing power in the internal medium of exchange, which is also the monetary unit of account in the economy. Inflation is a key economic indicator, and provides important insight on the state of the economy and the sound macroeconomic policies that govern it. A stable inflation not only gives a nurturing environment for economic growth, but also uplifts the poor and the fixed income citizens who are the most vulnerable in the society.

In the same way, a slowing down in the rate of inflation is known as 'disinflation'. It describes instances when the inflation rate reduces marginally, over the short term. Although it is used to explain periods of slowing inflation, disinflation should not be confused with deflation. Disinflation is commonly used by the State Bank to portray situations of slowing inflation. Instances of disinflation are not uncommon and are viewed as normal during healthy economic times. Although sometimes it is confused with deflation, disinflation is not considered to be as problematic because prices do not actually drop and disinflation does not usually signal the onset of a slowing economy. Deflation is a general decline in prices, often caused by a reduction in the supply of money or credit. A decrease in government, personal or investment spending can also cause deflation to occur. 

Inflation on the extreme end is known as 'Hyperinflation', i.e. extremely rapid or out of control inflation. There is no precise numerical definition of hyperinflation. It is a situation where the price increases are so out of control that the concept of inflation is meaningless. 

In economics, stagflation is the situation when both the inflation rate and the unemployment rate are persistently high. Stagflation occurs when the economy isn't growing but the prices are (which is not a commendable situation for an economy to be in). This happened to a great extent during 2007-08 when world oil prices rose dramatically, fueling sharp inflation in oil importing countries. For these countries, stagnation increased the inflationary effects. It is a difficult economic condition for a country: when inflation and economic stagnation are occurring simultaneously, a policy dilemma results, since actions that are meant to assist with fighting inflation might worsen economic stagnation and vice versa.

1.2: Measuring Inflation:

Over the years, ways and methods have been formulated to measure the rate of inflation in an economy in order to control it. The most well known measure of Inflation is the consumer price index (CPI). A consumer price index (CPI) measures changes in the price level of consumer goods and services purchased by households. As defined by the United States Bureau of Labor Statistics, CPI is "a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services." CPI is a statistical estimate constructed using the prices of a sample of representative items whose prices are collected periodically.

1.3: Inflation in Pakistan - A Dire Situation:

The economy of Pakistan is the twenty-seventh largest in the world (in absolute dollar terms) (IMF; 2010). It is a semi-industrialized economy, which mainly comprises of textiles, chemicals, food processing, agriculture and other industries. Growth poles of Pakistan's economy are situated along the Indus River diversified economies of Karachi and Punjab's urban centers, co-existing with less developed areas in other parts of the country. GDP growth, spurred by gains in the industrial and service sectors, remained in the 6-8% range in 2004-06. Inflation remains the biggest threat to the economy, jumping to more than 9% in 2005 before easing down to 7.9% in 2006. In 2008, following the surge in global petrol prices, inflation in Pakistan reached as high as 25 percent. From fiscal year 2003 until 2010, the average inflation rate in Pakistan was 10.15 percent, reaching an historical peak of 25.33 percent in August 2008 and a record low of 1.41 percent in July 2003. The central bank is pursuing tighter monetary policy while trying to preserve growth. Foreign exchange reserves are bolstered by steady worker remittances, but a growing current account deficit (driven by a widening trade gap as import growth outstrips export expansion) could draw down reserves and dampen GDP growth in the medium term.

Pakistan's economy is facing virtual "stagflation". The term is defined as a lack of economic activity due to an economic slowdown, creating massive unemployment, combined with rising inflation. It is a double-edged sword for the poor and deprived. It often results in a rise in crime and suicides, which is what we are witnessing in today's Pakistan. The double-digit inflation has become a serious problem for the south Asian country, where up to 40 per cent of its 170 million population lives below poverty line. Inflation, which has risen to 16 per cent, is pushing more people below the poverty line in the absence of any significant economic activity. Prices of essential food items have skyrocketed in the past three years. Sugar prices have quadrupled. Though the central bank's tight monetary policy could not tame the soaring inflation, it did stagnate the economic growth. The tight monetary policy has not allowed the private sector to play a key part in growth. High borrowing costs discouraged the demand for private sector credit, which in turn decreased private investment adversely affecting the prospects of economic growth. Astonishingly, the country is maintaining one of the world's highest benchmark interest rates, in an economy hurt by inflation, terrorism and falling foreign investment.

1.4: Studying Inflation:

For the developing economy of Pakistan, it is vital to know the reasons behind and the variables affecting the consumer prices in the domestic economy. Based on local perception and globally recognized factors, this paper tests the proposition whether inflation, measured in terms of Consumer Price Index (CPI), is significantly impacted in the following terms:

To test the proposition that Import Prices, measured in terms of unit value indices of imports, has a significant or an insignificant impact on inflation.

To test the proposition that Money Supply, that is broad money (M2) measured in terms of rupees, has a significant or an insignificant impact on inflation.

To test the proposition that Exchange Rate, in terms of nominal effective exchange rate (NEER), has a significant or an insignificant impact on inflation.

To test the proposition that Wheat Support Price, in terms of average per annum price of wheat per 40 kg of wheat, has a significant or an insignificant impact on inflation.

To test the proposition that the Petroleum Prices, measured in terms of percentage change in the average price of petrol (per liter) in one fiscal year, has a significant or an insignificant impact on inflation.

To test the proposition that the Minimum Wage Level, set by the government measured in terms of rupees per month, has a significant or an insignificant impact on inflation.

The following table lists and formally defines all the variables involved.

1.4.1: Defining variables:

Consumer Price Index (CPI)

Overall consumer price index - percentage change in the prices of goods in a basket of goods taken as a representative sample.

The research study measures inflation in terms of consumer price index (CPI), defined as follows:

The economic variables, that affect CPI (inflation), as per the focus of the research study, are as follows (please see the table on the next page):

Wheat Support Price

Guaranteed minimum government purchase price.

(Broad) Money supply

Second of the two monetary aggregates (that collectively define, 'money / money growth'), defined as increase in the yearly growth rate of money (stocks).

Import Prices

World price level of imports (particularly that of wheat).

(The level of) Petroleum Prices

A supply shock, measured in terms of percentage increase in the overall price of oil/petroleum (products) from the previous fiscal year.

(Level of) Minimum Wage

The minimum wage set across the economy (by labor policy)

(Nominal effective) Exchange Rate

Local currency expressed as the price of foreign currency (for example: Pakistani rupee expressed in terms of US $)

2 - The Review of Literature

Inflation is a wide spread dilemma whose origin goes to times way back into the history. Yet, to date, it is such an influential phenomenon that it has the potential to traumatize the everyday life of a common man and bring about a dire international crisis. What is inflation: it is the sustained increase in prices, which curbs the real value /purchasing power of money. Maintaining a low and stable level of inflation is one of the three widely acknowledged and recognized aims of macroeconomic policy [1] .

An unstable and high rate of inflation is regressive and adverse for the savings and economic growth. It reduces the real income and enhances uncertainty (Qayyum; 2006). It hurts the real returns of financial assets and consequently lowers the investment (which, in itself, results in stunted growth)(Mubarik; 2005) (Hasan, Khan Pasha, Rasheed; 1995). Also, inflation impinges on the international competitiveness of our exports by depreciating the real exchange rate, thereby pessimistically affecting the trade balance. Consequently, it lead to cost push inflation, based on (the rising price levels of) imported raw materials. What enhances cost-push inflation further is the inclined expected inflation in the economy, leading to higher wages and salaries. (Hasan, Khan, Pasha, Rasheed; 1995). Thereby, it is detrimental to the real economic growth (Qayyum; 2006), not in the short run but medium/long run (Khan, Schimmelpfennig; 2006). On the contrary, Mubarik (2005) states a study by Bruno and Easterly (1996), according to which inflation does not have a long term impact on an economy's growth as in the long term, economies/countries have (shown) the ability to recover/bounce back to the pre-high inflation rate (s) of growth. The underlying implication is that inflation is more sensitive towards/influenced by economic growth (taking place due to other economic factors), than vice versa. The surprising part is that the bases of this study were four Asian developing countries, namely Bangladesh, India, Pakistan and SriLanka, where the inflation is a dire problem.

According to an analysis (Mubarik; 2005), the negative relationship between inflation and growth stands true only for developing countries. For industrialized nations, the rule is reversed. Another understood assumption that has exceptions to it is regarding the effectiveness of low and stable level(s) of inflation in triggering or enhancing economic growth: it is assumed that inflation impedes economic growth, but low level of inflation does not always necessarily bring about high growth rates, 'even in long periods' (Mubarik; 2005). This view, however, is not without critical gaps, as other studies/papers conclusively affirm a positive relation between inflation and economic growth at low levels of inflation.

However, inflation is not only a cost-push phenomenon [2] but also an impact of demand-pull factors. Between the two sides, the monetarists support the cost-push inflation, claiming, "Inflation is a monetary phenomenon" (Qayyum; 2006). Even the understanding of historical trends and analysis reveal that cost-push inflation has been more dominant persistently; and has been closely associated with monetary policy; based on which the relative significance of monetary variables in determining the rate of inflation is hypothesized (Javed, Farooq, Shama; 2010). Amongst the various monetary factors, they emphasize, it is the money supply /growth that has the most significantly positive correlation inflation (Qayyum; 2006).

The most considerable demand-side factor that impinges on inflation is people's expectation about future rate of inflation: via generating greater demand for money (for future consumption), people's expectations/speculations about the future rate of inflation have an adverse impact on the actual rate of inflation (Qayyum; 2006).

Amongst various supply side cost-push factors, the wage (measured in terms of annual wage in the perennial industries) increases have been the one of the more influential ones in bringing about inflation, whether the increase comes about as result of unions' bargaining, increased productivity or increased demand (for the products) (Javed, Farooq, Shama; 2010).

Also, existence of monopoly power in industries has an analogous effect, defined as "administered-price theory of inflation". As firms (collectively, in 'imperfectly competitive markets') raise their price levels; the lowered living standards lead to demand for higher wages; thereby, implying cost-push inflation. Petroleum price level, yet another supply-side factor, has had a huge impact on the inflation worldwide. Economic theory explains this impact as an adverse supply shock (in which the supply of a product takes an unexpected sudden turn in either direction, such that the cost of production rises), which affects the local as well as international prices of the products, connected through linkages (Javed, Farooq, Shama; 2010).

The debate about money supply and inflation does not only revolve around its nature (whether it acts a demand-side factor or a supply side factor) but also on the extent of its impact (its impact in the short run and long run). Amidst the differing economic views, the consensus is that money supply leads the price level(s) to rise sustainably, affecting the overall stability of macroeconomic environment. (Javed, Farooq, Shama; 2010). The economic theories/views differ regarding whether the increase in money supply affect ay factor(s) other than inflation (the classical economist defy such possibility), to which extent money supply has to rise to have an impact on inflation (the neoclassical theories specify such an impact at excessive money supply only), and the employment level of economy (the Keynesians' view that working below the full employment level in an economy enables money supply to influence aggregate demand, output and overall employment in short run only). Yet, according to the monetarists, the most predominant monetary factor that affects inflation is the money supply 'through demand channel' (Javed, Farooq, Shama; 2010).

Theoretically speaking, the viability of the claim that "inflation is a monetary phenomenon", is based on the "quantity theory of money", whose identity is M*V = P*Y (Qayyum ; 2006) (Grauwe, Polan ; 2005). Measuring inflation as a percentage increase in consumer price index, the theory defines three variables that have correlation with inflation (Grauwe, Polan; 2005)(Qayyum; 2006):

m or gm (rate of growth of money supply);

y or gy (rate of growth of real output/income)

v or gv (rate of growth of income velocity of money)

Qayyum argues that amongst the three stated explanatory variables, only rate of growth of money supply is the key factor (Qayyum; 2006). Real income growth comes by an auspicious change in labour, capital and technology. In other words, it is connected with money demand, rather than money supply. On the other hand, the income velocity is associated with fiscal policy (as opposed to monetary policy) and holds significance (in the correlation between money supply and inflation) only if it is relatively nominal.

Grauve and Polan advance from the above-mentioned basic understanding of the relationship between inflation and money growth/supply (Grauve, Polan; 2005). They differentiate between long/short run impact of the money supply/growth, associating it with the countries which have been experiencing high levels of inflation over a relatively long periods of time. The thesis goes that for high-inflationary countries, the rate of growth in the money supply leads to high inflation rates in the long run but in the process, the real output remains constant (given that the impact is in the long run, the increase in money supply has to be permanent). On the other hand, low-inflation countries neither face high inflation nor any change in real outputs due to increase in the rate of growth of money supply (Grauve, Polan; 2005).

Emphasizing the fundamental role of money supply, Qayyum argues that even the root explanation of cost-push inflation and/or supply shocks lies in the central control of rate of money growth. Inflation occurs when the (rate of) growth of money exceeds that of economy overall (Qayyum; 2006).

An advanced econometric model by Javed, Farooq, Akram (2010) breaks down the money supply into four variables: narrow money supply (M1), broad money supply (M2), lag value of M2 (LM), and Lag value of CPI (LCPI). Amongst the four factors, broad money supply (M2) has relatively lesser impact than the other units of money supply (given that it has a positive coefficient in the model but is statistically insignificant). Another very crucial aspect of the concerned correlation is that money supply impacts the inflation with a lag of one year, substantiating the hypothesis that it is in the "second round" (i.e. with a lag of one fiscal year) that it reveals a significant correlation with inflation. The immediate of increase in money supply is merely on real GDP growth (Qayyum; 2006)(Javed, Farooq, Akram; 2010). In another inflation model by Khan, Schimmelpfennig (2006), the findings reveal that other than money supply (emphasizing on M2, i.e. broad money in particular), private sector credit growth rate also explains inflation with a lag of around 12 months (Khan, Schimmelpfennig; 2006).

One particular implication of the above analysis is in terms of the policy measure (ways/means to control the rate of inflation is) i.e. to keep the money supply in tight centralized control (Qayyum; 2006). In case of a failure to do so, as did the State Bank of Pakistan, inflation would be detrimental to the real economic growth (as explained earlier). Therefore, the primary focus of the monetary policy should be to maintain a low level of inflation, whether by immediate instrument (via keeping a tight money supply) or indirectly (through any other means). If the monetary policy were to be held tight (as suggested), it would make it possible for people not to speculate a rise in prices; based on the certainty that money supply would be held stable at a reasonable level by the central bank.

Although the monetary variables play a leading role in defining the rate of growth of inflation, the wheat support price (Javed, Farooq, Akram; 2010)(Khan, Gill; 2010)(Khan, Schimmelpfennig; 2006) and its administered prices along with the imported inflation also play an important role. On theoretical basis, it is not only the support price of wheat that has an impact on the inflation, but also a collective support price (system) of wheat, sugar cane, rice and cotton (Khan, Gill; 2010). Amongst the four crops mentioned, wheat support price has a relatively greater significance (in reference to inflationary impact) than do the others. Khan and Gill (2010), however, do not find any significant role of such price support(s) on inflation (i.e. CPI) in the long run. Also, Javed, Farooq, Akram (2010), in their analysis, find a positive but a statistically insignificant correlation of wheat support price with inflation. Empirically, wheat price only affect inflation in the short run but has no affect in the long run (Khan, Schimmelpfennig; 2006). The understood implication of this is that government effort(s) to stabilize the prices of agricultural output do not have an impact on the consumers when the inflation in the economy is already high and unstable.

Another monetary factor that has an impact on the inflation rate is the exchange rate (Javed, Farooq, Akram; 2010) (Choudhri, Khan; 2002). The question is that does the devaluation of Pakistani rupee have any inflationary effect in our economy. The usual perception is that the devaluation of currency (Pakistani rupee) is inflationary. Conceptually, the reasoning goes that the depreciation of Pakistani Rupee, along with rising international prices, consequently increases in the value of imports, leading to increase in the CPI (Khan, Gill; 2010) (Choudhri, Khan; 2002). Also, Ahmad and Ali (1999) assert that the recent empirical work in Pakistan provides consistent evidence that the domestic price level responds significantly but gradually to exchange rate devaluation" (Choudhri, Khan; 2002). However, challenging this notion, with the help of empirical analysis, the analysis reveals: Although theoretically consistent with the reasoning stated above, there is no significant pass-through of rupee depreciations to consumer prices (index) in the short run. Over the past two decades, the fall in rupee's real value over time even in the long run, Pakistan's inflation rate has not fully reflected the rate of rupee depreciation. (Choudhri and Khan; 2002) 

Another general perception is that the budget deficit creates inflation but empirically, budget deficit over the period of 1971-72 to 2005-06 has not played any role in inflation in the long run (Khan, Gill; 2010).

3 - METHODOLOGY AND ANALYTICAL CHOICE:

3.1: Research Type:

Research, as categorized by purpose, falls into two major categories: 'Basic Research' and 'Applied Research'. Also called 'pure research' or 'fundamental research', basic research is undertaken for increase in knowledge. On the other hand, the research, done with the intention of applying the results of the findings to solve specific problems currently being experienced by any organization is called "applied research" (reference). Applied research uses basic research, past theories, knowledge and methods to solve an existing problem. It deals with practical problems, following a problem-oriented approach (whereby incremental knowledge may or may not be used in future). This is the research type in which the researcher is able to draw conclusions/solutions from/for the given situations and is able to focus on uncovering what needs are not being met and use that information in designing products or services that would create their own demand. In the present world situation, more emphasis is being given to applied research to solve problems arising out of overpopulation and scarcity of natural resources.

For the scientific study of "Soaring CPI and its Causes", applied research techniques are used for it is much more practical on fundamentals and laws.

3.2: Data Type:

There are two types of data available: primary data and secondary data. Primary data is data observed or collected directly from first-hand experience, where as secondary data is the one that has already been collected and collated by somebody for reason(s) other than the current study. It can be used to get a new perspective on the current study.

'Inflation' is a macroeconomic variable/issue. For a macroeconomic variable, data is collected and published by the government, NGO's or the concerned authorities. Therefore, the data used for this research is secondary, not primary, in nature.

The date collected has already been subjected to processing/manipulation, by the appropriate authorities, giving values of each variable in its respective standard unit(s). The sources of the data compiled and studied are the Federal bureau of Statistics (Pakistan) and the State bank of Pakistan (websites). The data is reliable, verified and consistent with the international standards.

3.3: Reference Period for Research:

The reference period of this research is from June/July 2006 to June/July 2010.

3.4: Research Hypothesis:

(H0: B0 = 0): To test the hypothesis that import prices have no significant impact on inflation (CPI)

(H1: B0 ≠ 0): To test the hypothesis that import prices have a significant impact on inflation (CPI).

(H0: B1 = 0): To test the hypothesis that money supply has no significant impact on inflation (CPI).

(H1: B1 ≠ 0): To test the hypothesis that money supply has a significant impact on inflation (CPI).

(H0: B2 = 0): To test the hypothesis that exchange rate has no significant impact on inflation (CPI).

(H1: B2 ≠ 0): To test the hypothesis that exchange rate has a significant impact on inflation (CPI).

(H0: B3 = 0): To test the hypothesis that wheat support price has no significant t impact on inflation (CPI).

(H1: B3 ≠ 0): To test the hypothesis that wheat support price has a significant impact on inflation (CPI).

(H0: B4 = 0): To test the hypothesis that the petroleum price level(s) has no significant impact on inflation (CPI).

(H1: B4 ≠ 0): To test the hypothesis that the petroleum has a significant impact on inflation (CPI).

(H0: B5 = 0): To test the hypothesis that the minimum wage level has no impact on inflation (CPI).

(H1: B5 ≠ 0): To test the hypothesis that the minimum wage level has a significant impact on inflation (CPI).

3.5: Theoretical Framework & Variables under Consideration:

Petroleum Price:

Percentage change in the average per liter price of petrol in one fiscal year

(Hasan, Khan, Pasha, & Rasheed, Winter 1995) 4

(Khan, Bukhari, & Ahmed, 2005-06) 9

Wheat Support Price:

Average per annum wheat support price

(PKR /40 kg of wheat).

(Javed, Farooq, & Akram, September, 2010) 1

(Khan & Schimmelpfennig, 2006) 5

Inflation:

Annual percentage variation in overall Consumer Price Index (CPI)

(Mubarik, 2005) 7

(Khan & Saqib, 2008)10

Minimum Wage Level:

Legally set by labour policy, irrespective of the forces of supply and demand in labour market

(Javed, Farooq, & Akram, September, 2010) 1

Import Price Level

annual percentage change in the prices of imports

(Khan & Gill, 2010) 3

(Choudri & Khan, 2002) 8

Money Supply:

Broad money supply, including money base (M1), savings and deposits at commercial banks

(Javed, Farooq, & Akram, September, 2010) 1

(Qayyum, 2006)2

(Khan & Schimmelpfennig, 2006) 5

(Grauwe & Polan, 2005)6

Exchange Rate:

Nominal effective exchange rate,

as a coefficient (</>/= 1)

(Javed, Farooq, & Akram, September, 2010) 1

(Choudri & Khan, 2002) 8

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