Inflation

In mainstream economics, inflation means a rise in the general level of prices of goods and services over time.

This definition differs from that of monetary inflation, in which inflation refers to the increase of the money supply, which is based on the earliest definition of inflation, which concerned debasement of the currency.
Economists agree that high rates of inflation are caused by high rates of growth of the money supply. Views on the factors that determine moderate rates of inflation are more varied: changes in inflation are sometimes attributed to fluctuations in real demand for goods and services or in available supplies (i.e. changes in scarcity) and sometimes to changes in the supply or demand for money. In the mid-twentieth century, two camps disagreed strongly on the main causes of inflation at moderate rates: the "monetarists" argued that money supply dominated all other factors in determining inflation, while "Keynesians" argued that real demand was often more important than changes in the money supply.



While "inflation" usually refers to a rise in some broad price index like the consumer price index that indicates the overall level of prices, it is also used to refer to a rise in the prices of some specific set of goods or services, as in "commodities inflation", "food inflation", or "house price inflation" or core inflation (a measure of inflation of some sub-set of the broader index, usually excluding goods with higher volatility or strong seasonality).

What are the factors responsible for inflation?

Demand:


1- Increase in nominal money supply: Increase in nominal money supply without corresponding increase in output increases the aggregate demand. The higher the money supply the higher will be the inflation.

2- Increase in disposable income: When the disposable income of the people increases, their demand for goods and services also increases.

3- Expansion of Credit: When there's expansion in credit beyond the safe limits, it creates increase in money supply, which causes the increased demand for goods and services in the economy. This phenomenon is also known as 'credit-induced inflation'.

4- Deficit Financing Policy: Deficit financing raises aggregate demand in relation to the aggregate supply. This phenomenon is known as 'deficit financing-induced inflation'.

5- Black money spending: People having black money spend money lavishly, which increases
the demand un-necessarily, while supply remains unchanged and prices go up.

6- Repayment of Public Debts: When government repays the internal debts it increases the money supply which pushes the aggregate demand.

7- Expansion of the Private Sector: Private sector comes with huge capitals and creates employment opportunities, resulting in increased income which furthers the increase in demand for goods and services.

8- Increasing Public Expenditures: Non developmental expenditures of government lead to raise aggregate demand which results as increased demand for factors of production and then increased prices.





Supply:

1- Shortage of factors of production or inputs: Shortage of factors of production, i.e. raw material, labour capital etc causes the reduced production, which causes the increase in prices.

2- Industrial Disputes: When industrial disputes come to happen, i.e. trade unions resort strikes or employers decide lock outs etc the industrial production reduces. And as a short supply of goods in the market the prices go up.

3- Natural Calamities: Natural disasters, invasions, diseases etc effect the agricultural production, and shortage of supply which furthers the rise in prices.

4- Artificial Scarcities: Hoarders, black marketers and speculators etc create artificial shortage to earn more profits by keeping the prices high. (in Pakistan bird flu dilemma and sugar crises are the major examples in this regard)

5- Increase in exports (excess exports): When the country has tends to earn maximum foreign exchange and exports more and more without considering the domestic use of the commodities, it creates a shortage of commodities at home which increases the prices. (With reference to Pakistan, the failure of export bonus scheme during 1950's is the most common example of this type of cause of inflation)

6- Global factors: This factor includes the changing global environment. Most common example is the rise in oil prices. This factor of inflation may vary in nature, i.e. it can be political, strategic, economic or logistic in nature.

7- Neglecting the production of consumer goods: When the production of consumer goods is neglected with reference to the increased production of luxuries, it also creates inflation. For example in Pakistan, in last couple of years our services sector has grown with the highest rate of 8.8% (mainly telecom sector), while basic necessities have been ignored which created increase in the prices of consumer goods.

8- Application of law of diminishing returns: this law applies when the industries use old machines and methods and, which increase in cost by increasing the scale of production. This furthers the increase in prices and hence inflation bursts out.

Measures of inflation

Inflation is measured by calculating the inflation rate, which means the percentage rate of change of a price index, such as the Consumer Price Index.



Price indices include the following.

Consumer price index (CPI) which measure the price of a selection of goods and services purchased by a "typical consumer."

Cost-of-living indices (COLI) are indices similar to the CPI which are often used to adjust fixed incomes and contractual incomes to maintain the real value of those incomes.

Producer price indices (PPIs) which measures average changes in prices received by domestic producers for their output. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any eventual increase in the CPI. Producer price index measures the pressure being put on producers by the costs of their raw materials. This could be "passed on" to consumers, or it could be absorbed by profits, or offset by increasing productivity. In India and the United States, an earlier version of the PPI was called the Wholesale Price Index.

Commodity price indices, which measure the price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee.


The GDP Deflator is a measure of the price of all the goods and services included in Gross Domestic Product (GDP).


Core inflation Because food and oil prices change quickly due to changes in supply and demand conditions in the food and oil markets, it can be difficult to detect the long run trend in price levels when looking at those prices. Therefore most national statistical agencies also report a measure of 'core inflation', which removes the most volatile components (such as food and oil) from a wider price index like the CPI. Since core inflation is less affected by short run supply and demand conditions in specific markets, it helps central banks better measure the inflationary impact of current monetary policy.

Historical inflation Before collecting consistent econometric data became standard for governments, and for the purpose of comparing absolute, rather than relative standards of living, various economists have calculated imputed inflation figures. Most inflation data before the early 20th century is imputed based on the known costs of goods, rather than compiled at the time. It is also used to adjust for the differences in real standard of living for the presence of technology.

Asset price inflation An undue increase in the prices of real or financial assets, such as stock (equity) and real estate, can be called 'asset price inflation'.

While there is no widely-accepted index of this type, some central bankers have suggested that it would be better to aim at stabilizing a wider general price level inflation measure that includes some asset prices, instead of stabilizing CPI or core inflation only. The reason is that by raising interest rates when stock prices or real estate prices rise, and lowering them when these asset prices fall, central banks might be more successful in avoiding bubbles and crashes in asset prices.

True Money Supply (TMS)

Following their definition, Austrian economists measure the inflation by calculating the growth of the money supply, i.e. how many new units of money that are available for immediate use in exchange, that have been created over time.


Issues in measuring inflation

Measuring inflation requires finding objective ways of separating out changes in nominal prices from other influences related to real activity. In the simplest possible case, if the price of a 10 oz. can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price change represents inflation, according to the main stream definition. But we are usually more interested in knowing how the overall cost of living changes, and therefore instead of looking at the change in price of one good, we want to know how the price of a large "basket" of goods and services changes. This is the purpose of looking at a price index, which is a weighted average of many prices. The weights in the Consumer Price Index, for example, represent the fraction of spending that typical consumers spend on each type of goods (using data collected by surveying households).

Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods from the present are compared with goods from the past. This includes hedonic adjustments and "reweighting" as well as using chained measures of inflation. These adjustments are necessary because the type of goods purchased by 'typical consumers' changes over time, and the quality of some types of goods may change, and new types of goods may be invented.

As with many economic numbers, inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost increases, versus changes in the economy. Inflation numbers are averaged or otherwise subjected to statistical techniques in order to remove statistical noise and volatility of individual prices. Finally, when looking at inflation, economic institutions sometimes only look at subsets or special indices. One common set is inflation excluding food and energy, which is often called "core inflation".

Holding true to their definition, the Austrian economists do not alter their method of measuring inflation, but strives to keep track of the growth what according to their view is the "true" money supply.



Since inflation, according to the mainstream definition, is an increase in the general level of prices over time, it means a decline in the real value of money. That is, when the general level of prices rises, each monetary unit buys fewer goods and services.

Many prices are "sticky downward" and tend to creep upward, so that efforts to attain a zero inflation rate (a constant price level) punish other sectors with falling prices, profits, and employment. Efforts to attain complete price stability can also lead to deflation, which is generally viewed as a negative by Keynesians because of the downward adjustments in wages and output that are associated with it.

With inflation, the price of any given good is likely to increase over time, therefore both consumers and businesses may choose to make purchases sooner rather than later. This effect tends to keep an economy active in the short term by encouraging spending and borrowing, and in the long term by encouraging investments. But inflation can also reduce incentives to save, so the effect on gross capital formation in the long run is ambiguous.

Inflation is also viewed as a hidden risk pressure that provides an incentive for those with savings to invest them, rather than have the purchasing power of those savings erode through inflation. In investing, inflation risks often cause investors to take on more systemic risk, in order to gain returns that will stay ahead of expected inflation.[citation needed] Inflation also gives central banks room to maneuver, since their primary tool for controlling the money supply and velocity of money is by setting the lowest interest rate in an economy - the discount rate at which banks can borrow from the central bank. Since borrowing at negative interest is generally ineffective, a positive inflation rate gives central bankers "ammunition", as it is sometimes called, to stimulate the economy.

In general, high or unpredictable inflation rates are regarded as bad:

• Uncertainty about future inflation may discourage investment and saving.

• Redistribution

• Rent Seeking - happens when resources are used to merely transfer wealth rather than produce it. e.g. a company tries to gauge and combat the costs of inflation.

• inflation redistributes income from those on fixed incomes, such as pensioners, and shifts it to those who draw a variable income, for example from wages and current profits which may keep pace with inflation. The real value of retained profits are eroded by inflation as the historical cost balances stay fixed like pensioners´ fixed income.

• Debtors may be helped by inflation due to reduction of the real value of debt burden.

• A particular form of inflation as a tax is Bracket Creep (also called fiscal drag). By allowing inflation to move upwards, certain sticky aspects of the tax code are met by more and more people. For example, income tax brackets, where the next dollar of income is taxed at a higher rate than previous dollars, tend to become distorted. Governments that allow inflation to "bump" people over these thresholds are, in effect, allowing a tax increase because the same real purchasing power is being taxed at a higher rate.

• International trade: Where fixed exchange rates are imposed, higher inflation than in trading partners' economies will make exports more expensive and tend toward a weakening balance of trade.

Rising inflation can prompt trade unions to demand higher wages, to keep up with consumer prices. Rising wages in turn can help fuel inflation. In the case of collective bargaining, wages will be set as a factor of price expectations, which will be higher when inflation has an upward trend. This can cause a wage spiral.[citation needed] In a sense, inflation begets further inflationary expectations.

• Hoarding: people buy consumer durables as stores of wealth in the absence of viable alternatives as a means of getting rid of excess cash before it is devalued, creating shortages of the hoarded objects.

• Hyperinflation: if inflation gets totally out of control (in the upward direction),
• it can grossly interfere with the normal workings of the economy, hurting its ability to supply.

As noted, this definition of inflation is rejected by the Austrian School, which maintains that inflation is an excessive increase of the money supply, which in turn leads to a higher nominal price level, as the real value of each monetary unit is eroded and thus buys fewer goods and services. Austrian economists also believe that inflation sets off the business cycle (see Austrian Business Cycle Theory) and hold this to be the most damaging effect of inflation as artificially low interests rates due to exessive increases in the money supply that leads to overly ambitious investment, resulting in clusters of malinvestments, which has to be liquidated as they show their unprofitability.[21]

to be continued

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HISTORICAL TREND OF INFLATION IN PAKISTAN

INTRODUCTION:

The State Bank appeared to have woken up to the fact that the country was facing high inflation and increased the benchmark rate by a record 150 basis points. This followed the earlier four hikes of 50 basis points each in April 2005, July 2006, July 2007, and January 2008. These abrupt and harsh measures could undermine the credibility of the bank. The State Bank Governor’s statement contained many contradictions that need careful examination but the knee-jerk nature of the measures points to a major shortcoming: the bank failed to anticipate the rapid deterioration in inflation, growth and other key macro indicators. For example, its January 2007 monetary policy statement had noted, “while inflation is likely to ease-off further it may remain above the target 6.5 per cent target for unless come additional administrative measures are taken to reduce food inflation.”

Inflation and growth trends conduct its monetary policy accordingly because it can take around 18 months or so before the impact of its tightening or otherwise is felt on inflation. This requires analysis of historical information as well as judgements about the future trends especially in a developing country like Pakistan where the data is not always up-to-date and reliable.
The problem goes beyond just the failure to anticipate. Pakistan is the only one among the major Asian countries whose inflation rate has been persistently higher than its GDP growth rate since 2005.

The table below specifies average annual inflation.





Table: Average Annual Inflation (percentages)



Year ------------ Overall Inflation ----- Non-food/non-energy Inflation
2003-04 ------------ 4.6 ----------------- 3.8
2004-05 ------------ 9.3 ----------------- 7.2
2005-06 ------------ 7.9 ----------------- 7.5
2006-07 ------------ 7.8 ----------------- 5.9


It is also a matter of record that the real interest rates in Pakistan continued to decline throughout 2006-2007 after reaching their peak in April 2006. This writer noted in the EBR issue of January 22, 2007, “The real interest rates in Pakistan depict a declining trend since mid-2006 while those in India show an upward trend. Declining real interest rates can portend a higher inflationary environment 18 months down the road.”










Viewing Historical Trend through CPI, SPI & WPI


1. Consumer Price Index (CPI) is the main measure of price changes at the retail level.


It measures changes in the cost of buying a representative fixed basket of goods and services and generally indicates inflation rate in the country. The Consumer price index was computed for the first time with 1948-49 as a base for industrial workers in the cities of Lahore, Karachi and Sialkot only. Continuous efforts have been made, since then, to make CPI more representatives by improving and expanding its scope and coverage in terms of items, category of employees, cities and markets. Accordingly, the CPI series were computed with 1959-60, 1969-70, 1975-76, 1980-81 and 1990-91 as base years. At present, the CPI is being computed with 2000-01 as base year. And according to the studies of CPI, the inflation rate during the fiscal year 2000-2001 was 4.41, during the fiscal year 2001-2002 it dropped down to 3.54, further dropped to 3.10 during the fiscal year 2002-2003, rose again to 4.57 during 2003-2004, increased drastically to 9.28 during 2004-2005 and then dropped to 7.92 during 2005-2006. And by the mid of October 2006, the CPI is reported to be 8.43.


2. The Sensitive Price Indicator (SPI) is computed on weekly basis to assess the price movements of essential commodities at short intervals.


It is to review the price situation in the country. The SPI is being presented in the Economic Coordination Committee of the Cabinet (ECC). Sensitive price indicator was originally computed with 1969-70 as base which was subsequently switched over to 1975-76, 1980-81 and 1990-91 as base year. Presently, the SPI is being computed with base 2000-2001. And Sensitive Price Indicator (SPI) shows the facts as; 4.84 in 2000-2001, 3.37 in 2001-2002, 3.58 in 2002-2003, 6.83 in 2003-2004, 11.55 in 2004-2005 and 7.02 in 2005-2006. Recently (By the mid of October 2006) the SPI is reported as 9.8


3. The Wholesale Price Index (WPI) is designed to measure the directional movements of prices for a set of selected items in the primary and wholesale markets.



Items covered in the series are those which could be precisely defined and are offered in lots by producers/manufacturers. Prices used are generally those, which conform to the primary sellers realization at ex-mandi, ex-factory or at an organized Wholesale level. The WPI initially was computed with 1959-60 as base. Since then, continuous efforts have been made to make the WPI more representatives by improving and expending its scope and coverage in terms of commodities, quotations/markets, etc. Accordingly, WPI series were computed with 1969-70, 1975-76, 1980-81 and 1990-91 as base years. Presently, the WPI is being computed with 2000-01 as base. The Wholesale Price Index (WPI) tells the story as; 6.21 in 2000-2001, 2.08 in 2001-2002, 5.57 in 2002-2003, 7.91 in 2003-2004, 6.75 in 2004-2005 and 10.10 in 2005-2006.












Evaluating Historical Trend during Current Fiscal Year


Inflation Among the most appreciated developments, during current fiscal year, was the significant abatement of price pressure over the course of the year. For the first ten months of the fiscal year, all important barometers of price pressure in the economy indicated a steady deceleration in inflation.


4. Inflation during the first ten months July-April of the current fiscal year is estimated at 8.0 percent as against 9.3 percent in the same period last year.


5. Food inflation is estimated at 7.0 percent as against 12.8 percent in the same period last year.


6. Non-food inflation at 8.8 percent is on higher side compared with 6.9 percent in the same period last year.


7. The core inflation which excludes food and energy costs from the headline CPI, moved up and estimated at 7.7 percent as against 7.0 percent in the same period last year.


8. House rent index also played an important role in building inflationary pressure this year. With second largest weight in the CPI (23.4%) after food (40.3%), the house rent component of the CPI registered a marginal decline to 10.3 percent as against 11.1 percent in the same period last year.


When viewed in the context of year-on- year performance of inflation, the current fiscal year exhibits significant abatement of price pressure and declaration in overall inflation as well as its sub-indices.

• The current fiscal year, started with an inflation rate of 9.0 percent in July 2005, but continued to decelerate, reaching at 23 months low at 6.2 percent in April 2006.

• Food inflation was closed to 9.7 percent at the beginning of the current fiscal year but decelerated sharply to 3.6 percent in April 2006- the lowest in the last 31 months. The measures taken by the Government, particularly since April 2005, when overall inflation reached 93 months high at 11.1 percent (the last time inflation was at this level in July 1997).

• Food inflation peaked at 15.7 percent in April 2005 (last-time it was at 15.7 percent in May 1994), yielded handsome dividend in the shape of overall inflation decelerating to 6.2 percent and food inflation to 3.6 percent in April 2006. Notwithstanding a steady deceleration in inflation, the prices of some of the essential food items (out of the basket of 370 items in CPI) registered sharp increases, particularly during the second half of the fiscal year and therefore adversely affected the low and fixed income groups. The expenditure on food items constitutes bulk of the monthly expenditure of the poor segment of the society.

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A disturbing feature of the budget 2008-09

A disturbing feature of the budget 2008-09 is the double-digit target of 12 per cent set for inflation. Although inflation has emerged as a risk to the economy since 2004-05, such a high level of inflation has not been targeted in the budget or experienced in recent history. The hike in the prices of petroleum products and CNG has further fuelled inflationary expectations.

What are the causes of high level of inflation? Economic theory provides three possibilities of higher inflation described by Robert J. Gordon as the “triangle model”: (a) aggregate demand outstrips the aggregate supply of goods (demand pulled inflation),or (b) costs increase due to any supply side effects which increase the cost of production (cost-pushed inflation) or (c) inflation induced by adaptive expectations (built-in inflation). Any or all types of inflation can be generated by fiscal measures.

The government can adopt expansionary fiscal and monetary policies, which may cause demand pull inflation; simultaneously it has the power to impose indirect taxes or increase tax rate that may result in cost push inflation and finally it can generate “price/wage spiral” which trigger a process in which workers trying to keep their wages up with rise in prices and employers passing higher costs on to consumers.

The important question is: what explains the recent inflationary trend since 2004-05, and why government has set a high target of 12 per cent for 2008-09?

Since 2002-03, the monetary policy stance has been expansionary. There was lack of sterilisation of foreign exchange inflows since 9/11. The initial impact was, of course, growth in output in 2003-04 and 2004-05, which peaked at nine per cent. Thereafter, monetary expansion has increasingly spilled over into higher inflation, due to limits of capacity. The initial boom was basically a release of ‘repressed growth’.

The precipitous fall in interest rates sparked off an explosion in private sector credit and raised aggregate demand in the economy. Expansionary monetary policy also helped in creating ‘fiscal space’ due to the sharp fall in interest payments. As a result, aggregate demand outstripped the aggregate supply of goods and translated in relatively higher inflation till 2006-07.

In 2007-08, inflation was also fuelled by “external shocks” of rising oil and food prices. However, the impact had not been felt directly till recently because of limited pass through into domestic prices. An indirect effect has come via the sharp jump in the subsidy bill that has raised the fiscal deficit, financed largely by borrowings from the central bank.

It is clear that the expansionary fiscal policy is impacting on monetary policy. Also the high single digit inflation in the last three years and the soaring inflation this year have built-in inflationary expectations. Consequent behavioural changes along with soaring prices of energy and food and rupee depreciation have resulted in spiralling inflation. Thus the economy has been experiencing an inflation of 11 per cent rather than the target of 6.5 per cent for 2007-08.

The government resource mobilisation efforts are largely concentrated on taxes like custom, federal excise duty and sales tax. In this year’s budget, the rate of sales tax has been increased from 15 to 16 per cent. Due to a plethora of excise duties, sales taxes and various customs duties, business and industry would have no option but to pass on most of the taxes to the consumer. In this sense, it is a budget, which cuts at the roots of supply side economies by enacting direct cost increasing policies which are quite inflationary in nature.

The government plans to cut current expenditure both in nominal as well as in real terms. Given the size of budget deficit, this is a positive move if successfully implemented. While the current expenditure is expected to decline marginally by only Rs23 billion, subsidies are expected to drop from Rs407 billion to Rs295 billion. These subsidies are largely used to stabilize energy and food prices. The cut in subsidies will not only increase the fuel and electricity prices, but will affect every sector of the economy, by increasing the transportation and production costs. This will fuel the cost push inflation.

The impact of the budget deficit on inflation depends on its mode of financing. The current deficit for 2008-09 is being largely financed by non-bank borrowing (44.5 per cent) followed by both external resources and bank borrowing (25.6 percent each) and only 4.3 per cent through privatization. Of these four measures, bank borrowing or monetization of deficits is highly inflationary. The projected financing through bank borrowing is more than one per cent of the GDP and may lead to a high inflation.

It is obvious from the new taxation proposals and expenditure reduction strategy that the budget would promote cost-push inflation. The previous inflations have been largely “demand-pulled”, but this one clearly shifts the focus to “cost-pushed”. The cost-pushed inflation is worse than demand- pulled inflation, because costs when increased are built into prices and these price increases are very hard to undo.

Assuming the domestic demand continuesto grow at last five year’s average
of 8.1 percent and the real GDP growth target of 5.5 percent for FY09is achieved, the difference between domestic demand and supply is expected to widen further. Therefore, it is of utmost importance to:

(i). curtail aggregate demand pressures throughr estraining expenditures in
the shortrun;
(ii) increase the production capacity of the economy by addressing structural
constraints; and
(iii). improve factor productivity.

These measures are necessary for ensuring price stability and long term growth on sustainable basis. While it is expected that some of the demand pressures will recede in the current fiscal year, but if the supply side issues are not addressed, the ‘gap’ could remain unchanged and the expected favourable impact on inflation will be diluted.




Why Worry About Inflation?

High and persistent inflation is a regressive tax adversely impacting the poor and economic prospects. The poor hold few real assets or equity, and their savings are typically in the form of cash or low-interest bearing deposits; this group is most vulnerable to inflation as it erodes savings. Moreover, high and volatile inflation has been found to be detrimental to growth and financial sector development. High inflation obscures the role of relative price changes thus inhibiting optimal resource allocation.


Inflation hurts growth once it exceeds a certain threshold. A number of empirical studies have established that the relationship between inflation and growth is nonlinear. At low levels of inflation, inflation has either no impact or a positive impact on growth. However, once inflation exceeds a certain threshold, it has an adverse impact on long-run growth. In a panel of 140 countries, Khan and Senhadji (2001) estimate this threshold to be 1–3 percent for industrial countries and 7–11 percent in developing countries.

Focusing on Middle East and Central


Asian countries including Pakistan, Khan (2005) estimates the optimum inflation rate to be 3 percent and argues that policy-makers should keep inflation below 6 percent to avoid a negative impact on growth. Mubarik (2005) revisits the threshold question using exclusively time-series data for Pakistan from 1973 to 2000.




He finds that inflation in excess of 9 percent harms short-run growth in
Pakistan. Another recent study for Pakistan by Hussain (2005) estimates a
threshold of 4–6 percent beyond which inflation harms growth.


High inflation also inhibits financial development. Financial market institutions
are intermediaries that reduce frictions between savers and investors (including adverse selection, moral hazard, or conflicting time preferences). Inflation makes this intermediation more costly because inflation tax lowers long-run real returns. As a result, credit is rationed and financial depth is reduced. As in the case of growth, there appears to be a threshold beyond which inflation adversely affects financial sector developments, while there are no negative effects at low levels of inflation. Khan, Senhadji, and Smith (2005) estimate this threshold to be about 3–6 percent in a panel of 168 countries. The adverse effect of inflation on financial development is one mechanism by which inflation can hurt growth. For example,


Loayza and Ranciere (2005) find a positive long-run relationship between
financial development and growth in a sample of 75 countries.


In Pakistan, periods of low inflation are associated with high growth rates and vice versa. Figure 7 shows real per capita growth and CPI inflation. Between 1978 and 1991, inflation was 8 percent on average and real per capita growth averaged 3 percent. Between 1992 and 1997, inflation increased on average to 11 percent,while real per capita growth fell substantially and averaged only 1 percent.


Finally, between 1998, inflation was reduced again to an average of 5 percent, and real per capita growth displayed a dramatic recovery. Of course, there are other factors that determine growth in the short-run and in the long-run [e.g. van Rooden (2005)]. Nonetheless, Pakistan’s growth performance has been best when inflation was contained to 8 percent or lower.


For Pakistan, the direct inflation-growth nexus suggests a threshold of 4–6 or 9 percent, while the inflation-financial development nexus suggests a lower
threshold of 3–6 percent. Given that actual inflation will fluctuate around an
inflation target, it is prudent to set the target sufficiently low to ensure that actual inflation does not enter the double-digit range. Taken together, SBP’s inflation target of 5 percent is, therefore, appropriate.

5. Summary and Conclusions

The empirical results presented in this paper show that monetary factors determine inflation in Pakistan. Broad money growth and private sector credit growth are the key variables that explain inflation developments with a lag of around 12 months.


A long-run relationship exists between the CPI and private sector credit. The
wheat support price affects inflation in the short run, but not in the long run.


Pakistan’s growth record since the 1970s underscores that high and persistent inflation is harmful to growth. Periods of high inflation have coincided with low growth spells, while high growth episodes tend to be associated with a low inflation environment. In light of the empirical thresholds beyond which inflation harms growth and financial development, an appropriate inflation target for Pakistan is 5 percent.



The overarching objective of the SBP should, therefore, be price stability.
The SBP should first and foremost focus its attention and policies to keep inflation close to its target of 5 percent. In principle, the SBP could also target an exchange rate level as a nominal anchor to achieve macroeconomic stability. However, this implies adopting the anchor country’s monetary policy and may yield asuboptimal rate of inflation. In addition, the exchange rate would no longer be available to offset the impact of external shocks on the domestic economy.


The SBP is fully capable of implementing its own independent monetary policy
consistent with the needs of the domestic economy. Maintaining price stability will ultimately be the best policy contribution to sustained growth that the SBP can make. While there may not be a trade-off between inflation and growth in the short run, it certainly exists in the medium and long run.


Price stability can be approximated by different metrics. While headline inflation is better understood by the public, it is often argued that monetary policy should be more concerned with core inflation. Given the volatility of some components of the CPI, in particular food prices and energy prices, core inflation (approximated as nonfood, non-energy or the SBP’s trimmed mean definition) is a better measure of underlying inflation trends than headline inflation. Nonetheless, headline inflation is better understood by the public and affects households immediately.

Taken together, core inflation is the right target for monetary policy, in particular over the medium term, but the SBP also needs to keep a watchful eye on headline inflation.


Finally, monetary policy has to be forward-looking to achieve its inflation target. Current monetary conditions affect inflation with a lag of around 12 months in Pakistan. There seems to be a fairly stable relationship between private sector credit growth and inflation 12 months from now. In addition, there is also a relationship between broad money growth and inflation 12 months from now. Therefore, the SBP should set monetary policy today with a view to meeting its inflation target around one year from now.

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