Inflation Inflation or price inflation is a rise in the general level of prices of goods and services in an economy over a period

of time. It can also be described as a decline in the real value of money a loss of purchasing power. The level of inflation in Pakistan has been persistently rising since Partition. 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.

The economic survey 2010-11 unveiled 14.1% inflation in Pakistan, 4.6% higher than the target of 9.5%. 2009-10 overall inflation was 22% while in 2008-09 it was 23.3%. inflation soared to 15.7 after the floods, remained at 15% in December and fell to 14.2% in January. It is expected to stay high in FY2011 and expected to fall to 13% in FY2012. Even the IMF predicted 14% inflation due to sharp increases in petroleum and food prices.

Inflation is usually estimated by calculating the inflation rate of a price index, usually the Consumer Price Index. The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer". The inflation rate is the percentage rate of change of a price index over time. The cumulative increase in July-May 2010-11 of CPI is 14.1%

as against 11.5% last year, wholesale price Index rose 25.4% due to textile and energy prices and sensitive price index to 18.5%.

There was an increase of 0.23% in inflation in May over the previous month. Increase of 13.23% in food inflation with 15% rise in perishable items and 21.69% in non perishable items. Transport went up by 14.34%, education up by 6.02%, medical care increased by 14.84%. the main commodities which showed increase in their prices were: fresh milk (3.37%), cooking oil (1.67%), meat (1.02%). According to the textile group price of cotton cloth increased by 3.66%, petrol (5.94%), diesel (4.86%). Main items which showed decrease during May 2011 were tomatoes (45.21%), onions (18.72%), vegetables (10.82%), and wheat (9.39%).

In Pakistan food inflation is the major driver of inflation due to the devastating floods and rise in international food prices. Food inflation constitutes about 45.2% of inflation. In early may despite the increase in transport costs prices of food and vegetables showed mixed trends. Fresh milk prices increased from Rs 60 to Rs 66, sugar went from Rs 68 to Rs 75 per kg last month in april. Prices of pulses were lower sugar reported a fall of Rs 68 per kg from Rs 75 per kg. prices fell due to low demand or the absence of panic buying from retailers. Wheat prices fell from Rs 950 per 40 kg to around Rs 700 due to problems on the export front and absence of exporters as buyers and buyers were expecting other factors contributing to fall in wheat prices. Wheat also had an effect on sugar with sugar prices falling for the third consecutive time to Rs 60-65 per kg. Rates of most grains fell sharply in the market due to comfortable arrivals from upcountry centres. Early phutti arrival resulted in prices of cotton showing fall which was expected. Soaring prices of cotton in the international market encouraged growers to increase production. Presently prices of cotton are stable.

Later on towards the end of may wheat and sugar prices showed and upward trends. Sugar price increased by Rs 3 per kg reached Rs 67-68 kg, due to surge in international markets. Meanwhile prices of gur increased by Rs 100 per 100 kg. The price of a 20 kg bag of wheat flour increased by Rs per 20 kg price would further increased. Main reason of increase of price was export of wheat to Middle East. Special atta increased by Rs 15 and fine flour by Rs 10 per 20 kg bag In 2010-11 an overall surge of prices of major crops of sugarcane, wheat, and rice caused a Rs 342 billion transfer to the rural areas alone. Due to prices of food rising there were fears of a food crisis. Rice prices showed no rise. Production is expected to rise worldwide. In Pakistan rice production is expected to recover in 2012 due to the impact of floods. USDA projects Pakistan rice production to 6.8 million tons in FY2012. Due to falling prices exporters will be benefited. Even Food and Agriculture Organizations recorded prices of Pakistani rice in the Basmati category fell to $1025 from $1150 from December 2010 Due to the fall in palm oil rates internationally many ghee and cooking oil packers did not get the benefit and are still charging higher prices. Palm oil was $1340-1350 per ton in February 2011 compared to $1270-1300 in January. A 16 kg ghee tin is now priced at Rs 2500-2550 as compared to Rs 2650-2700 in February. Due to discount schemes ghee and cooking oil were selling at row rates in CSD stores and the pace is picking up at these stores. Beginning of the year Inland Equivalent Freight Margin increased by 45% increased petroleum costs led to higher prices. CNG price will increase by 15% from July 2011. CNG price is fixed at 50% price of petrol. The Oil and Gas Regulatory Authority fixed the price of CNG at Rs. 59.57 per kg. The purpose of raising the CNG price is to reduce the difference with the price of petrol

and therefore manage demand so that the gas could be used for industrial sector. Gas prices will be raised further to reduce cross subsidy. The low gas price versus substitute fuels results in large demands for gas. Gas pricing should ensure gas exchange and the state should fix the price of gas for domestic use only. The Oil and Gas Regulatory Authority is likely to reduce prices of different petroleum prices by Rs 6, the government may reduce petrol by Rs 1.5 per litre and diesel by Rs 5.5 per litre. The government is determined to bring POL and CNG prices at par the difference is 37%. Pakistan has the highest number of CNG running vehicles. All Pakistan CNG Association rejected the proposal to increase CNG prices by 15% every three months. Health professionals rejected the Rs40 billion allocations for both health and education sectors, saying no new schemes had been launched in the neither health sector nor salaries of doctors increased. Dr Abdul Malik of the Pakistan Islamic Medical Association (PIMA) termed the federal budget hopeless, saying allocation for health was nothing as compared to the growing inflation. Increases in prices of medicines affected the lower and middle classes. The PIDE said better macroeconomic management, prudent fiscal policy and a balanced monetary policy would revive the private sector. The government needs to reduce its excessive borrowing. Lower government borrowing, considered critical to limiting monetary expansion and to encourage private sector credit and by ensuring adequate supply of essential items because price stability is critical for making long term economic decisions. Pakistan is faced with serious challenges including macroeconomic stabilizers from unsustainable fiscal policies, loss making public sector and low and declining productivity. The government needs to revise its policies of excessive borrowing which are contributing to inflation.

IS/LM Curve

Inflation creates a difference between real and nominal interest rates. The nominal rate is the visible rate that people pay and receive, and the real interest rate is what is happening in terms of purchasing power. Thus if the rate of interest is 5% and the rate of inflation is 14.1%, a person who borrows Rs100,000 and pays back Rs105,000 in a year will pay back less in terms of purchasing power than he borrowed. He pays back Rs 105,000, but each rupee can buy 14.1% less than it did a year earlier. Hence his rate of interest in real terms is actually negative. The real interest rate is computed as the nominal interest rate less the rate of inflation.

The distinction between real and nominal interest rates is important in ISLM because investment spending should respond to the real interest rate and money demand to the nominal interest rate. To see why investment depends on the real rate, consider a situation of zero inflation in which a person buys a machine that will cost Rs100,000 and earn Rs105,000 one year later. This purchase will be worthwhile if the interest rate is below 5%. Now suppose that

inflation jumps from zero to 14.1%. The same machine will produce the same output, but because of the increase in prices, the output will be 14.1% more valuable in terms of the money it brings. Thus the Rs 100,000 machine will earn Rs119805 (which is 14.1% more than 105) in one year. The investment is now worthwhile at any nominal rate under 19.1% (which is a real rate under 5%.) Investment will remain constant if the real interest rate does not change; change in nominal rates will not change investment if it does not change the real rate.

Further, the rate of inflation independently affects the demand for money by changing its desirability as a store of wealth. As a result, the velocity of money increases. To some extent estimates of how sensitive money demand is to interest rates may be catching this sensitivity of money demand to inflation because rates of inflation and interest rates move together.

One could graph the ISLM model assuming that the vertical axis measured the real rate. Then any time the rate of inflation changed (and thus the nominal rate), LM curve would shift. A more rapid inflation would shift the LM curve to the right, for example, reducing real interest rates and increasing income. The problem with this solution, however, is that it leaves the rate of inflation as autonomous, unrelated to what is happening to fiscal and monetary policy. Most economists believe that macroeconomic policy is by far the most important determinant of rates of inflation.