SUBJECT MODULE: W1006

2013

Submitted By: Afrah A.Sheikh

Submitted To : Mrs. Narmeen Nasr

Student ID:

2

TABLE OF CONTENTS

1. What is Inflation? ………………………….…………………………3

2. The causes of Inflation…………………………………………..… 3

3. Causes of Inflation in a Country……………………………........….8

4. Explanation of the effects of Inflation……………………………...10

5. The ways in which Inflation can be curbed……………………..….11

6. References……………………………………………………………12

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Inflation

Introduction to Inflation:-

Inflation can be defined as a generalised and persistent increase in the level of prices In simple words it is a general increase in prices and fall in the purchasing value of money. It is regarded as the most important issue in Economics. Inflation is measured by the changes in the retail price index (RPI) which records the changes in the general level of prices paid by consumers for all the goods and services they buy. When inflation crosses reasonable limits, it has negative effects. It reduces the value of money, resulting in uncertainty of the value of gains and losses of borrowers, lenders, and buyers and sellers. Therefore, the increasing uncertainty discourages saving and investment.

Causes of Inflation:-

Inflation is the devasting condition when prices just keep going up, eating away the standard of living.

There are three main causes of inflation:

Demand-Pull Inflation Cost – Push Factor The monetarist view of inflation.

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Demand- Pull inflation : By the name itself it means that there is

too much demand in the economy which exceeds supply of goods and

services and therefore prices are pulled up. This situation is usually,but

not always associated with full employement in the economy. This is

usually explained by the phrase “too much money chasing too few goods”.

Economists often say that demand-pull inflation occurs when price levels

rise because of an imbalance in the aggregate supply and demand. When

the aggregate demand in an economy strongly outweighs the aggregate

supply, prices increase. This occurs when there is excess aggregate

demand in the overall economy or in a specific market or industry.

Businesses respond to high demand by raising prices to increase their

profit margins. Demand-pull inflation is associated with the boom phase

of the business cycle. The main causes of demand pull inflation are:

1. Faster rates of economic growth in other countries – providing a boost to

UK exports overseas

2. A weaker exchange rate which increases the price of imports and reduces

the foreign price of UK exports

3. Rising consumer confidence and an increase in the rate of growth of house

prices

4. A reduction in direct or indirect taxation - consumers have more

disposable income causing more demand

5. Rapid growth of the money supply as a consequence of increased bank

and building society borrowing

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Cost – Push Factor: Cost push inflation is inflation caused by an

increase in prices of inputs like labor, raw material, etc. The increased

price of the factors of production leads to a decreased supply of these

goods. While the demand remains constant, the prices of commodities

increase causing a rise in the overall price level and the overall price level

increases due to higher costs of production which reflects in terms of

increased prices of goods and commodities which majorly use these

inputs. This is inflation triggered from supply side i.e. because of less

supply. Apart from rise in prices of inputs, there could be other factors

leading to supply side inflation such as natural disasters or depletion of

natural resources, monopoly, government regulation or taxation, change in

exchange rates, etc. Generally, cost push inflation may occur in case of an

inelastic demand curve where the demand cannot be easily adjusted

according to rising prices. This is in essence cost push inflation , it is a

situation where rising costs “push up” prices.

This occurs when costs of production or operation are increasing. The

main key causes include:

1. Acceleration in wages

2. External shocks (e.g. commodity price fluctuations)

3. A depreciation in the £ exchange rate i.e. the more the weaker the

pound the more expensive are the goods.

The monetarist view of inflation: A set of views based

on the belief that inflation depends on how much money the

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government prints. Monetarists often argue that if the Money Supply rises faster than the rate of growth of national income then there will be inflation. Tight control of money and credit  is required to maintain price stability. The key is for monetary policy to be credible – in the hands of an independent central bank – so that people’s expectations of inflation are controlled

A simple way of explaining how a surge in the amount of money in circulation can feed through to higher inflation is shown in the flow chart below.

Excess money balances held by households and businesses can affect demand and output in several directions. Consumers will increase their own demand for goods and services adding directly to aggregate demand. Some of the excess balances will be saved in bonds and other financial assets, or invested in the

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housing market. An increase in the demand for bonds causes a downward movement in bond interest rates as there is an inverse relationship between the two and this can then stimulate an increase in investment. Money that flows into housing will push house prices higher, and knowing that might understand quite well how a booming housing market stimulates consumer wealth, borrowing and an increase in spending.

The Quantity Theory of Money By Famous Economist:

The theory rests on what is sometimes known as the Fisher identity as it was known and first developed by Irving Fisher or the equation of exchange. This is an identity which relates total aggregate demand to the total value of output (GDP).

M x V = P x YWhere

M is the money supply V is the velocity of circulation of money P is the general price level Y is the real value of national output (i.e. real GDP)

Money supply (M) multiplied by the velocity of circulation (V) = the value of national output (price level (P) x volume of transactions (Y))

Velocity of circulation  can be calculated by dividing the money value of national output by the money supply and it represents the number of times that a unit of currency (E.g. a £10 note) is used in a given period of time when used as a medium of exchange to buy goods and services

Inflation in Pakistan : In Pakistan the general price level is persistently rising since its establishment. The prices remained volatile

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during the decade of 1990’s ranging from 5.7 % to 13 % mainly because of declining economic growth, expansionary prices, output setbacks, higher taxes and a depreciation of Pakistan rupee.

The inflation rate started declining from 1998 onward due to improved supply position of goods and strict budgetary measures. The inflation rate was 5.7 % in 1998-99. It was brought down to 3.6 % in 1999-2000 and further to 3.1 % in 2002-2003. The inflation rate based on CPI (Consumer Price Index) has averaged 4.6 % during 2003-2004. The slight rise in prices was due to increase in price of wheat. The inflation rate reached as high as 9.3% in the year 2004-2005 mainly due to rise in price of wheat and increase in the international oil price.

Demand Pull Inflation in Pakistan:

Demand for non-development expenditures : The elected and non-elected governments in Pakistan since 1947 have not been able to curb the non-development expenditures.

Rapid monetary expansion: From the past years the growth in monetary assets has outstripped the rise in nominal GDP. The easy monetary policy adopted to kick start the stagnant economy has led to the rise in general price level.

Foreign Economic assistance : For rapid economic development, Pakistan has been receiving foreign and since early 50’s. The output of goods, therefore does not increase correspondingly with the rise in income.

Consumption habits : Pakistanis living in Urban and rural areas are mostly send thrift. They are proud of spending money on the goods which are used by the people in the advanced countries of the world. The increased expenditure on clothes, foods, cosmetics etc. have added much to the inflationary pressure in the country.

Construction of houses : people are spending their savings mostly on the purchase of land and construction of houses. The

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unproductive expenditure on the construction of houses, plazas etc. has also contributed to the rising trend in prices.

Increase in Wages: The rise in wages, salaries, dearness allowances, bonuses etc. in the annual budget increase the purchasing power of the employees. With the increase in the disposable income of the workers, the prices of the commodities go up. The workers gain press for higher wages.

Black Money: Black money is the unaccounted money receipts. It is generated through smuggling, tax evasion, price control etc. It is estimated that annual generation of black money is about 25% of GNP of the country. This huge amount pushes up the prices of land, houses, cars, air conditioners and other expensive items.

Cost-Push Factor of inflation in Pakistan:

Increase in Indirect   taxes : For increasing the revenue the Government is heavily relying on indirect taxes. The increase in the indirect taxes every year has given the general price level an inflationary push.

Depreciation of Rupee: The repeated and higher devaluations of Pakistani rupee has increased the cost and prices of imported goods. Depreciation of the currency thus is an important factor for the rise in the average level of prices in Pakistan.

Rise in Gas and Excise Duty: The multiplier effect of the rise in gas prices, and levying of excise duty, sales tax on a number of items has greatly contributed to the cost push effect.

Rise in support price of agriculture crops : The Government raises the support prices of cotton, wheat, sugar cane to protect the interests of farmers. This also has an inflationary impact on the currency.

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Increase in Wages : In Pakistan one of the factors leading to cost-push inflation in the rise in wage not backed by increase in productivity. The compensatory wage increase and the rise in prices are chasing each other at quite a rapid speed causing personal rise in the level of prices.

Rising prices of imported goods: The import prices of POL chemicals, fertilizers, non-electrical machinery etc have gone up in the world market. The cost and so the price of commodities using the imported items has gone up in the country.

Effects of Inflation :-

Inflation effects the different sectors of the economy such as on the distribution

of income ,wealth, production, Government, balance of payment, monetary

policy, social sector, political environment and different classes of the people

such as debtors & creditors, salaried class, wages earners, fixed income group,

additionally investors, shareholders, businessmen, agriculturists etc.

Inflation has other disastrous effects and can be very damaging for a number of

reasons. Initially people may be left worse off if prices rise faster than their

incomes. Never the less, inflation can reduce the value of an investment if the

returns prove insufficient to compensate them for inflation. If money is losing its

value, businesses and investors are less likely to make long-term contracts. This

discourages long-term investment in the nation’s productive capacity.  Precisely,

local spending, indeed, does get a shot in the arm. The new money works its way,

step by step, throughout the economic system. As the new money spreads, it bids

prices up and in the meantime, some people gain and other people lose.

In short, the counterfeiters and their local retailers have found their incomes

increased before any rise in the prices of the things they buy. But, on the other

hand, people in remote areas of the economy, who have not yet received the new

money, find their buying prices rising before their incomes. Retailers at the other

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end of the country, for example, will suffer losses. The first receivers of the new

money gain most, and at the expense of the latest receivers. Inflation, then,

confers no general social benefit; instead, it redistributes the wealth in favor of

the first-comers and at the expense of the laggards in the race.

Ways in which Inflation can be curbed :-

Inflation always hurts ones standard of living. Rising prices mean people have to

pay extra for the same goods and services. If income increases at a slower rate as

inflation, the standard of living declines even if one makes more so it is the root

cause in making and affecting economy and people of the country poor. If we

want to control inflation we shall have to inflict strict control over the supply of

money and evading any relaxation to the supply of money by making imports

cheaper, reducing demand for exports and increasing incentive for exporters to

cut costs. The government can increase taxes such as income tax and cut

spending. This improves the budget situation and helps to reduce demand in the

economy which reduces the inflation by the growth of an aggregate Demand. In

some cases, the economy seems to be growing reasonably strongly. Therefore,

the inflationary pressures can be reduced without causing a recession

In addition Lower wage growth helps to reduce cost push inflation, and helps to

moderate demand pull inflation then limiting wage growth can help to moderate inflation.

Besides, monetarism seeks to control inflation through controlling the money supply.

Monetarists believe there is a strong link between the money supply and inflation. It is

although believed that inflationary pressure can be reduced by more flexible labor.

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References:-

1. http://clausvistesen.squarespace.com/alphasources-blog/2007/7/21/

price-measurement-in-japan.html

2. http://www.tutor2u.net/blog/index.php/business-studies/comments/

qa-explain-the-causes-of-inflation

3. http://economictimes.indiatimes.com/definition/cost-push-inflation

4. http://www.investopedia.com/terms/m/monetarism.asp

5. http://www.tutor2u.net/economics/revision-notes/a2-macro-

monetarism.html

6. http://wiki.answers.com/Q/

What_are_the_main_Causes_of_inflation_in_Pakistan_in_recent_ti

me

7. http://notesforpakistan.blogspot.com/2009/08/causes-of-

inflation.html

8. http://www.economicshelp.org/blog/2269/economics/ways-to-

reduce-inflation/

9. http://pakobserver.net/detailnews.asp?id=136097

10. http://pakistantimes.net/pt/detail.php?newsId=12410

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