Inflation refers to a rise in prices that causes the purchasing power of a nation to fall. Inflation is a normal economic development as long as the annual percentage remains low; once the percentage rises over a pre-determined level, it is considered an inflation crisis.
The term “inflation” once referred to increases in the money supply (monetary inflation); however, economic debates about the relationship between money supply and price levels have led to its primary use today in describing price inflation. Inflation can also be described as a decline in the real value of money-a loss of purchasing power in the medium of exchange which is also the monetary unit of account. When the general price level rises, each unit of currency buys fewer goods and services. A chief measure of general price-level inflation is the general inflation rate, which is the percentage change in a general price index, normally the Consumer Price Index, over time. Inflation can cause adverse effects on the economy. For example, uncertainty about future inflation may discourage investment and saving. High inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future.
Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reducing the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.
Types of Inflation
The most important inflation is called demand-pull or excess demand inflation. It occurs when the total demand for goods and services in an economy exceeds the supply available, so the prices for such goods and services rise in the economy.
The name indicates the cause i.e. costs of production rise, for one reason or another, and forces up the prices of finished goods and services. Often a rise in wages in excess of any gains in labor productivity is what raises unit costs of production and thus raises prices. This is less common than demand-pull, but can occur independently as well as in conjunction with it.
Pricing power inflation
It occurs whenever businesses in general decide to boost their prices to increase their profit margins. This does not occur normally in recessions but when the economy is booming and sales are strong.
Causes of Inflation
There are many causes for inflation, depending on a number of factors.
Excess money printing
Inflation can happen when governments print an excess of money to deal with a crisis but don’t have resources at backed, usually governments are allowed to print only that amount of currency that is equal to gold available to that country. As a result, prices end up rising at an extremely high speed to keep up with the currency surplus. In which prices are forced upwards because of a high demand.
High Production Cost
Another common cause of inflation is a rise in production costs, which leads to an increase in the price of the final product. For example, if raw materials increase in price, this leads to the cost of production increasing which in turn leads to the company increasing prices to maintain steady profits. Rising labor costs can also lead to inflation.
International lending and national debts
Inflation can also be caused by international lending and national debts. As nations borrow money, they have to deal with interests, which in the end cause prices to rise as a way of keeping up with their debts.
Inflation may be caused by federal taxes put on consumer products such as cigarettes or fuel. As the taxes rise, suppliers often pass on the burden to the consumer; however, once prices have increased, they rarely go back, even if the taxes are later reduced. For example a rise in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an extension to the range of products to which VAT is applied. These taxes are levied on producers (suppliers) who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden of the tax onto consumers. For example, if the government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push inflation.
Effects of Inflation
Most effects of inflation are negative, and can hurt individuals and companies alike, below is a list of negative and “positive” effects of inflation.
People will try to get rid of cash before it is devalued, by hoarding food and other commodities creating shortages of the hoarded objects.
Increased risk – Higher uncertainties:
Uncertainties in business always exist, but with inflation risks are very high, because of the instability of prices.
Fixed income recipients will be hurt:
Because while inflation increases, their income doesn’t increase, and therefore their income will have less value over time.
Lowers national saving:
When there is a high inflation, saving money would mean watching your cash decrease in value day after day, so people tend to spend the cash on something else.
Existing creditors will be hurt:
Because the value of the money they will receive from their borrowers later will be lower than the money they gave before.
Distortion of relative prices:
Usually the prices of goods go higher, especially the prices of commodities.
Causes an increase in tax bracket
People will be taxed a higher percentage if their income increases following an inflation increase.
Causes business life cycles:
Many companies will have to go out of business because of the losses they incurred from inflation and its effects).
It can benefit the inflators (those responsible for the inflation)
It can benefit early and first recipients of the inflated money (because the negative effects of inflation are not there yet).
It can benefit the cartels (it benefits big cartels, destroys small sellers, and can cause price control set by the cartels for their own benefits).
It might relatively benefit borrowers who will have to pay the same amount of money they borrowed (+ fixed interests), but the inflation could be higher than the interests; therefore they will be paying less money back. (example, you borrowed $1000 in 2008 with a 5% fixed interest rate and you paid it back in full in 2010, let’s assume the inflation rate for 2005, 2006 and 2007 has been 13%, and borrower was charged 5% of interests, but in actual borrower earning 8% of interests, because 13% (inflation rate) – 5% (interests) = 8% profit, which means you have paid only around 65- 70% of the real value in the 3 years.
The first three effects are only positive to a few elite, and therefore might not be considered positive by the general public.
How to Survive Inflation?
Be wise when holding cash, whether in your home or in your savings account, if you’re earning 5% interest on the money you have in your bank, and inflation rate is 10% then you’re in reality losing 5% and not earning anything.
Be careful when buying bonds, high inflation rates completely destroy the value of long-term bonds.
Invest in durable goods or commodities rather than in money. Check out our commodities list. Invest in things that you’re going to use anyway and will serve you for a long time.
Invest for long-term capital gains, because short term investments tend to give deceptive results or sense of making profits while in reality you’re not making profits.
Manage wisely your recurring monthly bills such as (phone bills, cable TV…), it would help to reduce them or eliminate some of them.
Ask yourself, do I really need these things I’m spending my money on? Think how much and how often you will need something before buying it.
Use the money saving tips such as: you need to reduce your consumption of things that are rising rapidly in price (e.g, gas) without having to reduce your consumption of goods that are rising less rapidly or even falling in price (eg, clothes).
Buy only what is need, especially objects that have multi-tasks, and are considered durable goods.
Inflationary Factors in Pakistan
Several supply and demand factors could be responsible for this surge in inflation.
If occurs can cause large fluctuations in food and oil prices, which impacts over all inflation, at times, can be so extreme that these cannot be countered through demand management, including monetary policy.
Increased domestic demand
First, increased domestic demand can create an output gap, putting upward pressure on prices. Growth in private consumption on the average remained over 10 per cent between FY04 and FY06, depicting signs of demand side pressures on price level. The relationship between growth and inflation depends on the state of the economy. High growth, without an increase in inflation, is possible if the productive capacity or potential output of the economy is growing enough to keep pace with demand. A prolonged phase of rising inflation in such a case can have severe consequences for the economy.
Rising trade deficit
The expectations effect is very important since there is a danger that the current high rate of inflation can get locked into expectations of inflation. People expect higher salaries to compensate for expected increase in prices, speculation in asset prices increases, credit meant for manufacturing sector diverts to real estate and stock markets, and hoarders, profit and rent seekers become active in expectation of high price in the future. All this can have devastating effect for the prices.
Fiscal policy remained expansionary
Fiscal policy has remained expansionary in the last few years. Expansionary fiscal policy fuels domestic demand and puts pressure on the current account deficit. It widens the investment-saving gap, which has to be financed externally. Financing of fiscal deficit through money creation adds to inflationary pressures. Increased government borrowing from central bank can have serious consequences for general price level.
Expansionary monetary policy
The expansionary monetary policy- high growth in money supply and loose credit policy- was believed to be contributing to high inflation. Although expansion of credit is usual in expanding economies, excessive credit growth can have adverse effects on real variables.
Rising import prices
Rising import prices are also considered an important factor for inflation. Exchange rate, if depreciating can also put upward pressure on price level. Increase in prices of goods, such as petrol, raw material etc makes our imports costlier, impacting on cost of production.
Similarly, indirect taxes are also blamed as the main cause of inflation. The indirect taxes, such as sales tax and excise duties raise the prices of consumer goods. This creates inflationary pressure. On the other hand, direct taxes reduce the take-home income and have anti-inflationary effect. A substantial increase in support price of wheat is estimated to have an inflationary effect on consumer prices, particularly food prices. This effect is due to the fact that wheat and wheat-related products account for 5.1 per cent of the CPI basket.
Price Indices in Pakistan
Four different price indices are used in Pakistan over the course of fiscal year, namely: the Consumer Price Index (CPI), the Wholesale Price Index (WPI), the Sensitive Price Index (SPI) and the GDP deflator. The CPI is the main measure of price changes at the retail level. It covers the retail prices of 374 items in 35 major cities and reflects roughly the changes in the cost of living of urban areas. The WPI is designed for those items which are mostly consumable in daily life on the primary and secondary level; these prices are collected from wholesale markets as well as from mills at organized wholesale market level. The WPI covers the wholesale price of 106 commodities prevailing in 18 major cities of Pakistan. The SPI shows the weekly change of price of 53 selected items of daily use consumed by those households The SPI is based on the prices prevailing in 17 major cities and is computed for the basket of commodities being consumed by the households belonging to all income groups combined. In Pakistan, the main focus is placed on the CPI as a measure of inflation as it represents more with a wider coverage of 374 items in 71 markets of 35 cities around the country. As such, the change in CPI becomes an indicator of the inflation that affects all of us. WPI indicates the change in wholesale prices which affects businesses and industries. And SPI that covers a limited number of essential items of daily use including food and fuel can be termed as the inflation for the poor.
Graphical Analysis of Inflation from 2008 to 2012 Using CPI
The inflation rate in Pakistan was last reported at 10.8 percent in March of 2012. From 2003 until 2010, the average inflation rate in Pakistan was 10.15 percent reaching an historical high of 25.33 percent in August of 2008 and a record low of 1.41 percent in July of 2003.
Inflation effects the different sectors of the economy (Effects on the distribution of income and wealth, Effects on production, Effects on the Government, Effects on the Balance of Payment, Effects on Monetary Policy, Effects on Social Sector, Effects on Political environment) and different classes of the people (Debtors & Creditors, Salaried Class, Wages earners, Fixed income group, Investors and shareholders, Businessmen, Agriculturists).
A reasonable rate of inflation–around 3- 6 per cent– is often viewed to have positive effects on the national economy as it encourages investment and production and allows growth in wages. 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. The increasing uncertainty discourages saving and investment. Not only can high inflation erode the gains from growth, it also makes the poor worse off and widens the gap between the rich and the poor. If much of the inflation comes from increase in food prices, it hurts poor more since over half of family budget of the low wage earners goes for food. Second, it redistributes income from fixed income earners (for instance pensioners) to owners of assets and earners of large and variable income, such as profits.
For Pakistan’s economy, inflation can be bad if it crosses the threshold of six per cent, and can be extremely harmful if it crosses the double digit level. Several supply and demand factors could be responsible for this surge in inflation. Supply-side shocks can cause large fluctuations in food and oil prices, effects of which on overall inflation, at times, can be so excessive that these cannot be countered through demand management.