WHAT IS INFLATION?

The measure of price increases within a set of goods and services over a period of time is
known as inflation. The most common gauge of inflation is known as the CPI, or consumer
price index, which measure the price increases (decreases) of basic consumer goods and
services. The GDP deflator is another very important measure of inflation as it measures the
price changes in goods that are produced domestically. In effect, inflation decreases the value
of your money and makes it more expensive to buy goods and services.
WHAT IS THE CPI?
The consumer price index, aka. CPI is the key gauge for inflation; it measures price increases
and decreases on common group of consumer goods and services on a monthly basis. The
CPI is calculated by taking a weighted average of price change for a pre-determined group of
goods. The goods are weighted in order of their importance. The consumer price index is very
similar, but not to be confused with, to the cost of living index which allows for substitutions of
the items as prices move higher or lower.
WHAT IS THE GDP DEFLATOR?
Gross Domestic Product deflator. A measure of the change in prices of goods newly produced
within ac country over the course of a specific time period. It is used in economics to account for
inflation. When the deflator is used, it allows GDP to be compared to other time periods
inconstant dollars.

CAUSES OF INFLATION
There are a few different reasons that can account for the inflation in our goods and services;
let's review a few of them.
• Demand-pull inflation refers to the idea that the economy actual demands more goods
and services than available. This shortage of supply enables sellers to raise prices until
an equilibrium is put in place between supply and demand.

• The cost-push theory , also known as "supply shock inflation", suggests that shortages
or shocks to the available supply of a certain good or product will cause a ripple effect
through the economy by raising prices through the supply chain from the producer to the
consumer. You can readily see this in oil markets. When OPEC reduces oil supply,
prices are artificially driven up and result in higher prices at the pump.

• Money supply plays a large role in inflationary pressure as well. Monetarist economists
believe that if the Federal Reserve does not control the money supply adequately, it may
actually grow at a rate faster than that of the potential output in the economy, or real
GDP. The belief is that this will drive up prices and hence, inflation. Low interest rates
correspond with a high levels of money supply and allow for more investment in big
business and new ideas which eventually leads to unsustainable levels of inflation as
cheap money is available. The credit crisis of 2007 is a very good example of this at
work.

• Inflation can artificially be created through a circular increase in wage earners demands
and then the subsequent increase in producer costs which will drive up the prices of their
 goods and services. This will then translate back into higher prices for the wage earners
or consumers. As demands go higher from each side, inflation will continue to rise.
.
TYPES OF INFLATION
• Hyperinflation is the most extreme inflation phenomenon, with yearly price increases of
three-digits percentage points and an explosive acceleration.

• High inflation could range anywhere between 50% and 100%. High inflation is a
situation of price increase of 30%-50% a year. Both kinds can be stable or dangerously
accelerate to enter in an hyperinflation condition.

• Moderate inflation -. One could consider an inflation as moderate when it ranges from
5% to 25-30%.

• Low inflation can be characterized from 1-2% to 5%. Around zero there is no inflation
(price stability). Below zero, a country faces deflation.

EFFECTS OF INFLATION
The effects of inflation can be brutal for the elderly who are looking to retire on a fixed income.
The dollars that they expect to retire with will be worth less and less as time goes on and
inflation goes higher.
When the balance between supply and demand spirals out of control, buyers will change their
spending habits as they meet their purchasing thresholds and producers will suffer and be
forced to cut output. This can be readily tied to higher unemployment rates. When extremes
arise in the supply/demand structure, imbalances are created.
The mortgage crisis of 2007 is a great example of this. Home prices were increasing at a very
rapid rate from 2002 to 2005 and got to the point where the prices became too high, forcing
buyers to step aside. This lack of demand forced sellers to drop prices back to a point where
there is demand. As I write this article, this equilibrium has still not come into the real estate
market. This is due to many factors, as you will read in our mortgage crisis article, but the
extreme acceleration of inflation in home prices is directly correlated to the pullback we are
seeing.
A similar example can be seen in the internet euphoria in the stock market back in 1998 to
2000. This rapid acceleration in stock prices eventually became unsustainable and led to a
disastrous fall.
The point that is being made is that if inflation is not contained and rises at an unsustainable
rate; the stronger the impact on the other side. There is a saying; "the bigger they are, the
harder they fall".
STAGFLATION DEFINITION
The generally agreed-upon stagflation definition is a state of the economy that exhibits
elevated unemployment rates and inflation at the same time. Typically, stagflation presents
serious problems for monetary policymakers, since the remedies for high unemployment are
nearly directly opposed to the remedies available for inflationary cycles. Most economists
believe stagflation can be attributed to either failed economic policies or to destructive or
catastrophic events that seriously affect the production capability of the overall economy. During
the 1970s, for instance, the United States experienced a prolonged period of stagflation due
primarily to shortages of raw materials. Livestock feed manufacturing was significantly
impacted by the loss of the Peruvian anchovy fishery in 1972, but the most significant economic
factor was likely the oil crisis of 1973, when OPEC severely limited the international oil supply in
order to control prices and boost profits for their members.
NEGATIVE EFFECTS OF STAGFLATION
Regardless of its origins, stagflation is likely to cause significant and prolonged economic
problems that cannot be easily resolved. High unemployment reduces the overall buying power
of consumers and companies, and increasing prices lessen that buying power even more. This
can put a financial squeeze on both the consumer and the corporate sector and cause still more
unemployment as companies try to compensate for lower profits, increasing expenses and the
resulting reduction in financial liquidity.
DIFFICULTIES IN ADDRESSING STAGFLATION
Because stagflation is a combination of high unemployment and inflation, the remedies
available for one of these conditions typically make the other worse. For instance, monetary
policy adjustments that are intended to curb inflation typically create higher unemployment,
while government spending to reduce unemployment usually worsens inflationary spirals.
Macroeconomic solutions to stagflation generally result in limited improvement at best and may
even make the situation significantly worse due to the simultaneous presence of these two
inverse economic effects. Generally, the only viable solution for stagflation is to boost the
production capability of the economy by restoring the supply of raw materials or creating new
economic streams that take advantage of materials that are still readily available. This process
usually takes time and investment on the part of economic policymakers, and cannot be
instituted overnight or without careful planning and preparation.
DEFLATION DEFINITION
The accepted deflation definition is an overall decrease in the cost of goods and services
throughout the economy. Deflation results in an increase in the value of cash on hand due to the
expanded buying power available with the same amount of money. Conversely, deflation
magnifies debt both on the personal level and for corporations and governments who must now
repay their obligations by giving up a larger chunk of purchasing power than was the case prior
to deflation.
CAUSES OF DEFLATION
Most economic experts attribute deflation to a decline in the demand for goods and services that
forces manufacturers and retailers to reduce prices in order to move their products. This
reduction in demand may be caused by catastrophic economic or political events or simply by
an aversion to risk on the part of most investors in the market. When potential returns on
investment fall significantly, investors typically move most or all of their available funds into low-
risk Treasury backed securities or even into gold, silver, and other precious metals. This creates
a scarcity of cash on the market, creating a credit crunch that can seriously impact the overall
demand for goods and services within the economy

Yearly Inflation Rates of Pakistan ( 1990-91 = 100)

Inflation Rates based on Sensitive Price Indicator (SPI), Consumer Price Index (CPI) and Wholesale Price Index
(WPI) are
 Period SPI CPI WPI
1991-1992 10.54 10.58 9.84
1992-1993 10.71 9.83 7.36
1993-1994 11.79 11.27 11.40
1994-1995 15.01 13.02 16.00
1995-1996 10.71 10.79 11.10
1996-1997 12.45 11.80 13.01
1997-1998 7.35 7.81 6.58
1998-1999 6.44 5.74 6.35
1999-2000 1.83 3.58 1.77
2000-2001 4.84 4.41 6.21
2001-2002 3.37 3.54 2.08
2002-2003 3.58 3.10 5.57
2003-2004 6.83 4.57 7.91
2004-2005 11.55 9.28 6.75
2005-2006 7.02 7.92 10.10
2006-2007 10.82 7.77 6.94

Note: Yearly Inflation rates for the year 1991-02 to 2000-01 are based on 1990-91=100 while
inflation rates for the year 2001-02 till to date are based on 2000-01=100

1
MEASURES TO CONTROL INFLATION

We have studied above that inflation is caused by the failure of aggregate

supply to equal the increase in aggregate demand. Inflation can, therefore, be
controlled by increasing the supplies and reducing money incomes in order to control
aggregate demand. The various methods are usually grouped under three heads
:Monetary measures , fiscal measures and other measures.
1. Monetary Measures
Monetary measures aim at reducing money incomes.

(a) Credit Control. One of the important monetary measures is monetary policy. The
central bank of the country adopts a number of methods to control the quantity and
quality of credit. For this purpose, it raises the bank rates, sells securities in the open
market, raises the reserve ratio, and adopts a number of selective credit control
measures, such as raising margin requirements and regulating consumer credit.
Monetary policy may not be effective in controlling inflation, if inflation is due
to cost-push factors. Monetary policy can only be helpful in controlling inflation due to
demand-pull factors.
(b) Demonetization of Currency. However, one of the monetary measures is to
demonetize currency of higher denominations. Such a measure is usually adopted
when
there is abundance of black money in the country.

(c) Issue of New Currency. The most extreme monetary measure is the issue of new
currency in place of the old currency. Under this system, one new note is exchanged
for a number of notes of the old currency. The value of bank deposits is also fixed
accordingly. Such a measure is adopted when there is an excessive issue of notes and
there is hyperinflation in the country. It is very effective measure. But is inequitable for
its hurts the small depositors the most.

2. Fiscal Measures
Monetary policy alone is incapable of controlling inflation. It should, therefore,
besupplemented by fiscal measures. Fiscal measures are highly effective for
controllinggovernment expenditure, personal consumption expenditure, and private
and publicinvestment. The principal fiscal measures are the following:

(a) Reduction in Unnecessary Expenditure. The government should reduce

unnecessary expenditure on non-development activities in order to curb inflation.
Thiswill also put a check on private expenditure which is dependent upon
governmentdemand for goods and services. But it is not easy to cut government
expenditure.Though economy measures are always welcome but it becomes difficult to
distinguish between essential and non-essential expenditure. Therefore, this measure
should be supplemented by taxation.

(b) Increase in Taxes.To cut personal consumption expenditure, the rates of

personal, corporate and commodity taxes should be raised and even new taxes
should be
levied, but the rates of taxes should not be so high as to discourage saving,
investment
and production. Rather, the tax system should provide larger incentives to those who
save, invest and produce more. Further, to bring more revenue into the tax-net, the
government should penalize the tax evaders by imposing heavy fines. Such measures are
bound to be effective in controlling inflation. To increase the supply of goods within the
country, the government should reduce import duties and increase export duties.

(c) Increase in Savings. Another measure is to increase savings on the part of the people.
This will tend to reduce disposable income with the people, and hence personal
consumptionexpenditure. But due to the rising cost of living, people are not in a position to
save muchvoluntarily. Keynes, therefore, advocated compulsory savings or what he called
`deferredpayment' where the saver gets his money back after some years. For this
purpose, thegovernment should float public loans carrying high rates of interest, start
saving schemeswith prize money, or lottery for long periods, etc. It should also introduce
compulsory provident fund, provident fund-cum-pension schemes, etc. compulsorily. All
such measures to increase savings are likely to be effective in controlling inflation.

(d) Surplus Budgets. An important measure is to adopt anti-inflationary budgetary policy.

For this purpose, the government should give up deficit financing and instead have surplus
Budgets. It means collecting more in revenues and spending less.

(e) Public Debt. At the same time, it should stop repayment of public debt and postpone it
To some future date till inflationary pressures are controlled within the economy. Instead,
the
Government should borrow more to reduce money supply with the public.
Like the monetary measures, fiscal measures alone cannot help in controlling
Inflation. They should be supplemented by monetary, non-monetary and non fiscal
measures.

3. Other Measures
The other types of measures are those which aim at increasing aggregate supply and
reducing aggregate demand directly.

(a) To Increase Production. The following measures should be adopted to increase

production:

(i) One of the foremost measures to control inflation is to increase the production of
essential consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.

(ii) If there is need, raw materials for such products may be imported on preferential
Basis to increase the production of essential commodities.

(iii) Efforts should also be made to increase productivity. For this purpose,

industrialpeace should be maintained through agreements with trade unions, binding them

not to resortto strikes for some time.

(iv) The policy of rationalization of industries should be adopted as a long-

termmeasure. Rationalization increases productivity and production of industries through

the useof brain, brawn and bullion.

(v) All possible help in the form of latest technology, raw materials, financial help,
subsidies, etc. should be provided to different consumer goods sectors to increase
production.
(b) Rational Wage Policy. Another important measure is to adopt a rational wage and
income policy. Under hyperinflation, there is a wage-price spiral. To control this,
thegovernment should freeze wages, incomes, profits, dividends, bonus, etc. But such a
drasticmeasure can only be adopted for a short period and by antagonizing both workers
andindustrialists. Therefore, the best course is to link increase in wages to increase
inproductivity. This will have a dual effect. It will control wage and at the same time
increaseproductivity, and hence production of goods in the economy.

(c) Price Control. Price control and rationing is another measure of direct control to check
inflation. Price control means fixing an upper limit for the prices of essential
consumergoods. They are the maximum prices fixed by law and anybody charging more
than theseprices is punished by law. But it is difficult to administer price control.

(d)Ration ing. Rationing aims at distributing consumption of scarce goods so as to make

them available to a large number of consumers. It is applied to essential consumer
goodssuch as wheat, rice, sugar, kerosene oil, etc. It is meant to stabilise the prices of
necessariesand assure distributive justice. But it is very inconvenient for consumers
because it leads toqueues, artificial shortages, corruption and black marketing. Keynes did
not favour rationingfor it "involves a great deal of waste, both of resources and of
employment."

Conclusion. From the various monetary, fiscal and other measures discussed above, it
becomes clear that to control inflation, the government should adopt all
measuressimultaneously. Inflation is like a hydra-headed monster which should be fought
by using all the weapons at the command of the government