Inflation and its Causes: The Case of Pakistan

High inflation has badly hit the rich and the poor alike, but the poverty stricken class is the worst target. Inflation discourages savings by reducing the real rate of return on financial assets leading to lower investment and growth.

Inflation is defined as the persistent rise in the general price level. A number of theories explain the causes of inflation. The quality theory of money stresses on expectations of the buyer of a currency about its purchasing power and the quantity theory of money emphasizes on the role of excess money supply in explaining inflation. The debate moved on to cost push and the demand-pull factors of inflation particularly in the Keynesian era where inflation was believe to be caused by the changes in the aggregate demand or aggregate supply. The demand-pull inflation was mainly cause by the increase in aggregate demand while the cost-push inflation was the result of supply shocks.

Inflation is not always bad for the economy and a reasonable rate, around 3 to 6 percent for developing country like Pakistan is viewed as beneficial for the economy. This level of inflation encourages investment and growth and allows higher wages. When inflation crosses this threshold line, it negatively affects the economy by reducing value of money and creating uncertainty about the gains and losses to borrowers and lenders and results into low savings and investment. Inflation also discourages savings by reducing the real rate of return on financial assets leading to lower investment and growth.

High inflation widens the gap between the rich and the poor due to the erosion in the real growth and value of assets leaving the poor worse off (Easterly and Fischer, 2001). Inflation driven by the food prices particularly hurts the low income groups more than others as they spend higher proportion of their budget on food. It is therefore important to control inflation if it crosses a reasonable limit. It also redistributes income from fixed income earners (for instance, pensioners) to owners of assets and earners of large and variable income, such as profits.

In case of Pakistan, annual inflation was above 11 percent in 15 of its 64 years of history. Not surprisingly, average real per capita income growth was 2.8 percent in the years having less than 11 percent inflation, as compared to the years of high inflation. During high inflation years, 1.5 percent growth in real per capita income, on average, was recorded. The above arguments suggest that for Pakistan’s economy, inflation can be bad if it crosses the threshold of 6 percent, and can be extremely harmful if it crosses the double digit level. Hence, it becomes more important for policy makers to identify the real causes of inflation and design strategies accordingly. To identify the causes of inflation, as a first step it seems necessary to look into the theories of inflation and see what recent literature leads us to.

To control inflation, a number of approaches are being adopted in different time periods. The Keynesian approach used fiscal policy as an important tool in controlling inflation. The falling money wages during the 1950s led the economists to investigate new explanations. It resulted in the developing of the Phillips Curve by A.W. Phillips. The model suggests a negative relationship between inflation and unemployment. Later on, the model was modified to incorporate the links between inflation and growth (Barro, 1995). The modern extensions of the famous Phillips Curve suggest a positive relationship between inflation and the output gap, exchange rate and inflation expectations (Scheibe, J and D. Vines, 2005).  The inflation and growth nexus however is dependent on the state of the economy. Inflation is expected to decline if the growth in the productive capacity of the economy keeps pace with the demand.  It is also possible in a situation of negative output gap i.e. actual output lower than the potential output with sufficient excess capacity to meet the demand pressures.  However, the situation reverses when the output gap narrows down, spare capacity vanishes and the economy starts operating on full employment level. In this situation, the further gain in growth comes at the cost of rising inflation. A real threat of rapid inflation materializes if demand continues to grow but the productive capacity of the economy does not expand. In such a case, a prolonged rising inflation can have adverse impact on the economy.

Inflation became the important target in the macroeconomic policies and debates during 1970s and 1980s and the classical economists were preparing to come up with new explanations to challenge Keynesian concepts. The Monetarist model known as ‘quantity theory of money’ was the significant development which has its roots in the classical economic theory.  The theoretical model was developed by Friedman (1968, 1970, and 1971) and empirically tested by Schwartz (1973). The model shows the past behavior of money supply to output ratio as the main determinant of current inflation. Contrary to Keynesian approach, the model emphasizes more on the monetary policy to control inflation against fiscal policy. It states that ‘inflation is always and everywhere a monetary phenomenon.’ The other important model was the ‘Structuralist Model’ advocated by Sunkel (1958), Streeten (1962), Baumol (1967) and Maynard and Rijckeghem (1976). The emphasis of this model was on the supply-side factors including food prices, wages, import prices and administered prices as determinants of inflation. According to this theory, long run inflation can be explained by the differential rates in productivity growth, wages and elasticity of income and prices between the industrial and services sectors.

In case of Pakistan, inflation is commonly measured by consumer price index (CPI) consisting of a basket of about 450 consumer items. The other measures include producer price index (PPI) and GDP deflator.