Inflation Pakistan

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Chapter 4

Inflation in Pakistan: An Historical Perspective

Pakistans economy over the years showed fairly good economic growth with a modicum

of price stability, despite the fact that it has gone through a massive devaluation, oil

Rapid increase in the oil prices, wheat shortage, increase in money supply, growth rate in

redit availability to private sector are the highlighted

shocks, crop failures, floods, Afghan war, earthquake, rapid political changes, military

authoritarianism, war on terror and inconsistency of economic and development policies.

It surprised observers by surviving in the worst economic crises but failed to deliver in

times of macro stability. The economy has seen GDP growth rate of 6 per cent or more,

almost 19 out of 38 years of the period of this study and inflation rate of less than 5

percent only 5 times. It is obvious that GDP growth has been inflationary in Pakistan and

inflation lies low in terms of priorities. Inflation became a matter of concern only since

around the start of the 1990s, coinciding with the start of structural adjustment

programme with the IMF.

4.1 Historical account of inflation in Pakistan

Pakistans inflation rate over the years has been satisfactory according to most analysts.

In the 1970s its average was 11.9 per cent per annum, in the 1980s the average fell to 7.5

per cent, in 1990s it rose again to 9.7 per cent and the average of 2000-08 is 6.4 percent.

commercial banking and increased c

factors of inflation rate to exceed the average. Inflation process in Pakistan confirms the

theory whenever high inflation takes place it short-lived.

Most analysts adopted the bottom up approach for explaining inflationary process in

Pakistan. Sectoral changes resulting from oil price hike or wheat price movements are

only a part but not the inflation in which all prices move in same proportion. If we divide

inflationary process into its components, in 1970s supply shocks were the major reason

and in 1990s monetary expansion, decline in total factor productivity, lack of fiscal

discipline, administered prices were the causative factors.

Inflation in Pakistan ranges from 3 per cent to 27 percent. On average Pakistans inflation

rate over the period of analysis is 8.8 per cent. With the standard deviation of 5.3 per

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cent, it is moderately high and may be one of the causative factors of uncertainty which

can hamper growth and development.

Figure 4-1: Trend of inflation rate in Pakistan

15

20

25

0

5

10

1970 1975 1980 1985 1990 1995 2000 2005

The graphical representation in Fig. 4.1 gives peaks of inflation. In 1973-75 inflation was

at its peak ranging fro

30INFLATION RATE

m 26.7 per cent to 20.9 per cent. The second round of high inflation

happened in 1980-81; it reached 12 per cent. Other peaks were observed in 1991-92 when

flation touched 11.8 per cent; in 1994-95 inflation went up to 13 per cent. 1990s was

e decade of high volatility. In general, food and non-food inflation with expansionaryonetary policy were the causative factor of inflation. This is the time when Structural

Adjustment Programme was started and markets began to be deregulated. The State Bank

got its au period

from 1999-2003 was marked by price stability and inflation rate hovered around 3-4 per

cent. Inflation rate rose to 9.8 per cent in 2004, this time catching the attention of policy

makers with urgency for controlling prices. In 2008 inflation rate reached 14 percent

which is inimical to growth as total factor productivity is on decline, agricultural sector is

not clicking and energy prices have broken all records. 2009 is likely to end up with an

inflation rate of 20 per cent. There is thus urgency for controlling inflation.

in

thm

tonomy and exchange rate regime switched from fixed to free float. The

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4.2 Growth and inflation relation

In the period of the study, average annual growth rate of real GDP was 5.4 per cent with a

standard deviation of 2.5 per cent. It ranges from 0.5 per cent to 11.4 per cent. GDP

growth rate remained below 5 per cent until late 1970s, in 1980s average real GDPgrowth rate was 6 per cent, the 1990s experienced lowest average growth rate of 4.6 per

cent and average of 2000-08 stands at 6 per cent. The key drivers of real GDP growth in

Pakistan were good harvests, high growth rate of large scale manufacturing sector, strong

performance of services sector, activity in housing sector, global economic environment,

reliance on markets and windfall gains. The need is always felt for consistent market

based macro policies.

In economic literature, a debate exists on growth- inflation trade-off. Thirlwall and

Barton (1971) report a positive relationship between inflation and growth. Gillman et al.

(2002) indicated that the reduction of high and medium inflation (double-digit) to

moderate single-digit figures has a significant positive effect on growth for the OECD

countries. Ghosh and Phillip (1998) found that at very low inflation rates, growth and

inflation are positively correlated. However, they are negatively correlated at high level

of inflation.

The diagrammatic exposition (Fig. 4.2) of annual time series data of GDP growth rate

and inflation rate over the period of analysis suggested no significant relationship

etween the two growth performance

was dismal in the years of high, double-digit in

As illustrated in Fig. 4.2, growth rates remained below 5 per cent until late 1970s during

w tion re mostly double-digit and it could be confirme n this sen that

in 1986 inflation rate was at its lowest point which followed the high growth rate of 1985.

In 1990s inflation rate was in double- digit d econ y had to ce poor g th

performance. Peak analysis of the real GDP growth and inflation rate clea the

theoretical re exists a trade-off between high inflation rate and low

conomic growth.

b variables, though on average it could be said that

flation.

hich infla mained d i se

an om fa row

rs

debate that the

e

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Figure 4-2: Relationship between GDP growth rate and Inflation rate

0

4

12

16

20

24

GDP INF

GDP GROWTH RATE AND INFLATION RATE28

8

1970 1975 1980 1985 1990 1995 2000 2005

ad to face poor

growth rate which is an indicator of uncertainty. When inflation rate was above 9 per cent

(threshold level) in the economy it generated GDP growth rate of 6 percent and above for

In 1974 inflation was at its historical height of 27 per cent and GDP growth was 3.5 per

cent. In 1975 inflation dropped a little to 21 per cent and GDP growth recovered to 4.2

per cent. 1n 1980-81 no clear-cut trade-off was there but a positive trend existed.

Inflation and growth rate were both high in double- digit. The last decade portrays a

mixed trend and no clear picture can be observed. On average it could be suggested that

growth performance was dismal in the years of double-digit inflation rate in Pakistan.

The lowest observed rate of inflation in 1986 was preceded by a very high growth rate in

1985. In 1990s inflation rate was in double-digit and the economy h

growth performance. It, therefore, can be suggested that high inflation is one of the

causative factors for low growth rate in the economy but we cannot generalize.

There exists a weak positive correlation of 3.9 per cent between inflation and real GDP

growth rate. This low value of correlation suggests that no significant relationship exists.

The data of real GDP growth and CPI inflation rate showed that on average growth rate

was 5.4 with a standard deviation of 2.5 and the same values for inflation rate were 8.8

with standard deviation of 5.3. Inflation rate showed greater volatility compared to GDP

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6 times out of 19 times of the study. It is 32 per cent of the entire high growth period of

the country.

Table 4-1: Analysis of Inflation and GDP Growth

GDP Growth4.00 - 6.00 -


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4.3

There has been a long debate ole of money in an economy,

the star being the q theory o y, which that there is la ong

term relationship between m oney is constant.Keynes he quantity theory of money sis for monetary policy. H

the theory of loanable funds as well. The m rists restat quantity of

money f theory of and. an, (1983) its chief

exponent, increase in money su , via portfo justment, leads to increase in prices.

urther, prices increase due to unanticipated inflation in the economy4.

was 15.4 per cent with a standard

70-2008 was 5.4 per cent with a

Relationship between inflation rate and money supply

in economics regarding the r

ting point uantity f mone states

oney and prices when the velocity of mrejected t as a ba e rejected

oneta ed the theory

in terms o money dem According to Friedm

pply lio ad

F

After the independence of the country, the newly set up SBP adopted the monetarist

approach and the main objective was price stability and development of financial sector

in Pakistan. In this era, monetary policy gave importance to the asset side of the banking

system. Credit to government was the main source of monetary expansion. In 1960s the

policy of liberalization was adopted and for the first time in the history of Pakistan credit

to the private sector was extended liberally and this trend continued until the banks were

nationalized in early 1970s. In general, monetary expansion in Pakistan depended on the

projected growth rate and projected monetization requirements in the economy.

Annual average growth rate of broad money supply

deviation of 6.4, whereas GDP growth rate during 19

standard deviation of 2.5. There is again weak positive correlation between broad money

supply and real GDP; it was found as 8.1 per cent. Therefore, it could be said that money

supply and output growth have some degree of positive but weak association.

In Pakistan money supply and inflation rate have experienced high growth rates but these

have not influenced the output growth apparently. There is a very weak correlation

between growth rate in broad money and inflation rate which was 14.1 per cent. The

average growth in broad money was 15.4 percent with the standard deviation of 6.4

percent. Average inflation rate was recorded as 8.8 percent with the standard deviation of

5.3. By looking at Fig. 4.4 it could be inferred that expansionary monetary policy resulted

4Friedman (1983: p. 16)

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in a high inflation rate in the next period. But inflation in Pakistan is more volatile as

compared to money supply.

Figure 4-4: Relationship between broad money Supply and inflation rate

20

25

30

35INFLATION RATE AND GROWTH RATE IN M2

-5

0

5

1970 1975 1980 1985 1990 1995 2000 2005

M2G INF

The trend in Fig. 4.4 shows that both inflation rate and growth in broad money supply

follows the trend and fluctuations. In 1970s when inflation increased due to supply shock,

money supply also increased due to massive devaluation of the Pakistan rupee. Inflation

rate varies from 2 per cent to 27 per cent whereas money supply changes from 1 per cent

to 33 percent. One can conclude that inflation is high when broad money supply increasesrapidly in the economy.

Table 4-2: Descriptive Analyses of Broad Money Growth, GDP Growth Rate and

Inflation Rate - 1970-2007

10

15

Statistics M2G GDPG CPI NXR

Mean 15.40 5.20 8.79 26.39

Median 16.07 5.06 7.80 18.00

Standard Deviation 6.43 2.49 5.68 19.09

Kurtosis 4.71 2.89 5.34 2.022

Skewness 0.89 0.18 1.56 0.73

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Table 4.2 shows that the inflation rate, nominal exchange rate and money supply are

highly volatile as have very high standard deviation compared to GDP. In a managed

floating exchange rate regime, the role of monetary policy is limited as it is subservient to

the imports transmitting countries exchange rates. CPI and growth rate in broad money

supply are highly volatile series. For observing the trends in CPI, broad money supply

(M2) ee

Annex-4-II). The line graphs show upward trend during the period of 1970-2007. One

important conclusion which can be drawn is that inflation rate, money supply, nominal

exchange rate and output series are positively related.

4.4 Relationship between interest rate and inflation

Interest rate is the price of using liquidity. It is very important that it should depict the

risk and real cost of holding money for the decision between speculation and investment.

There are various interest rates in Pakistan, such as call money rate, coupon rate, discount

rate, T-bills rate, and Karachi Interbank Borrowing Offer Rate (KIBOR). Call money rate

is the interbank lending and borrowing rate without collateral. Coupon rate is the interest

rate paid on bounds on biannual basis. Discount rate is the three days repurchase order

der of last resort. T- Bill rate is the

, GDP and market exchange rate (MXR) we plot the log series against time (S

rate and it is a facility provided by the SBP as a len

rate charged on Government borrowing. KIBOR rate is also an interbank offer rate. It is

used for interbank borrowing without collateral. It is determined on the basis of bids,

which is why it is called a consensus rate. With tenure one to three years, it is considered

as the benchmark for corporate lending. In this study we using call money rate as an

indicator for interest rate because it is the rate which central bank determines and can

influence the money market and the level of real income and the price level.

In Pakistan a divergence exists between different interest rates like deposits rate, lending

rate and call money rate. This divergence leads to segmentation and creates arbitrage in

the bonds market of Pakistan, which leads to inefficiency. Various authors have pointed

out the need for narrowing the spread rate in Pakistan for improving the asset quality and

banking activities. Call money rates are used as a proxy of interest rate in this study. It is

short term interest rate.

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Figure 4-5: Relationship between Inflation Rate and Call Money Rate

5

10

15

20

25

30Relationship between Inflation rate and Call Money Rate

0

1970 1975 1980 1985 1990 1995 2000 2005

INF CALLMON

Call money rate moves with the changes in inflation rate. Average of call money rate

during 1970-2008 is 8.15 per cent

8.78 per cent. Inflation rate is more volatile;

value is 27 per cent compared to the interest rate, the lowest value is 2.14 per cent and the

n of inflation rate is 5.19 and for the call

e value of currency and

oney supply leads to the depreciation

and the average inflation rate for the same period is

its lowest value is 3.1 per cent and highest

highest is 12.1 per cent. The standard deviatio

money rate 2.29. Interest rates are usually controlled in Pakistan because of its direct

implications for investment, and due to underdeveloped financial market. The rigidity in

the interest rates has negative impact on savings and on the growth of bonds market. It

provides only a limited portfolio for investment in Pakistan. We can sum up that when

the State Bank of Pakistan increases money supply which generates inflation, it raises

interest rate to offset the price effect. There exists a weak positive correlation of 24 per

cent between inflation rate and call money rate in Pakistan.

4.5 Relationship between inflation rate and exchange rate

Expectations play the most important role in determining th

inflation rate at a given interest rate. Increase in m

of currency in foreign exchange market. The chain of causation runs like this: as money

supply increases, it generates inflation, which raises interest rates and hence depreciates

the currency in foreign exchange market. When the domestic currency depreciates it

increases the imported prices, such as raw material, which leads to increase in the cost of

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production and in turn increases the domestic prices and change the aggregate demand

and hence generate inflation.

Usually movements in exchange rate affect the monetary policy stance and the central

bank has to adjust monetary variables in the economy. If Pakistans currency depreciates

in the foreign market then it exerts pressure on State Bank to decrease the money supply

either via interest rate effect or by applying quantitative controls. In Pakistan exchange

rates were fixed until 1990s. No clear-cut relationship exists between the two variables.

Figure 4-6: Relationships between Market Exchange Rate and Inflation Rate

0

10

20

30

40

50

60

70

1970 1975 1980 1985 1990 1995 2000 2005

MXR INF

MARKET EXCHANGE RATE AND INFLATION RATE

4.6 Impact of inflation on saving and investment

Savings and investment are the two basic macro fundamentals which give a true picture

of the economy. Economic literature explains that a country is poor because of low

savings and investment. A number of studies concluded that there exists a positive

relationship between GDP growth, investment and saving. When inflation increases in an

economy it erodes the value of money and people prefer to spend than to save. If people

expect higher inflation and interest rates are low as in the case of Pakistan, households

prefer to consume and fixed interest rates lower the cooperate saving. It would generateuncertainty in the economy. Interest rates and savings are widely accepted in economic

theory as determinants of investment. Money supply increases prices which in turn

increases the interest rates which ultimately appear as low investment and low savings.

Inflation negatively affects savings and investment due to the fewer alternatives available

for offsetting its effects.

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Historically speaking, Pakistan is one of the lowest savers in the world. The Government

has launched various schemes for mobilization of savings with limited success. The data

of national saving shows that the highest saving rate was 23 per cent and lowest -10 per

cent of GDP with the standard deviation of 7.5 per cent, which makes national saving rate

very sensitive to changes in the economic conditions. Average national savings rate was

12 per cent during 1970-2008 (See Annex-4-III). These facts shed light on the

unsustainable macroeconomic growth of Pakistan. Saving rate is not only low and

volatile but also negatively correlated with inflation rate. The correlation coefficient is

found to be -31 per cent. It confirms that in a high inflationary environment households

and corporate sector prefer not to save.

Average total investment was 16 per cent with a standard deviation of 11 per cent. There

exists a strong positive correlation (74 per cent) between total investment and inflation

rate (See Annex-4-IV).

Figure 4-7: Relationship between National Saving, Total Investment

and Inflation Rate

25.00

0.00

5.00

10.00

15.00

70s 80s 90s 2000-08

inflation rate national saving total investment

The average analysis of inflation rate, national savings and total investment confirms that

high inflation contributes to total investment due to the interest rate effect and capital

gain effect in the short run. One cannot draw this conclusion for savings in Pakistan.

When inflation takes place, on one hand people prefer to consume due to substation

effect decreases the savings rate and, on the other hand, increased income due to high

inflation generates the income effect which means more income will generate more

20.00

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savings. Simple statistics show that savings are negatively related to inflation rate in

Pakistan. It is not only the high inflation

adversely

inflation and in spite of issues related to

1987, ILO published the resolution on the standards of price measurements. In 1996,

but also the associated uncertainty which

affects the saving rate in Pakistan (See Annex-4-V).

4.7 Issues in measurement of inflation rateIncrease in prices can be measured in various ways. The most commonly used indicators

in Pakistan are Consumer Price Index (CPI), the Wholesale Price Index (WPI) and

Sensitive Price Indicator (SPI). Each of these measures faces practical difficulties in

compiling averages of averages of prices. Consumer Price Index is most widely used in

Pakistan and elsewhere for the measurement of inflation rate. It has an upward bias due to

quality effect, substitution effect, new goods effect and outlet effect. In addition, there is

an urban bias and coverage (items) bias.

Due to problems associated with the impact of

measurement, controlling inflation is agenda item number one in all types of economies.

If we relate this thinking to the source of inflation, it points towards the effectiveness of

economic policies. An implicit consensus has somehow emerged that sound monetary

policy is more effective in influencing economic growth via price stability in a

developing country, even though markets have not yet completely developed.

Measuring prices is immensely important for measuring economic activity and inflation

rate in economy. But it is not easy to have exact calculation of general price level. In

Boskin report was published and a debate started on the measurement issue of price

indices. Consumer Price index has an upward bias in estimating prices. In Pakistan the

official measure of inflation is CPI, while Wholesale Price Index (WPI) and Sensitive

Price Indicator (SPI), a subset of CPI, are also issued. Monetary policy formulation for

controlling inflation depends on the accuracy of the price index. The choice of price

index will enable the central bank to answer why there is need to control inflation at all.

CPI is a weighted index which measures price change at retail level and in aggregate

form provides estimates of general price level. There are certain measurement issues. It

measures the price change in private consumption expenditure. If inflation in a country is

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due to public spending or budget deficit then any measure of inflation should incorporate

changes in prices for public consumption.

CPI in Pakistan is measured on the basis of monthly prices and the base is revised after

10 years. It is a long time to compare two baskets of the goods. In UK, CPI base iss prices change in one month comparable with the other

Pakistan has a market selection bias. Markets have been selected on the

basis of volume of sales. It further assumes that majority of the urban consumers make

changed every year. It make

month more realistic. It also provides a remedy for substitution bias. Inflation rate

computed on the basis of 10 years base period makes comparison irrelevant. Government

of Pakistan has decided to change the base time period from 10 years to 5 years but it has

not yet been implemented [See Federal Bureau of Statistics (2008)]. The CPI covers the retail

prices of 374 items in 35 major cities and reflects roughly the changes in the cost of

living of urban areas, 71 markets and 10 commodity groups and covers 92 commodities.

It took price quotations from 106216 retail shops. [See Federal Bureau of Statistics

(2008)].CPI in

their purchases from these markets. Weight for each CPI item has been developed from

Family Budget Survey and represents the percentage expenditure share of a specified

item in the total expenditure of the household on all CPI goods and services. There are

four income groups: the lowest income group has income level upto Rs. 3000 and highest

income group is Rs 12000 and above. The highest weight assigned in measurement of

CPI is for food which is 40 percent. When minimum wage is Rs. 6000 and the official

poverty line for the average family size also works out to be higher, the low income

group of Rs 3000 reflects income class bias. Prices for CPI are collected directly from the

retail shops according to a predetermined time table. For the food and beverages group,

prices are collected on 11-14 of each month. For Apparel, Textile, etc prices are collected

on 1-3 of every month. The collection of unit price data on specific dates is arbitrary and

source of bias. With this type of rough and incomplete measure, one cannot predict the

dynamic relationship of a variable. There is an urgent need to revamp the methodology

for measuring inflation in the economy.

Further, there is the need to measure and exactly quantify the bias in measurement of

inflation, which is either overstates or understates the actual inflation rate in the

economy. Whatever the actual inflation rate, however, it does not lessen the

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responsibility of monetary authorities for controlling it. It is not the inflation rate but its

cyclical nature and its capacity to create uncertainty, which makes a case for controlling

it. Once monetary authorities are committed to control inflation, they need a sophisticated

policy and a realistic measurement.

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