Inflation can be illustrated as the persistent enlargement in the general price elevel of goods and services in economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services. Consequently, inflation reflects a reduction in purchase power per unit of money – a loss of real value in the medium of exchange and unit of account within the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general prize index (normally the consumer prize index) over time. The opposite of inflation is deflation.

Inflation affects an economy in various ways, both positive and negative. Pessimistic effects of inflation include an increase in the oppurnity cost of holding money, uncertainty over future inflation which may discourage onvestment and savings, and if inflation were rapid enough, shortages of goods as consumers begin hoarding out of concern that prices will increase in the future. Despite the negative impact, it also possesses positive ampact for the economice stability as mentioned belows.

Fndamentally, inflation gives everyone an incentive to spend and invest, because if they don’t, their money will be worth less in the future. This spending and investment can benefit the economy.Inflation reduces the real burden of debt, both public and private. If you have a fixed-rate mortgage on your house, your salary is likely to increase over time due to inflation, but your mortgage payment will stay the same. Over time, your mortgage payment will become a smaller percentage of your earnings, which means that you will have more money to spend.Inflation keeps nominal interest rates above zero, so that central banks can reduce interest rates, when necessary, to stimulate the economy.

Souces of inflation and Pakistan and impact on economy

Unreleting increase in prizes: The unrelenting increase in prices of both food (which fall in winter and pick up in summer) and non-food items has been aggravated by energy shortfalls, the firming up of commodity prices internationally, especially oil, the weak pace of implementation of critical infrastructural projects and the strengthening of inflationary expectations of economic actors.

Higher demand and cost: The current inflation has both cost-push and demand-pull factors. The former pressure emanates from agricultural growth being lower than population growth, floods in two successive years and high commodity prices (food and oil),internationally which are transmitted to domestic prices because we now have a largely open economy.While the domestic market prices of wheat are determined by the government’s procurement price for the crop (for the last few years higher than world prices) that of other crops have become closely aligned with international prices, making food inflation inevitable.The sharp increases in prices of fuel and energy also go a long way in explaining the rise in costs of farming, transportation of crops to markets and the processing of these items.

Rapid rise in consumption: Another factor explaining the demand-side food inflation is the rise in consumption of protein-based products. Higher incomes in rural areas because of either higher crop prices or better yields per acre are increasing the consumption of higher protein items, contributing to food inflation.

However, it is not that clear how supply shocks on account of the floods were transmitted to the general price inflation.

A price increase set off by a supply shock in one sector should merely affect the prices in this sector relative to the average price level in other sectors as it pushes up the price level within the sector without transforming into generalised inflation, because the manufacturing sector and areas subjected to administered prices (electricity, gas, fuel and other utilities) account for around 65 per cent of the economy.

Poor control of money by SBP: on account of the high budget deficits whose financing has partly come from the State Bank (and better understood as ‘printing of money’) and partly from crowding out the private sector from the banking system, resulting in the economy settling at a high-inflation-low-growth equilibrium.

A questioned frequently asked is why the SBP’s monetary tightening has failed to contain inflation.

We need to understand that the transmission mechanism of the supposed impact of interest rate adjustments operates with a lag of a year or so – and there is enough past evidence that the outcome is in sync with what should be expected.

Interest rates changes

Secondly, and more importantly, an interest rate revision/rise is expected to change the behaviour of the borrower. In the case of the private sector it does, but not in the case of Islamabad whose thirst for money somehow cannot be quenched, irrespective of the price.

In fact, if Islamabad borrows directly from the SBP (‘printing of money’) it is effectively at zero cost. Whatever interest the SBP charges on these advances (which become the SBP’s earnings) it pays back to Islamabad – the ‘owner’ of SBP – as profits.

LIQUIDITY

Fourthly, the large liquidity pumped into the system over the last three years or so by the SBP (the original sin) will have to be siphoned off before monetary tightening through higher policy rates begins to take effect. This has become difficult because of the continuing sin of high budget deficits; although there is an illusory reduction in the rate of growth of money supply because some liquidity is being drained out as a result of declining foreign exchange reserves – not something affordable.

Recommendation of controlling

There would be a pro-active agriculture policy and supporting interventions that enhance per acre productivity, since inflation from the supply side eventually spills over into demand inflation.

Admittedly, monetary tightening to contain inflation has resulted in sacrificing some growth. So, while designing the proposals indicated it is important to carefully examine the quality of the necessary fiscal adjustment because this has implications for long-term growth. Fiscal and supporting economic policies should not only enhance domestic savings but also help lower the capital cost to produce one unit of output.