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Inflation

“Inflation is measured as the annual percent change in the prices of goods deemed necessary for life in that country. The specific goods included in this "market basket" change only rarely, so this measure reflects fluctuation in purchasing power of the national currency.”

- International Monetary Fund (IMF)

Inflation refers to a general and sustained rise in the level of prices of goods and services. That is, prices of the vast majority of goods and services on sale to consumers just keep on rising and rising. Prices change over time so inflation is always given per period of time - per month or per year.

Inflation is referred to as either Demand-pull Inflation or Cost Push Inflation or Imported Inflation

Demand-pull Inflation

Inflation caused by an increase in aggregate demand is called demand-pull inflation. Aggregate demand in an economy will rise if spending by governments, consumers and/or firms increases. Consumers will be able to spend more of their incomes if they reduce saving or if a government cuts income taxes.

An increase in aggregate demand will cause prices to increase and inflation to rise if firms are unable to increase the supply of goods and services at the same rate as demand because the economy is at or above its NAIRU.

To finance an increase in aggregate demand consumers and firms may borrow more from the banking system and/or the government can issue more notes and coins. Both of these ways of financing an increase in demand involve increasing the supply of money in the economy.

Cost-push Inflation

Inflation caused by higher costs feeding into higher prices is called Cost-push inflation. The cost of producing goods and services can rise because workers demand increases in wages not matched by increased productivity. Firms may pass these higher costs on to consumers as higher prices so that they do not have to suffer a cut in their profits. However, as wages rise the demand for labour will tend to fall and workers could be made unemployed. To prevent a rise in unemployment the government may expand the supply of money to boost aggregate demand.

Continual increases in prices may take place if workers demand more and more wages time and time again. This will cause a wage-price spiral. As prices rise, workers will want more wages so they can buy the more expensive products. However, these higher wages simply add to firms' costs and so prices rise even further prompting even higher wage demands. And so it goes on.

Imported Inflation

Many materials and finished goods and services are imported from overseas. An increase in their prices will also boost inflation in Pakistan. This imported inflation can occur if the value of the Pakistani Rupee falls against foreign currencies like the US dollar, UK pound, Indian Rupee or French franc. As the value of the Rupee falls the price paid for imported products will rise even if the prices of those goods in US dollars, French francs or other foreign currencies have not changed. The reverse is also true: if the value of the Rupee rises the price paid for imported products will fall.

How to Measure Inflation?

The rate of inflation is measured by calculating the percentage price increase in goods and services, usually over a year. Percentage price rises are usually shown by a price index. In this case, index numbers or indices are simply a way of expressing the change in prices of a number of items as a movement in just one single number. The average price of all the items selected in the first year, or base year, is given the number 100. If on average all the prices of the selected items rise by 25% over the following year the price index for the second year will be 125. If in the next year price rises average 10% the price index will now stand at 137.5 (that is, 137.5 - 125 = 12.5 which is 10% of 125). Thus on average prices have risen by 37.5% over years 1 and 2.

Inflation in Pakistan

In official data, the rate of inflation measured by the Consumer Price Index (CPI) during 2004-05 increased by 9.28 percent, as compared to 4.57 percent during the preceding year. However, inflation in the food prices was much rampant with 12.49 percent increase. Inflation in Pakistan during the last 12-months increased to 9.28 percent, highest level during the last five years.

The country is under severe price pressure for some time due to upsurge in food prices, coupled with supply shocks of essential items. Rising monetary expansion and fuel prices also contributed to the