COURSE: MANAGERIAL ECONOMICS

INFLATION

Submitted to
Sir. Rana Ilyas

Institute of Business & Technology

Submitted by
Farah Nawaz, BME-1012

10th March, 2012

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ACKNOWLDGEMENT

Saying thank you is more than good manners. It is good spirituality

-ALFRED STEINDL Apart from my efforts, the success of any project depends largely on the encouragement and guidelines of many others. I take this opportunity to express my gratitude to the people who have been instrumental in the successful completion of this presentation. I would like to show my greatest appreciation to Sir, Rana Ilyas. I cant say thank you enough for his tremendous support and help. Without his encouragement this project would not have materialized. The guidance and support received from my family, friends and all the other individuals who played a supporting role in the completion of this project. Your contribution means the world to us and I cannot say enough to thank you. I am grateful for your constant support and help. Regards, Farah Nawaz

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Table of Contents
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Executive Summary. 4 Introduction......... 5 Background. 7

Purpose & Scope.13 What is Inflation........... 14 History. 10 Issues in Measuring Inflation. 12 Types of Inflation.. 14 Causes of Inflation.. 18 Effects of Inflation.. 26 Controlling Inflation.. 29 12 Ways to Beat Inflation.. 33 Inflation Rate of Pakistan.. 38 Conclusion & Recommenations..40 Bibliography......41

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EXECUTIVE SUMMARY
Everyone is familiar with the term Inflation as rising prices. This means the same thing as fall in the value of money. For example, a person would like to buy 5kgs of apple with Rs. 100, at the present rate of inflation, say, zero. Now when the inflation rate is 5%, then the person would require Rs. 105 to buy the same quantity of apples. This is because there is more money chasing the same produce. Thus, Inflation is a monetary aliment in an economy and it has been defined in so many ways, which can be defined as the change in purchasing power in a currency from period to period relative to some basket of goods and services.1. When analysing Capital Budgeting Decisions with inflation, it is required to distinguish between expected and unexpected inflation. The difference between unexpected and expected inflation is of crucial importance as the effects of inflation, especially its redistributive effect, depend on whether it is expected or not. Expected inflation refers to the loss the manager anticipates in buying power over time whereas unexpected inflation refers to the difference between actual and expected inflation. If rate of inflation is expected, then the manager take steps to make suitable adjustments in their proposals to avoid the adverse effects which could bring to them.

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INTRODUCTION
A simple commonly used definition of the word inflation is simply "an increase in the price you pay for goods." In other words, a decline in the purchasing power of your money". But there is more to inflation than that. There is "Price Inflation" and "Monetary Inflation". Technically, Price Inflation is when prices get higher or it takes more money to buy the same item. Monetary Inflation is an increase in the money supply which generally results in price inflation. This acts as a "hidden tax" on the consumers in that country. Monetary inflation is commonly referred to as the government "printing money" although the actual process is a bit more complex than just cranking up the printing presses the effects are essentially the same. As the money supply increases the currency loses it's purchasing power and the price of goods and services increases. This process usually takes 18 months to 2 years so the government is able to spend the newly minted dollars at the old value before consumers realize that they have been cheated into accepting something that will purchase less than they originally thought it would. The term "inflation" usually refers to a measured rise in a broad price index that represents the overall level of prices in goods and services in the economy. The Consumer Price Index (CPI), the Personal Consumption Expenditures Price Index (PCEPI) and the GDP deflator are some examples of broad price indices. The term inflation may also be used to describe the rising level of prices in a narrow set of assets, goods or services within the economy, such as commodities (which include food, fuel, metals),

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financial assets (such as stocks, bonds and real estate), and services (such as entertainment and health care). The Reuters-CRB Index (CCI), the Producer Price Index, and Employment Cost Index (ECI) are examples of narrow price indices used to measure price inflation in particular sectors of the economy. Asset price inflation is a rise in the price of assets, as opposed to goods and services. Core inflation is a measure of price fluctuations in a sub-set of the broad price index which excludes food and energy prices. The Federal Reserve Board uses the core inflation rate to measure overall inflation, eliminating food and energy prices to mitigate against short term price fluctuations that could distort estimates of future long term inflation trends in the general economy.[15]

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BACKGROUND

When you can measure what you are speaking about and express it in numbers, you know something about it, but when you cannot measure it, when you cannot express it in numbers, your knowledge is of a meager and unsatisfactory kind. Inflations are the most dramatic events of price history. By examining them it may be possible to craft better economic policy. Patrick Henry pro-claimed,

"I have but one lamp by which my feet are guided and that is the lamp of experience."
George Santayana observed,

"Those who cannot re-member the past are condemned to repeat it."

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PURPOSE & SCOPE

My aim of taking this topic for assignment was that Managerial Economics is also the core subject in our MBA and Inflation is one of the most important aspects of Managerial Economics. By taking the advantage of this chance of presenting the report and delivering the presentation in front of my class mates I thought to cover the topic Inflation to share some important knowledge with all of them which can benefit to all of us in our subject. Inflation as a whole is the huge topic which cannot be covered in just one presentation, which is the reason I have specified it up to certain limit in order to have full concentration on the areas I worked out.

This report is submitted, being the requirement of our subject Managerial Economics, assigned by our course instructor Mr. Rana Ilyas.

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What is Inflation:
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services; consequently, inflation is also erosion in the purchasing power of money a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time. Inflation can have positive and negative effects on an economy. Negative effects of inflation include a decrease in the real value of money and other monetary items over time; uncertainty about future inflation may discourage investment and saving, and high inflation may lead to shortages of goods if consumers begin hoarding out of concern that prices will increase in the future. Positive effects include a mitigation of economic recessions, and debt relief by reducing the real level of debt. Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied. Low or moderate inflation may be attributed to fluctuations in real demand for goods and services, or changes in available supplies such as during scarcities, as well as to growth in the money supply. However, the consensus view is that a long sustained period of inflation is caused by money supply growing faster than the rate of economic growth. Today, most mainstream economists favor a low steady rate of inflation. Low (as opposed to zero or negative) inflation may reduce the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn, and reduce the risk that a liquidity trap prevents monetary policy from stabilizing the economy. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control the size of the money

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supply through the setting of interest rates, through open market operations, and through the setting of banking reserve requirements.

History:
Inflation originally referred to the debasement of the currency. When gold was used as currency, gold coins could be collected by the government, melted down, mixed with other metals such as silver, copper or lead, and reissued at the same nominal value. By diluting the gold with other metals, the government could increase the total number of coins issued without also needing to increase the amount of gold used to make them. When the cost of each coin is lowered in this way, the government profits from an increase in seignior age. This practice would increase the money supply but at the same time lower the relative value of each coin. As the relative value of the coins decrease, consumers would need more coins to exchange for the same goods and services. These goods and services would experience a price increase as the value of each coin is reduced. By the nineteenth century, economists categorized three separate factors that cause a rise or fall in the price of goods: a change in the value or resource costs of the good, a change in the price of money which then was usually a fluctuation in the commodity price of the metallic content in the currency, and currency depreciation resulting from an increased supply of currency relative to the quantity of redeemable metal backing the currency. Following the proliferation of private bank note currency printed during the American Civil War, the term "inflation" started to appear as a direct reference to the currency depreciation that occurred as the quantity of redeemable bank notes outstripped the quantity of metal available for their redemption. The term inflation then referred to the devaluation of the currency, and not to a rise in the price of goods. This relationship between the over-supply of bank notes and a resulting depreciation in their value was noted by earlier classical economists such as David Hume and David Ricardo, who would go

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on to examine and debate to what effect a currency devaluation (later termed monetary inflation) has on the price of goods (later termed price inflation, and eventually just inflation).

Calculating Inflation: Inflation is usually estimated by calculating the inflation rate of a price index, usually the Consumer Price Index.[16] The Consumer Price Index measures prices of a selection of goods and services purchased by a "typical consumer". The inflation rate is the percentage rate of change of a price index over time. For instance, in January 2007, the U.S. Consumer Price Index was 202.416, and in January 2008 it was 211.080. The formula for calculating the annual percentage rate inflation in the CPI over the course of 2007 is

The resulting inflation rate for the CPI in this one year period is 4.28%, meaning the general level of prices for typical U.S. consumers rose by approximately four percent in 2007.[18] Other widely used price indices for calculating price inflation include the following:

Cost-of-living indices (COLI) are indices similar to the CPI which are often used to adjust fixed incomes and contractual incomes to maintain the real value of those incomes. Producer price indices (PPIs) which measures average changes in prices received by domestic producers for their output. This differs from the CPI in that price subsidization, profits, and taxes may cause the amount received by the producer to differ from what the consumer paid. There is also typically a delay between an increase in the PPI and any eventual increase in the CPI. Producer price index measures

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the pressure being put on producers by the costs of their raw materials. This could be "passed on" to consumers, or it could be absorbed by profits, or offset by increasing productivity. In India and the United States, an earlier version of the PPI was called the Wholesale Price Index. Commodity price indices, which measure the price of a selection of commodities. In the present commodity price indices are weighted by the relative importance of the components to the "all in" cost of an employee. Core price indices: because food and oil prices can change quickly due to changes in supply and demand conditions in the food and oil markets, it can be difficult to detect the long run trend in price levels when those prices are included. Therefore most statistical agencies also report a measure of 'core inflation', which removes the most volatile components (such as food and oil) from a broad price index like the CPI. Because core inflation is less affected by short run supply and demand conditions in specific markets, central banks rely on it to better measure the inflationary impact of current monetary policy.

Issues In Measuring Inflation:

Measuring inflation in an economy requires objective means of differentiating changes in nominal prices on a common set of goods and services, and distinguishing them from those price shifts resulting from changes in value such as volume, quality, or performance. For example, if the price of a 10 oz. can of corn changes from $0.90 to $1.00 over the course of a year, with no change in quality, then this price difference represents inflation. This single price change would not, however, represent general inflation in an overall economy. To measure overall inflation, the price change of a large "basket" of representative goods and services is measured. This is the purpose of a price index, which is the combined price of a "basket" of many goods and services. The combined price is the sum of the weighted average prices of items in the "basket". A weighted price is calculated by multiplying the unit price of an item to the number of those items the average consumer purchases. Weighted pricing is a necessary means to

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measuring the impact of individual unit price changes on the economy's overall inflation. The Consumer Price Index, for example, uses data collected by surveying households to determine what proportion of the typical consumer's overall spending is spent on specific goods and services, and weights the average prices of those items accordingly. Those weighted average prices are combined to calculate the overall price. To better relate price changes over time, indexes typically choose a "base year" price and assign it a value of 100. Index prices in subsequent years are then expressed in relation to the base year price.[10] Inflation measures are often modified over time, either for the relative weight of goods in the basket, or in the way in which goods and services from the present are compared with goods and services from the past. Over time adjustments are made to the type of goods and services selected in order to reflect changes in the sorts of goods and services purchased by 'typical consumers'. New products may be introduced, older products disappear, the quality of existing products may change, and consumer preferences can shift. Both the sorts of goods and services which are included in the "basket" and the weighted price used in inflation measures will be changed over time in order to keep pace with the changing marketplace. Inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost shifts. For example, home heating costs are expected to rise in colder months, and seasonal adjustments are often used when measuring for inflation to compensate for cyclical spikes in energy or fuel demand. Inflation numbers may be averaged or otherwise subjected to statistical techniques in order to remove statistical noise and volatility of individual prices. When looking at inflation economic institutions may focus only on certain kinds of prices, or special indices, such as the core inflation index which is used by central banks to formulate monetary policy. Most inflation indices are calculated from weighted averages of selected price changes. This necessarily introduces distortion, and

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can lead to legitimate disputes about what the true inflation rate is. This problem can be overcome by including all available price changes in the calculation, and then choosing the median value. This measure is known as "median inflation".

Types of Inflation:
Cost Push Inflation
Cost-push inflation occurs when businesses respond to rising production costs, by raising prices in order to maintain their profit margins. There are many reasons why costs might rise: Rising imported raw materials costs perhaps caused by inflation in countries that are heavily dependent on exports of these commodities or alternatively by a fall in the value of the pound in the foreign exchange markets which increases the UK price of imported inputs. A good example of cost push inflation was the decision by British Gas and other energy suppliers to raise substantially the prices for gas and electricity that it charges to domestic and industrial consumers at various points during 2005 and 2006. Rising labour costs - caused by wage increases which exceed any improvement in productivity. This cause is important in those industries which are labour-intensive. Firms may decide not to pass these higher costs onto their customers (they may be able to achieve some cost savings in other areas of the business) but in the long run, wage inflation tends to move closely with price inflation because there are limits to the extent to which any business can absorb higher wage expenses. Higher indirect taxes imposed by the government for example a rise in the rate of excise duty on alcohol and cigarettes, an increase in fuel duties or perhaps a rise in the standard rate of Value Added Tax or an extension to the range of products to which

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VAT is applied. These taxes are levied on producers (suppliers) who, depending on the price elasticity of demand and supply for their products, can opt to pass on the burden of the tax onto consumers. For example, if the government was to choose to levy a new tax on aviation fuel, then this would contribute to a rise in cost-push inflation. Cost-push inflation can be illustrated by an inward shift of the short run aggregate supply curve. This is shown in the diagram below. Ceteris paribus, a fall in SRAS causes a contraction of real national output together with a rise in the general level of prices.

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Demand Pull Inflation

Demand-pull inflation is likely when there is full employment of resources and when SRAS is inelastic. In these circumstances an increase in AD will lead to an increase in prices. AD might rise for a number of reasons some of which occur together at the same moment of the economic cycle

A depreciation of the exchange rate, which has the effect of increasing the price of imports and reduces the foreign price of UK exports. If consumers buy fewer imports, while foreigners buy more exports, AD will rise. If the economy is already at full employment, prices are pulled upwards. A reduction in direct or indirect taxation. If direct taxes are reduced consumers have more real disposable income causing demand to rise. A reduction in indirect taxes will mean that a given amount of income will now buy a greater real volume of goods and services. Both factors can take aggregate demand and real GDP higher and beyond potential GDP. The rapid growth of the money supply perhaps as a consequence of increased bank and building society borrowing if interest rates are low. Monetarist economists believe that the root causes of inflation are monetary in particular when the monetary authorities permit an excessive growth of the supply of money in circulation beyond that needed to finance the volume of transactions produced in the economy. Rising consumer confidence and an increase in the rate of growth of house prices both of which would lead to an increase in total household demand for goods and services Faster economic growth in other countries providing a boost to UK exports overseas.

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The effects of an increase in AD on the price level can be shown in the next two diagrams. Higher prices following an increase in demand lead to higher output and profits for those businesses where demand is growing. The impact on prices is greatest when SRAS is inelastic. In the first diagram the SRAS curve is drawn as non-linear. In the second, the macroeconomic equilibrium following an outward shift of AD takes the economy beyond the equilibrium at potential GDP. This causes an inflationary gap to appear which then triggers higher wage and other factor costs. The effect of this is to cause an inward shift of SRAS taking real national output back towards a

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macroeconomic equilibrium at Yfc but with the general price level higher than it was before.

Causes of Inflation:
Historically, a great deal of economic literature was concerned with the question of what causes inflation and what effect it has. There were different schools of thought as to the causes of inflation. Most can be divided into two broad areas: quality theories of inflation and quantity theories of inflation. The quality theory of inflation rests on the expectation of a seller accepting currency to be able to exchange that currency at a later time for goods that are desirable as a buyer. The quantity theory of inflation rests on the quantity equation of money, that relates the money supply, its velocity, and the nominal value of exchanges. Adam Smith and David Hume proposed a quantity theory of inflation for money, and a quality theory of inflation for production. Currently, the quantity theory of money is widely accepted as an accurate model of inflation in the long run. Consequently, there is now broad agreement among economists that in the long run, the inflation rate is essentially dependent on the growth rate of money supply. However, in the short and medium term inflation may be affected by supply and demand pressures in the economy, and influenced by the relative elasticity of wages, prices and interest rates. The question of whether the short-term effects last long enough to be important is the central topic of debate between monetarist and Keynesian economists. In monetarism prices and wages adjust quickly enough to make other factors merely marginal behavior on a general trend-line. In the Keynesian view, prices and wages adjust at different rates, and these differences have enough effects on real output to be "long term" in the view of people in an economy.

Unemployment
A connection between inflation and unemployment has been drawn since the emergence of large scale unemployment in the 19th century, and connections continue to be drawn this today. In

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Marxian economics, the unemployed serve as a reserve army of labour, which restrain wage inflation. In the 20th century, similar concepts in Keynesian economics include the NAIRU (NonAccelerating Inflation Rate of Unemployment) and the Phillips curve, as described below.

Keynesian view
Keynesian economic theory proposes that changes in money supply do not directly affect prices, and that visible inflation is the result of pressures in the economy expressing themselves in prices. The supply of money is a major, but not the only, cause of inflation. There are three major types of inflation, as part of what Robert J. Gordon calls the "triangle model.

Demand-pull inflation is caused by increases in aggregate

demand due to increased private and government spending, etc. Demand inflation is constructive to a faster rate of economic growth since the excess demand and favourable market conditions will stimulate investment and expansion. Cost-push inflation, also called "supply shock inflation," is caused by a drop in aggregate supply (potential output). This may be due to natural disasters, or increased prices of inputs. For example, a sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push inflation. Producers for whom oil is a part of their costs could then pass this on to consumers in the form of increased prices. Built-in inflation is induced by adaptive expectations, and is often linked to the "price/wage spiral". It involves workers trying to keep their wages up with prices (above the rate of inflation), and firms passing these higher labor costs on to their customers as higher prices, leading to a 'vicious circle'. Built-in inflation reflects events in the past, and so might be seen as hangover inflation.

Demand-pull theory states that the rate of inflation accelerates whenever aggregate demand is increased beyond the ability of the economy to produce (its potential output). Hence, any factor that

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increases aggregate demand can cause inflation. However, in the long run, aggregate demand can be held above productive capacity only by increasing the quantity of money in circulation faster than the real growth rate of the economy. Another (although much less common) cause can be a rapid decline in the demand for money, as happened in Europe during the Black Death, or in the Japanese occupied territories just before the defeat of Japan in 1945. The effect of money on inflation is most obvious when governments finance spending in a crisis, such as a civil war, by printing money excessively. This sometimes leads to hyperinflation, a condition where prices can double in a month or less. Money supply is also thought to play a major role in determining moderate levels of inflation, although there are differences of opinion on how important it is. For example, Monetarist economists believe that the link is very strong; Keynesian economists, by contrast, typically emphasize the role of aggregate demand in the economy rather than the money supply in determining inflation. That is, for Keynesians, the money supply is only one determinant of aggregate demand. Some Keynesian economists also disagree with the notion that central banks fully control the money supply, arguing that central banks have little control, since the money supply adapts to the demand for bank credit issued by commercial banks. This is known as the theory of endogenous money, and has been advocated strongly by post-Keynesians as far back as the 1960s. It has today become a central focus of Taylor rule advocates. This position is not universally accepted banks create money by making loans, but the aggregate volume of these loans diminishes as real interest rates increase. Thus, central banks can influence the money supply by making money cheaper or more expensive, thus increasing or decreasing its production.

Keynesian views on unemployment and inflation

A fundamental concept in Keynesian inflation analysis is the relationship between inflation and unemployment, called the Phillips curve. This model suggests that there is a trade-off

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between price stability and employment. Therefore, some level of inflation could be considered desirable in order to minimize unemployment. The Phillips curve model described the U.S. experience well in the 1960s but failed to describe the combination of rising inflation and economic stagnation (sometimes referred to as stagflation) experienced in the 1970s. Thus, modern macroeconomics describes inflation using a Phillips curve that shifts (so the trade-off between inflation and unemployment changes) because of such matters as supply shocks and inflation becoming built into the normal workings of the economy. The former refers to such events as the oil shocks of the 1970s, while the latter refers to the price/wage spiral and inflationary expectations implying that the economy "normally" suffers from inflation. Thus, the Phillips curve represents only the demand-pull component of the triangle model. Another concept of note is the potential output (sometimes called the "natural gross domestic product"), a level of GDP, where the economy is at its optimal level of production given institutional and natural constraints. (This level of output corresponds to the NonAccelerating Inflation Rate of Unemployment, NAIRU, or the "natural" rate of unemployment or the full-employment unemployment rate.) If GDP exceeds its potential (and unemployment is below the NAIRU), the theory says that inflation will accelerate as suppliers increase their prices and built-in inflation worsens. If GDP falls below its potential level (and unemployment is above the NAIRU), inflation will decelerate as suppliers attempt to fill excess capacity, cutting prices and undermining built-in inflation. However, one problem with this theory for policy-making purposes is that the exact level of potential output (and of the NAIRU) is generally unknown and tends to change over time. Inflation also seems to act in an asymmetric way, rising more quickly than it falls. Worse, it can change because of policy: for example, high unemployment under British Prime Minister Margaret Thatcher might have led to a rise in the NAIRU (and a fall in potential) because many of the unemployed found themselves as structurally

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unemployed (also see unemployment), unable to find jobs that fit their skills. A rise in structural unemployment implies that a smaller percentage of the labor force can find jobs at the NAIRU, where the economy avoids crossing the threshold into the realm of accelerating inflation.

Monetarist view
Monetarists believe the most significant factor influencing inflation or deflation is the management of money supply through the easing or tightening of credit. They consider fiscal policy, or government spending and taxation, as ineffective in controlling inflation. According to the famous monetarist economist Milton Friedman, "Inflation is always and everywhere a monetary

phenomenon."

Monetarists assert that the empirical study of monetary history shows that inflation has always been a monetary phenomenon. The quantity theory of money, simply stated, says that the total amount of spending in an economy is primarily determined by the total amount of money in existence. This theory begins with the identity:

where

M is the quantity of money. V is the velocity of money in final expenditures; P is the general price level; Q is an index of the real value of final expenditures;
In this formula, the general price level is affected by the level of economic activity (Q), the quantity of money (M) and the velocity of money (V). The formula is an identity because the velocity of money (V) is defined to be the ratio of final expenditure ( ) to the quantity of money (M).

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Velocity of money is often assumed to be constant, and the real value of output is determined in the long run by the productive capacity of the economy. Under these assumptions, the primary driver of the change in the general price level is changes in the quantity of money. With constant velocity, the money supply determines the value of nominal output (which equals final expenditure) in the short run. In practice, velocity is not constant, and can only be measured indirectly and so the formula does not necessarily imply a stable relationship between money supply and nominal output. However, in the long run, changes in money supply and level of economic activity usually dwarf changes in velocity. If velocity is relatively constant, the long run rate of increase in prices (inflation) is equal to the difference between the long run growth rate of money supply and the long run growth rate of real output. 'Inflation to me is the net result of sophisticated dynamic interactions of four groups of explanatory factors: Demand side (or monetary shocks); supply side(or real shocks), inertial factors and political processes( role of institutions); that is to say, inflation is always and everywhere a macroeconomic and institutional phenomenon'- Polodoo (2005)

Rational expectations theory

Main article: Rational expectations theory Rational expectations theory holds that economic actors look rationally into the future when trying to maximize their well-being, and do not respond solely to immediate opportunity costs and pressures. In this view, while generally grounded in monetarism, future expectations and strategies are important for inflation as well. A core assertion of rational expectations theory is that actors will seek to "head off" central-bank decisions by acting in ways that fulfill predictions of higher inflation. This means that central banks must establish their credibility in fighting inflation, or have economic actors make bets that the economy will expand, believing

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that the central bank will expand the money supply rather than allow a recession.

Austrian theory
The Austrian School asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation. Austrian economists believe there is no material difference between the concepts of monetary inflation and general price inflation. Austrian economists measure monetary inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time. This interpretation of inflation implies that inflation is always a distinct action taken by the central government or its central bank, which permits or allows an increase in the money supply. In addition to state-induced monetary expansion, the Austrian School also maintains that the effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world. Austrians argue that the state uses inflation as one of the three means by which it can fund its activities (inflation tax), the other two being taxation and borrowing. Various forms of military spending is often cited as a reason for resorting to inflation and borrowing, as this can be a short term way of acquiring marketable resources and is often favored by desperate, indebted governments. In other cases, Austrians argue that the government actually creates economic recessions and depressions, by creating artificial booms that distort the structure of production. The central bank may try to avoid or defer the widespread bankruptcies and insolvencies which cause economic recessions or depressions by artificially trying to "stimulate" the economy through "encouraging" money supply growth and further borrowing via artificially low interest rates. Accordingly, many Austrian economists support the abolition of the central banks and the fractional-reserve banking system, and advocate returning to a 100 percent gold standard, or

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less frequently, free banking. They argue this would constrain unsustainable and volatile fractional-reserve banking practices, ensuring that money supply growth (and inflation) would never spiral out of control.

Real bills doctrine

Main article: Real bills doctrine Within the context of a fixed specie basis for money, one important controversy was between the quantity theory of money and the real bills doctrine (RBD). Within this context, quantity theory applies to the level of fractional reserve accounting allowed against specie, generally gold, held by a bank. Currency and banking schools of economics argue the RBD, that banks should also be able to issue currency against bills of trading, which is "real bills" that they buy from merchants. This theory was important in the 19th century in debates between "Banking" and "Currency" schools of monetary soundness, and in the formation of the Federal Reserve. In the wake of the collapse of the international gold standard post 1913, and the move towards deficit financing of government, RBD has remained a minor topic, primarily of interest in limited contexts, such as currency boards. It is generally held in ill repute today, with Frederic Mishkin, a governor of the Federal Reserve going so far as to say it had been "completely discredited." Even so, it has theoretical support from a few economists, particularly those that see restrictions on a particular class of credit as incompatible with libertarian principles of laissez-faire, even though almost all libertarian economists are opposed to the RBD. The debate between currency, or quantity theory, and banking schools in Britain during the 19th century prefigures current questions about the credibility of money in the present. In the 19th century the banking school had greater influence in policy in the United States and Great Britain, while the currency school had more influence "on the continent", that is in non-British countries, particularly in the Latin Monetary Union and the earlier Scandinavia monetary union.

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Anti-classical or backing theory

Another issue associated with classical political economy is the anticlassical hypothesis of money, or "backing theory". The backing theory argues that the value of money is determined by the assets and liabilities of the issuing agency. Unlike the Quantity Theory of classical political economy, the backing theory argues that issuing authorities can issue money without causing inflation so long as the money issuer has sufficient assets to cover redemptions. There are very few backing theorists, making quantity theory the dominant theory explaining inflation.

Effects of Inflation:
General
An increase in the general level of prices implies a decrease in the purchasing power of the currency. That is, when the general level of prices rises, each monetary unit buys fewer goods and services. The effect of inflation is not distributed evenly in the economy, and as a consequence there are hidden costs to some and benefits to others from this decrease in the purchasing power of money. For example, with inflation lenders or depositors who are paid a fixed rate of interest on loans or deposits will lose purchasing power from their interest earnings, while their borrowers benefit. Individuals or institutions with cash assets will experience a decline in the purchasing power of their holdings. Increases in payments to workers and pensioners often lag behind inflation, especially for those with fixed payments. Increases in the price level (inflation) erodes the real value of money (the functional currency) and other items with an underlying monetary nature (e.g. loans and bonds). However, inflation has no effect on the real value of non-monetary items, (e.g. goods and commodities, gold, real estate).

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Negative
High or unpredictable inflation rates are regarded as harmful to an overall economy. They add inefficiencies in the market, and make it difficult for companies to budget or plan long-term. Inflation can act as a drag on productivity as companies are forced to shift resources away from products and services in order to focus on profit and losses from currency inflation. Uncertainty about the future purchasing power of money discourages investment and saving. And inflation can impose hidden tax increases, as inflated earnings push taxpayers into higher income tax rates. With high inflation, purchasing power is redistributed from those on fixed incomes such as pensioners towards those with variable incomes whose earnings may better keep pace with the inflation. This redistribution of purchasing power will also occur between international trading partners. Where fixed exchange rates are imposed, rising inflation in one economy will cause its exports to become more expensive and affect the balance of trade. There can also be negative impacts to trade from an increased instability in currency exchange prices caused by unpredictable inflation.

Positive
Labor-market adjustments Keynesians believe that nominal wages are slow to adjust downwards. This can lead to prolonged disequilibrium and high unemployment in the labor market. Since inflation would lower the real wage if nominal wages are kept constant, Keynesians argue that some inflation is good for the economy, as it would allow labor markets to reach equilibrium faster. Debt relief Debtors who have debts with a fixed nominal rate of interest will see a reduction in the "real" interest rate as the inflation rate rises. The real interest on a loan is the nominal rate minus the inflation rate. (R=n-i) For example if you take a

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loan where the stated interest rate is 6% and the inflation rate is at 3%, the real interest rate that you are paying for the loan is 3%. It would also hold true that if you had a loan at a fixed interest rate of 6% and the inflation rate jumped to 20% you would have a real interest rate of -14%. Banks and other lenders adjust for this inflation risk either by including an inflation premium in the costs of lending the money by creating a higher initial stated interest rate or by setting the interest at a variable rate. Room to maneuver The primary tools for controlling the money supply are the ability to set the discount rate, the rate at which banks can borrow from the central bank, and open market operations which are the central bank's interventions into the bonds market with the aim of affecting the nominal interest rate. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy - this situation is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate. Tobin effect The Nobel prize winning economist James Tobin at one point had argued that a moderate level of inflation can increase investment in an economy leading to faster growth or at least higher steady state level of income. This is due to the fact that inflation lowers the return on monetary assets relative to real assets, such as physical capital. To avoid inflation, investors would switch from holding their assets as money (or a similar, susceptible to inflation, form) to investing in real capital projects.

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Controlling Inflation:
A variety of methods have been used in attempts to control inflation.

Monetary policy
Today the primary tool for controlling inflation is monetary policy. Most central banks are tasked with keeping the federal funds lending rate at a low level, normally to a target rate around 2% to 3% per annum, and within a targeted low inflation range, somewhere from about 2% to 6% per annum. A low positive inflation is usually targeted, as deflationary conditions are seen as dangerous for the health of the economy. There are a number of methods that have been suggested to control inflation. Central banks such as the U.S. Federal Reserve can affect inflation to a significant extent through setting interest rates and through other operations. High interest rates and slow growth of the money supply are the traditional ways through which central banks fight or prevent inflation, though they have different approaches. For instance, some follow a symmetrical inflation target while others only control inflation when it rises above a target, whether express or implied. Monetarists emphasize keeping the growth rate of money steady, and using monetary policy to control inflation (increasing interest rates, slowing the rise in the money supply). Keynesians emphasize reducing aggregate demand during economic expansions and increasing demand during recessions to keep inflation stable. Control of aggregate demand can be achieved using both monetary policy and fiscal policy (increased taxation or reduced government spending to reduce demand).

Fixed exchange rates

Under a fixed exchange rate currency regime, a country's currency is tied in value to another single currency or to a basket of other currencies (or sometimes to another measure of value, such as

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gold). A fixed exchange rate is usually used to stabilize the value of a currency, vis-a-vis the currency it is pegged to. It can also be used as a means to control inflation. However, as the value of the reference currency rises and falls, so does the currency pegged to it. This essentially means that the inflation rate in the fixed exchange rate country is determined by the inflation rate of the country the currency is pegged to. In addition, a fixed exchange rate prevents a government from using domestic monetary policy in order to achieve macroeconomic stability. Under the Bretton Woods agreement, most countries around the world had currencies that were fixed to the US dollar. This limited inflation in those countries, but also exposed them to the danger of speculative attacks. After the Bretton Woods agreement broke down in the early 1970s, countries gradually turned to floating exchange rates. However, in the later part of the 20th century, some countries reverted to a fixed exchange rate as part of an attempt to control inflation. This policy of using a fixed exchange rate to control inflation was used in many countries in South America in the later part of the 20th century (e.g. Argentina (19912002), Bolivia, Brazil, and Chile).

Gold standard

The gold standard is a monetary system in which a region's common media of exchange are paper notes that are normally freely convertible into pre-set, fixed quantities of gold. The standard specifies how the gold backing would be implemented, including the amount of specie per currency unit. The currency itself has no innate value, but is accepted by traders because it can

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be redeemed for the equivalent specie. A U.S. silver certificate, for example, could be redeemed for an actual piece of silver. The gold standard was partially abandoned via the international adoption of the Bretton Woods System. Under this system all other major currencies were tied at fixed rates to the dollar, which itself was tied to gold at the rate of $35 per ounce. The Bretton Woods system broke down in 1971, causing most countries to switch to fiat money money backed only by the laws of the country. Austrian economists strongly favor a return to a 100 percent gold standard. Under a gold standard, the long term rate of inflation (or deflation) would be determined by the growth rate of the supply of gold relative to total output. Critics argue that this will cause arbitrary fluctuations in the inflation rate, and that monetary policy would essentially be determined by gold mining, which some believe contributed to the Great Depression.

Wage and price controls

Another method attempted in the past have been wage and price controls ("incomes policies"). Wage and price controls have been successful in wartime environments in combination with rationing. However, their use in other contexts is far more mixed. Notable failures of their use include the 1972 imposition of wage and price controls by Richard Nixon. More successful examples include the Prices and Incomes Accord in Australia and the Wassenaar Agreement in the Netherlands. In general wage and price controls are regarded as a temporary and exceptional measure, only effective when coupled with policies designed to reduce the underlying causes of inflation during the wage and price control regime, for example, winning the war being fought. They often have perverse effects, due to the distorted signals they send to the market. Artificially low prices often cause rationing and shortages and discourage future investment, resulting in yet further shortages. The usual economic analysis is that any product or service that is under-priced is overconsumed. For

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example, if the official price of bread is too low, there will be too little bread at official prices, and too little investment in bread making by the market to satisfy future needs, thereby exacerbating the problem in the long term. Temporary controls may complement a recession as a way to fight inflation: the controls make the recession more efficient as a way to fight inflation (reducing the need to increase unemployment), while the recession prevents the kinds of distortions that controls cause when demand is high. However, in general the advice of economists is not to impose price controls but to liberalize prices by assuming that the economy will adjust and abandon unprofitable economic activity. The lower activity will place fewer demands on whatever commodities were driving inflation, whether labor or resources, and inflation will fall with total economic output. This often produces a severe recession, as productive capacity is reallocated and is thus often very unpopular with the people whose livelihoods are destroyed (see creative destruction).

Cost-of-living allowance
The real purchasing-power of fixed payments is eroded by inflation unless they are inflation-adjusted to keep their real values constant. In many countries, employment contracts, pension benefits, and government entitlements (such as social security) are tied to a cost-of-living index, typically to the consumer price index. A cost-of-living allowance (COLA) adjusts salaries based on changes in a cost-of-living index. Salaries are typically adjusted annually. They may also be tied to a cost-of-living index that varies by geographic location if the employee moves. Annual escalation clauses in employment contracts can specify retroactive or future percentage increases in worker pay which are not tied to any index. These negotiated increases in pay are colloquially referred to as cost-of-living adjustments or cost-ofliving increases because of their similarity to increases tied to externally-determined indexes. Many economists and compensation analysts consider the idea of predetermined future "cost of living increases" to be misleading for two reasons: (1) For most recent

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periods in the industrialized world, average wages have increased faster than most calculated cost-of-living indexes, reflecting the influence of rising productivity and worker bargaining power rather than simply living costs, and (2) most cost-of-living indexes are not forward-looking, but instead compare current or historical data.

12 Ways To Beat Inflation Dont Let Rising Prices Get You Down

What can we do to cushion ourselves from the impact of inflation in the long term? Inflation is also viewed as a hidden risk pressure that provides an incentive for those with savings to invest them, rather than have the purchasing power of those savings erode through inflation.

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There are a couple of strategies we can implement to protect our finances accordingly:

Two General Strategies To Beat Inflation

1. Recognizing that inflation erodes purchasing power in the long run. You can make sure you are well invested for the long term so that the performance of your investments more than make up for any kind of inflationary effect that our money experiences throughout the years. 2. Being mindful of when inflation rates rise. You can monitor inflation rates, recognize upward inflationary pressures and capitalize on these changes as it happens. Lets take a look at these plans in more detail.

Insure Yourself From Inflation For The Long Term

#1 Buy a house. If you buy a house today, you are automatically hedged for inflation. Your house is a fixed asset and any kind of fixed asset becomes more valuable with time thanks to all around asset inflation. #2 Consider landlording. If you invest in real estate today and become a landlord, youll be happy to know that rents are subject to inflationary pressures as well. You have the capability to raise rates when the cost of living goes up everywhere. #3 Build or preserve your earning power. If you are in a position to earn, the best way to battle pricing increases is to keep a job or some other income stream going. You then expect wages and earnings to go up along with everything else. Without earning power, you may want to consider other ways

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to protect yourself from inflation, such as amassing appreciating assets. #4 Own your own business. Once youre a business owner you can always raise rates, fees, prices along with the costs of operating your business. This is yet another reason to escape corporate serfdom. #5 Keep a diversified investment portfolio. Keep a core portfolio of stocks and bonds, and if youre a bit more adventurous, you can reserve a small amount of your portfolio to inflationary hedges such as precious metals, commodities and real estate. #6 Consider using inflation-indexed securities in your portfolio. You want insurance from inflation? Then try TIPs and I-Bonds, which are types of bonds that offer inflation protection. Some good points about these investments: even in the case of a deflationary environment, you still receive the face value of the bond while interest rates keep at zero or higher; these bonds do not correlate with typical asset classes like stocks and bonds, so they offer diversification; and they pay out more when inflation rises.

Counteract Inflationary Pressures With Additional Moves

Once inflation creeps up, it could spell bad news for stocks and bonds. So here are a few, more anticipatory (or even reactionary) strategies to counteract inflations effect on your portfolio. #1 Keep money in short term funds. When there are inflationary concerns, it may be best to keep your money in short term accounts where you dont lock in rates. This is

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because higher inflation rates are soon followed by higher interest rates as well. Keep you options open at this time. #2 Watch interest and yield rates and lock them in when youre comfortable. When inflation trends are higher, interest rates typically follow suit. To this day, I have family who were lucky enough to lock in skyhigh interest rates with long term high-yield CDs when rates were so much higher. #3 Invest in commodities. Buying commodities is a traditional inflationary hedge. If youve somehow decided that commodities arent your thing during periods of tame inflation, youre not alone. But you may want to reconsider this unconventional asset class once inflationary pressures increase. You can check out PIMCO Real Return Commodities Fund (PCRIX) which invests in a variety of commodities, or those that track the Dow Jones AIG Commodity Index, which invests only 35 percent to 40 percent in energy such as Deutsche Bank Commodity Tracking Index (DBC). MONEY Magazine also recommends the T. Rowe Price New Era (PRNEX) mutual fund as a good inflation hedge. #4 Invest in gold. How about gold? Its no secret that gold has had a spotty performance throughout history. This is because it may be considered more as a crisis hedge rather than an investment. During peace-time, gold has had weak returns. At any rate, if you want true crisis insurance, you can buy gold through these avenues: as gold bullion and coins, exchange traded funds, stocks, mutual funds and even jewelry.

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#5 Rework your debt. When you carry debt, you benefit from a rise in inflation since the value of owed money is worth less over time. So you actually get a break if you carry a bunch of debt such as school and car loans, home equity loans and such. For instance, if inflation rates leapt by several percentage points, any money youve borrowed in the past would be worth less than the money you borrow at current rates so by trading any variable-rate debt such as credit card debt or home equity lines of credit) for fixed-rate debt, youll actually benefit from an environment with higher inflation. #6 Cut your spending even more. This should be the simplest advice but may be the hardest to follow: think hard before you buy anything. Practice abstinence: when items are priced higher, youll be spending more, so try every excuse you can to avoid making purchases. Or change your shopping habits so you buy at lower cost places.

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Inflation Rate of Pakistan

In sheer contrast to significant abatement in the inflationary pressures across the globe, the inflation in Pakistan has depicted downward rigidity. All price indices like CPI, WPI and SPI witnessed a clear downtrend in recent months. The inflation rate as measured by the changes in Consumer Price Index (CPI) after reaching peak at 25.3 percent in August 2008, showing easing since November 2008 but bounced back to 21.1 percent in February 2009 mainly because of spike in the prices of some food items like onion, chicken farm, sugar etc. WPI inflation is following international declining trend but non-food component of the CPI showed some stubbornness till February 2009. The CPI inflation averaged 23.5 percent in July-February 2008-09 as against 8.9 percent in the comparable period of last year [See Table]. Inflation Situation in Pakistan (%) July August September October November December January February CPI 24.3 25.3 23.9 25.0 24.7 23.3 20.5 21.1 WPI 34.0 35.7 33.2 28.4 19.9 17.6 15.7 15.0 SPI 33.0 33.9 31.1 32.7 29.8 25.8 20.8 23.4 Core Inflation 14.7 16.4 17.3 18.3 18.9 18.8 18.91 18.85

The food inflation is estimated at 28.9 percent in July-February 2008-09 as against 13.0 percent in the comparable period of last year. The relative slowdown in domestic inflation since September 2008 is mainly driven by the deceleration in food inflation whereas non-food component has generally remained stubborn. Notwithstanding recent downward trajectory, the food inflation is still quite high and is attributable to stubbornness of prices of edible oil, pulses, rice, milk, sugar, poultry, meat, wheat, wheat flour, fresh vegetables and fruits. The non-food inflation stood at 19.3 percent, against 5.9 percent in the corresponding period of

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last year. The non-food inflation is also high because of hike in transport group, fuel and lighting group and house rent index. The downward adjustment of petroleum prices in the month of November is neutralized by frequent hikes in electricity and gas prices. On current trends and barring any adverse shocks, it is expected that the average inflation for the year (2008-09) as measured by CPI will be close to 20 percent. The core inflation which represents the rate of increase in cost of goods and services excluding food and energy prices also went up from 5.7 percent to 17.8 percent in this period. Notwithstanding, all demand compression, the core inflation resisted all downward pressures and remained sticky at around 18.9 percent for the last four consecutive months. Notwithstanding all monetary tightening during May 2007 to December 2008, the core inflation has also depicted first deceleration since May 2007 in December 2008 but hovered around 18.9 percent. The month of February witnessed fractional decline in the core inflation. The Wholesale Price Index (WPI) during first eight months of 200809 has increased by 24.7 percent, as against 11.7 percent in the comparable period of last year. It has declined from as high as 35.7 percent in August 2008 to 15.0 percent in February 2009, reflecting a marked downward correction in the last six months. This downturn is contributed by both food and non-food components. The non-food component fell more steeply from 37.4 percent in August 2008 to 9.8 percent in February 2009. Food component has decelerated from 33.5 percent in August 2008 to 22.0 percent in February 2009. The Sensitive Price Indicator (SPI) has recorded an increase of 26.1 percent during this period (Jul-February 2008-09) as against 9.9 percent in the same period of last year. Going forward, the prices of edibles like sugar, wheat, meets, onions will be crucial in determining the fate of the SPI. Going forward, the prices of edibles like sugar, wheat, ghee/ cooking oil will be crucial in determining the fate of the SPI.

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Conclusion & Recommendations

What lies ahead in the Twenty-first century? No one knows, of course. There will be wars, governments will collapse, ideologies will gain control over economic common sense, and governments will be tempted to use inflation to solve their economic and financial problems. We must remember that inflation is a choice that can be avoided. One prediction we would like to make here is that if the Twentieth century was a century of the proliferation in currencies, the Twenty-first century will be a century that sees a reduction in the number of world currencies. Central Banks were a growth industry during the Twentieth century. Few countries had a Central Bank in 1900, and most countries and colonies linked their currencies to one another through the Gold Standard. As countries gradually removed gold and silver from their national monetary systems, and replaced them with paper, inflation resulted. The world will never go back to the Gold Standard. But it can return to a world in which most of the worlds currencies are linked to several central currencies, such as the Dollar, Euro and Yen, or possibly to a single Eurodollar currency. Whether these reserve currencies return to relative price stability, and can avoid the problems of the Twentieth century remains uncertain, but it is a goal to aim for.

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BIBLIOGRAPHY:
1. 2. 3. 4. 5. 6. Macroeconomics (Fourth Edition) by David C. Colander. Principles of Economics by Robert Frank and Ben Bernanke. Economic Survey of Pakistan www.wikipedia.com www.investopedia.com www.about.com

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