Analysing Inflation: Monetary and Real Theories

In: The Pakistan development review: PDR, Band 35, Heft 4II, S. 761-771

Abstract

The paper seeks to analyse the inflationary trends observed in
Pakistan in the recent past by applying both the monetary and real
theories. The former explains inflation in terms of changes in liquidity
per unit of real output and velocity whereas the latter makes use of
real variables, especially, the structure of economy. Since the ratio
between money spending (quantity of money times velocity) and real GDP
defines general price level, monetary theory offers a natural tool for
analysing inflation. Even factors like raising utility prices by the
government or higher expected inflation add to inflation only when the
additional demand for money generated by these factors is met with an
accommodating increase in money supply (with stable velocity). During
FY86 to 96 in Pakistan, money supply grew by 15.4 percent, GDP by 5.3
percent, and velocity by –0.24 percent. This yields an estimated
inflation of 9.4 percent, very close to the actual one of 9.2 percent.
Interestingly enough, more than half of the money expansion during the
90s emanated from credit for budgetary support, rendering the latter an
active source of inflation. Under the real theory, we focused on
full-cost-pricing wherein the market value-added price is defined as a
weighted sum of various primary costs, e.g., wages, profits, and net
indirect taxes. To capture the impact of terms of trade, foreign trade
flows were added. It has been estimated that the overall inflation of
9.4 percent during FY86–95 was contributed to the extent of 5.6 points
by profits, 2.2 points by wages, 0.9 by net indirect taxes and 0.7 by
terms of trade. From policy perspective, monetary analysis has an edge
over real analysis as controlling inflation through monetary management
is relatively easier than through regulating various costs elements
which go into the formation of price.