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It's not what you don't know that kills you. It's what you don't know that you don't know that does you in!

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Thursday, October 20, 2011

In Layman's Terms: Inflation

It would seem as if the public’s cry for control over increasing prices fall on deaf ears, or at least our leaders do little to convince us otherwise. As the political realm gears up for another round of unfulfilled promises, one issue that will rear its ugly head is the burden on the common man’s pocket.

Be it budgeting for chicken instead of lentils (after Musharraf’s infamous solution) or the grand larceny at the pump, what matters most to people is how far their hard earned rupee could be stretched.

With all the talk about possible relief in the past budget for the poor or the lack of, it is imperative to understand the concept of inflation and how this menace has plagued our economy for as long as it has. Also, we must understand what our leaders can do to rid ourselves of this problem, and whether they can at all.

Inflation is the upward trend in general level of prices of goods and services in an economy. An inadvertent upside of the rising inflation is the reduction in unemployment. Inflation and unemployment are two of the most closely watched indicators of economic performance.

The price of oil and petroleum related products have soared in the recent past, and as such, this has created a supply shock that has sent inflation through the roof. Worse yet, such supply shocks receive monetary validation from the state bank through increase of money supply (i.e. printing money). This in turn causes the prices to go up even further, making each rupee less valuable.

State bank of Pakistan can control inflation by controlling the quantity of money. State bank can lower the rate of growth of money supply, creating an excess demand for money. This in turn would spike the interest rate, reducing real aggregate demand and also any inflationary gap. Much to our dismay, this is easier said than done. Reducing inflation takes time and incurs significant costs.

A direct result of reducing inflation is a decline in the national income, caused by greater unemployment. A dip in the amount of jobs created in the economy is severely frowned upon, as we already suffer from a huge brain drain, the effects of which, is a topic for another day. Also, the temporary increase in interest rate translates into lesser borrowing and as a result, reduced economic activity.

Therefore, reducing inflation is a catch 22 situation. It is one that requires short term pain for long term gain. The real question is whether we can tinker with a fragile economy, already on crutches. Whichever policy we choose, the only thing certain is that we will feel its effects.

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