MACROECONOMICS

TERM REPORT

GDP AND INFLATION

Submitted by:
Mariam Fatima Burhan (20181-24727)
 Asna Mohsin (20181-24230)

What is Inflation?
Inflation is the rate of increase in prices of goods or services. This does not necessarily mean that
all prices have increased. Inflation is, therefore, described a persistent general increase in prices.
Inflation is usually given as the percentage increase in overall prices over a year. There are
different measures of inflation which are commonly used in economic literature. The most often
mentioned and most widely used is the Consumer Price Index (CPI).

What is GDP?
Gross domestic product (GDP) is known as financial value of all the finished goods and services
produced within a country's borders in a specific time period. Though GDP is usually calculated
on an annual basis, it can be calculated on a quarterly basis as well .GDP includes all private and
public consumption, government outlays, investments, private inventories, paid-in construction
costs and the foreign balance of trade (exports are added, imports are subtracted). To simply put
it, GDP is a broad measurement of a nation’s overall economic activity.
 INFLATION
Nominal and Real Variables

Nominal variables measure objects that tell how dollar values and the cost of living are changing,
the price level, the inflation rate, the nominal GDP, nominal wage rate and nominal interest rate.
Real variables measure quantities that tell what is happening to economic well-being., real GDP,
employment and unemployment, the real wage rate, consumption, investment and real interest
rate. The difference between nominal and real variables is the inflation rate. For example, the
difference between the nominal interest rate and the real interest rate is the inflation rate. The
nominal interest rate is the stated rate of return on a financial asset, such as the interest rate a
bank pays on a certificate of deposit. The real interest rate is the nominal rate of return adjusted
for inflation.

Real interest rate = nominal interest rate - inflation rate

Nominal interest rate = real interest rate + inflation rate
Inflation rate = nominal interest rate - real interest rate

Deflation:
It indicates a general decline occurring in prices for goods and services when the inflation rate
falls below 0 percent

Hyperinflation

Hyperinflation is very high and typically accelerating inflation. It quickly erodes the real value of
the local currency, as the prices of all goods increase. This causes people to minimize their
holdings in that currency as they usually switch to more stable foreign currencies. Hyperinflation
is often associated with some stress to the government budget, such as wars or their aftermath,
sociopolitical upheavals, a collapse in export prices, or other crises that make it difficult for the
government to collect tax revenue. A sharp decrease in real tax revenue coupled with a strong
need to maintain government spending, together with an inability or unwillingness to borrow,
can lead a country into hyperinflation. Hyperinflation effectively wipes out the purchasing power
of private and public savings; distorts the economy in favor of the hoarding of real assets; causes
the monetary base, whether specie or hard currency, to flee the country; and makes the afflicted
area anathema to investment.
Causes of Inflation:
In long run, a fall in interest rates may stimulate too much demand – for example in raising
demand for loans or in leading to house price inflation. Monetarist economists believe that
inflation is caused by “too much money chasing too few goods" and that governments can lose
control of inflation if they allow the financial system to expand the money supply too quickly. In
short run, expectations of inflation are important in shaping what actually happens to inflation.
When people see prices are rising for everyday items they get concerned about the effects of
inflation on their real standard of living. One source of short run changes in inflation is shifts in
aggregate demand – in desired spending by government, businesses and consumers.

Inflation Measures used in Pakistan:

Consumer Price Index (CPI):
It measures changes in the price level of market basket of consumer goods and services
purchased by households.
Sensitive Price Indicator (SPI):
It is computed on weekly basis to assess the price movement of essential commodities at short
interval so as to review the price situation in the county.
Whole Sale Price Index (WPI):
It is an index that measures and tracks the changes in the price of goods in the stages before the
retail level – that is, goods that are sold in bulk and traded between entities or businesses instead
of consumers.

Pakistan’s Inflation Rate:

According to International Monetary Fund (IMF) there was an increase in the inflation rate for
Pakistan to 7.5 percent (from 3.9 percent in 2018) and revised GDP growth rate downward to 4
percent in 2019 (from 5.8 percent in 2018).IMF in its World Economic Report released in April
2018, had projected Pakistan’s GDP growth at 4.7 percent and inflation rate at 5.2 percent for
2019.
Pakistan’s annual inflation rate rose to 8.21% in February of 2019 from 7.19% in the previous
month. It was the highest inflation rate since June of 2014, as prices advanced faster for food &
non-alcoholic beverages (4.52% from 1.58% in January); furniture & household equipment
(9.24% from 8.18%); education (10.21% from 10.04%); other goods & services (9.87% from
8.96%). On the other hand, cost slowed for housing & utilities (11.55% from 11.59%); transport
(13.32% from 14.96%); clothing & footwear (6.85% from 7.17%); communication (7.77% from
7.79%); health (7.76% from 8.40%); and restaurants & hotels (5.70% from 5.59%). On a
monthly basis, consumer prices increased 0.64%, after a 1% rise in January. Inflation Rate in
Pakistan
averaged 7.75
percent from
1957 until
2019, reaching
an all-time
high of 37.81
percent in
December of
1973 and a
record low of
-10.32 percent
in February of
1959.

This graph
shows Inflation in % of Pakistan from 2018 to 2019
 GROSS DOMESTIC PRODUCT
GPD can be measured in several different ways.  The most common methods include:

 Nominal GDP – the total value of all goods and services produced at current market
prices. This includes all the changes in market prices during the current year due to
inflation or deflation.
 Real GDP – the sum of all goods and services produced at constant prices. The prices
used in determining the Gross Domestic Product are based on a certain base year or the
previous year. This provides a more accurate account of economic growth, as it is already
an inflation-adjusted measurement, meaning the effects of inflation are taken out.
 Actual GDP – real-time measurement of all outputs at any interval or any given time. It
demonstrates the existing state of business of the economy.
 Potential GDP – ideal economic condition with 100% employment across all sectors,
steady currency, and stable product prices.

Why GDP is Important?

The national income and product accounts (NIPA), which form the basis for measuring GDP,
allow policymakers, economists and business to analyze the impact of such variables
as monetary and fiscal policy, economic shocks such as a spike in oil price, as well as tax and
spending plans, on the overall economy and on specific components of it. Along with better
informed policies and institutions, national accounts have contributed to a significant reduction
in the severity of business cycles since the end of World War II.

How GDP is measured in Pakistan?

 The Pakistan Bureau of Statistics (PBS) is responsible for collection, compilation and
dissemination of GDP Data.

 Pakistan National Accounts estimates are prepared in the light of the UN System of
National Accounts (SNA) 2008.
  PBS uses a combination of approaches for compilation of GDP
 Production approach;
 Income approach; and
 The expenditure approach

Why GDP Fluctuates

GDP fluctuates because of the business cycle. When the economy is booming, and GDP is rising,
there comes a point when inflationary pressures build up rapidly as labor and productive capacity
near full utilization. This leads the central bank to commence a cycle of tighter monetary policy
to cool down the overheating economy and quell inflation.

GDP growth rate in Pakistan from 2017 to 2018:

RELATIONSHIP BETWEEN GDP AND INFLATION

For many years the relationship between economic growth and inflation has been one of the most
widely researched topics in macroeconomics. The Traditional Keynesian model includes Aggregate
Demand (AD) and Aggregate Supply (AS) curves, which illustrates the inflation – economic growth i.e.
GDP relationship.

Numerous studies with several theories have been carried out, which precisely aimed in exploring the
relationship between inflation and growth. These experimental studies have tried to examine whether
the connection between inflation and long-run growth is linear, non-linear, casual or non-existent. The
aggregate supply-aggregate demand (AS-AD) framework hypothesized a positive relationship between
inflation and growth, whereas growth increased, so did inflation. The ‘dynamic adjustment’ of the short-
run AD and AS curves yields an adjustment path which exhibits an initial positive relationship between
inflation and growth, however, turns negative towards the latter part of the adjustment path.

Higher production leads to a lower unemployment rate, further fueling demand. Increased wages
lead to higher demand as consumers spend more freely. This leads to higher GDP combined
with inflation. An increase in inflation means that prices have risen. With an increase in
inflation, there is a decline in the purchasing power of money, which reduces consumption and
therefore GDP decreases. High inflation can make investments less desirable, since it creates
uncertainty for the future and it can also affect the balance of payments because exports become
more expensive. As a result, GDP is decreases further. So it appears that GDP is negatively
related to inflation. However, there are studies indicating that there may also be a positive
relationship. The Phillips curve, for example, shows that high inflation is consistent with low
rates of unemployment, implying that there is a positive impact on economic growth.
Inflation can mean either an increase in the money supply (i.e. the government printing more
money) or an increase in price levels. Increase in money supply will increase prices of products
and services because an ample supply of “easy money” will encourage people to spend it fast and
increase the demand for all kinds of “goodies”, causing their prices to increase.
On the surface, inflation is good, since high demand will encourage companies to increase
production and this will improve the overall throughput and GDP. Improved GDP will
strengthen the stock market, because investors are always excited about companies’ profitability
which has a strong link to higher production throughput and enhanced GDP
The economy grew by 5.2% in 2018, after growths of 5.4% in 2017. However, economic
growth is projected to slow around 3.9% during the FY2019, according to the Asian
Development Bank (ADB), amidst large budget deficits and external account imbalances. High
inflation is also a concern. In March 2019, Pakistan’s inflation stood at 9.4%, up from 8.2% in
the previous month and 3.2% in the same period last year, according to the Pakistan Bureau of
Statistics (PBS), amidst rising energy prices and the depreciation of the domestic currency. In
fact, it was the highest level recorded since November 2013.