Introduction
In our last lesson, we examined the immense challenge of Pakistan's public debt, establishing how chronic fiscal and current account deficits have trapped the nation in a cycle of borrowing and eroded its economic sovereignty. We concluded by noting that the consequences of this debt—particularly currency devaluation and deficit financing—are primary catalysts for inflation.
This lesson builds directly on that foundation to address the learning outcome: Assess the primary drivers of inflation in Pakistan and analyze the effectiveness of monetary and fiscal policy responses. We will dissect the complex causes behind the persistent rise in the cost of living that has afflicted Pakistan, a topic of critical importance for both the populace and for CSS examiners. You will learn to distinguish between different types of inflationary pressures and, most importantly, critically evaluate the policies deployed by the State Bank and the government to manage them. This analysis will equip you with the conceptual depth required for a sophisticated discussion of one of Pakistan's most pressing socio-economic issues.
Understanding Inflation: More Than Just Rising Prices
At its core, inflation is a sustained increase in the general price level 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 reflects a reduction in the purchasing power per unit of money.
To begin, let's establish a clear conceptual framework for what inflation is, how it's measured, and why a certain level of it can even be considered healthy for an economy.
Uncovering Pakistan's Economy: What is Inflation? | Dr. Athar Mansoor | TWT | World Times Institute
Dr. Athar Mansoor, in a discussion with the World Times Institute, provides an excellent and accessible explanation of these foundational concepts.
Please watch the following segments: What is inflation? Here, Dr. Mansoor defines inflation, explains its calculation via the Consumer Price Index (CPI) basket, and clarifies its direct impact on purchasing power. He also introduces the Producer Price Index (PPI) as a predictive tool. Healthy vs. harmful inflation. In this part, he explains why a low, stable inflation rate (e.g., 2-4%) is beneficial, as it incentivizes both production and consumption, while the double-digit inflation seen in Pakistan is deeply damaging.
As Dr. Mansoor clarifies, the challenge for Pakistan has not been inflation itself, but its high, volatile, and persistent nature. The graph below, showing Year-on-Year CPI inflation, vividly illustrates this volatility, with a dramatic peak reaching 38% in May 2023.
This is not an abstract economic indicator. It has a direct and severe impact on the daily lives of citizens, as the cost of essential goods skyrockets. The table below, based on data from the Pakistan Bureau of Statistics, quantifies this impact on everyday items.
The Primary Drivers of Inflation in Pakistan
Inflation in Pakistan is not the result of a single cause but rather a confluence of several reinforcing factors. For analytical clarity, we can group these into three categories: cost-push drivers, demand-pull drivers, and structural factors that create persistence.
1. Cost-Push Inflation: The Supply-Side Squeeze
This type of inflation arises from an increase in the cost of production, which producers pass on to consumers in the form of higher prices. In Pakistan, this is arguably the most significant driver.
- Imported Inflation and Currency Devaluation: As a net importer, Pakistan is highly exposed to global price shocks. The two main channels are:
- Global Commodity Prices: Increases in the international price of oil, edible oil, and industrial raw materials directly translate into higher domestic prices.
- Exchange Rate Depreciation: This is a crucial link to our previous lesson. A persistent current account deficit puts downward pressure on the Pakistani Rupee. As the rupee devalues against the US dollar, the cost of all imports rises in rupee terms. This affects everything from the fuel in your car to the raw materials for Pakistan's industries.
Uncovering Pakistan's Economy: What is Inflation? | Dr. Athar Mansoor | TWT | World Times Institute
Dr. Athar Mansoor provides a clear analysis of how these supply-side factors, particularly imported costs and devaluation, fuel inflation.
Watch the segment from supply-driven inflation, where he explains why inflation in Pakistan is mostly a supply-side phenomenon, rooted in the cost of imported petroleum and other raw materials. He uses the automotive industry as a case study to illustrate how devaluation, freight costs, and input prices combine to cause massive price hikes. Following this, watch his explanation of the link between the import bill and the exchange rate, and his critique of artificially controlling the currency, a policy which, while temporarily suppressing inflation, ultimately damages exports and worsens the underlying trade deficit.
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Administered Prices and Energy Tariffs: The government periodically adjusts the prices of electricity and natural gas to reflect costs and manage subsidies. These adjustments, often mandated under IMF programs, have a broad inflationary impact, increasing costs for households and industries alike.
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Fiscal Policy Choices: Government taxation policies, especially a heavy reliance on indirect taxes like the General Sales Tax (GST) and the Petroleum Development Levy (PDL), directly increase the final price of goods and services for consumers.
The State Bank of Pakistan's Annual Report for FY25 provides a detailed breakdown of how these factors contributed to the sharp disinflation seen in that year, reinforcing their importance as drivers.
[PDF] Monetary Policy and Inflation - State Bank of Pakistan
To understand the mechanics of these drivers with official data, we will turn to the SBP's analysis.
Please read section 3.4, "Inflation," in its entirety. It begins with the sentence "The NCPI inflation dropped" and continues for the next few pages. As you read, focus on how the report attributes the decline in inflation to specific supply-side factors: Food Inflation: Note the discussion on the bumper wheat crop and government procurement policy, which led to a sharp fall in wheat prices. Energy Inflation: Pay close attention to the explanation of how downward adjustments in electricity tariffs (QTA and FCA) and a fall in global oil prices drove energy inflation down. This demonstrates the reverse of what happens when these costs rise.
2. Demand-Pull Inflation: The Fiscal Connection
This occurs when aggregate demand in the economy outstrips aggregate supply, leading to "too much money chasing too few goods." In Pakistan, this is intrinsically linked to the government's fiscal management, which we discussed in the previous lesson.
When the government runs a large fiscal deficit, it must finance it by borrowing. Historically, a significant portion of this borrowing came directly from the State Bank (effectively, printing money). This practice injects new money into the economy without a corresponding increase in the production of goods and services, stoking demand-pull inflation. While recent reforms have aimed to curb this direct monetization, the legacy of fiscal indiscipline and its connection to inflation remains.
3. Structural Factors and Inflation Persistence
Perhaps the most complex aspect for a CSS-level analysis is understanding why inflation, once it rises in Pakistan, tends to be "sticky" or persistent. It doesn't come down easily even when the initial shock has passed.
[PDF] Monetary Policy and Inflation - State Bank of Pakistan
The SBP report contains an excellent analytical section that breaks down the structural reasons for this persistence. This is crucial for an advanced answer.
Please read Box 3.2: "Persistence in Core Inflation in Pakistan." This box, starting with the text "Inflation persistence refers", identifies several key factors. Focus on understanding: Backward-looking inflation perceptions: How expectations of future inflation are based on past inflation. Market imperfections: How a lack of competition allows firms to keep prices high. Indexation of wages: How wages are adjusted based on past inflation, creating a wage-price spiral. Weak coordination between fiscal and monetary policies: This is a critical point. The box explains how an expansionary fiscal policy can undermine the efforts of a contractionary monetary policy.
Analyzing Policy Responses and Their Effectiveness
Having identified the drivers, we now turn to evaluating the policy responses from the two key institutions: the State Bank of Pakistan (monetary policy) and the Government of Pakistan (fiscal policy).
Monetary Policy: The SBP's Battle with Inflation
The SBP's primary tool for controlling inflation is the policy rate (or interest rate). The theory is straightforward:
- To combat high inflation, the SBP implements a contractionary (or tight) monetary policy by raising the policy rate.
- This makes borrowing more expensive for businesses and consumers, which reduces investment and consumption, thereby cooling down aggregate demand and easing inflationary pressures.
- Conversely, to stimulate a slowing economy, the SBP can cut the policy rate.
Effectiveness: While the SBP consistently uses its policy rate to respond to inflation, how effective has it been?
[PDF] Coordination and Effectiveness of Fiscal and Monetary Policies in ...
A 2025 research paper by Samiullah and Ahmad, published in the Pakistan Economic Review, provides a rigorous and critical evaluation of policy effectiveness over three decades.
Please read the following sections to grasp their core findings: First, read the Abstract and the Introduction (first two pages) to understand the study's purpose and context. Next, examine Table 2 ("Macroeconomic Environment and Policy Response Matrix") and the accompanying analysis on page 41. Focus on the authors' conclusion regarding monetary policy: it has been in the right direction about 67% of the time, rightly adopting a contractionary stance during high-inflation episodes. Finally, and most importantly, read the analysis of the Impulse Response Functions (IRFs) from the bottom of page 43 through page 44. The authors find that while the SBP responds correctly, its policies are often ineffective. Note the crucial finding: it fails to control inflation but does succeed in harming economic growth.
The findings from this paper are profound. They suggest that while the SBP acts in accordance with economic theory, its efforts are neutralized by the structural rigidities and supply-side nature of inflation in Pakistan. Raising interest rates can curb demand, but it does little to solve inflation caused by a devaluing currency or rising global oil prices. Furthermore, this policy comes at the high cost of stifling economic growth.
The lack of coordination with fiscal policy, as highlighted in both the SBP report and the research paper, is a key reason for this ineffectiveness. The central bank cannot win the fight against inflation alone if the government is simultaneously fueling it with large, unfunded expenditures.
Fiscal Policy: The Government's Role
The government's tools to fight inflation are more direct but often politically more difficult to implement. They include:
- Fiscal Consolidation: Reducing the budget deficit by cutting non-productive expenditure and expanding the tax base (preferably through direct taxes on income and wealth).
- Supply-Side Interventions: Taking administrative measures to prevent hoarding, improving supply chains for food items, and pursuing long-term reforms like privatizing loss-making state-owned enterprises (a process seen with PIA in 2025).
- Managing Administered Prices: Resisting politically motivated delays in tariff adjustments that lead to larger, more disruptive shocks later.
Effectiveness: As with monetary policy, the effectiveness of fiscal policy has been severely limited. The Samiullah and Ahmad paper concludes that fiscal policy has been inconsistent with its target nearly half the time and is largely ineffective at influencing either growth or inflation.
Uncovering Pakistan's Economy: What is Inflation? | Dr. Athar Mansoor | TWT | World Times Institute
Dr. Athar Mansoor offers a compelling diagnosis of why fiscal policy often fails, framing it as a problem of political will.
Watch his concluding remarks on the "categorical measures" to control inflation. He argues that tackling inflation requires taking "bitter pills"—unpopular political decisions like cutting non-developmental expenditure, broadening the tax net, and shifting the economic structure away from unproductive real estate speculation towards productive, export-oriented industries. This highlights the political economy constraints that prevent effective fiscal responses.
Conclusion
Inflation in Pakistan is a multi-headed beast, driven by a powerful combination of external shocks, currency weakness, fiscal indiscipline, and deeply embedded structural factors. Understanding this complexity is key to moving beyond simplistic diagnoses.
Key Takeaways:
- Primary Drivers: Inflation is primarily a cost-push phenomenon, driven by the cost of imported energy and raw materials, which is amplified by a persistently devaluing currency. This is supplemented by demand-pull pressures from large fiscal deficits and structural factors like backward-looking expectations that make inflation persistent.
- Monetary Policy Response: The State Bank of Pakistan actively uses its policy rate to combat inflation, raising it to cool the economy. However, analysis shows this policy is often ineffective in controlling supply-side inflation and comes at the significant cost of reduced GDP growth.
- Fiscal Policy Response: The government's fiscal response is often inconsistent and undermined by political compulsions. While the required measures—expenditure cuts, tax reforms, and structural changes—are well known, the political will to implement these "bitter pills" is frequently lacking.
- The Coordination Problem: A fundamental reason for policy failure is the weak coordination between monetary and fiscal authorities. A contractionary monetary policy cannot succeed if it is accompanied by an expansionary fiscal policy.
Preview of the Next Lesson:
The relentless inflation we have discussed has a devastating impact on the livelihoods of ordinary Pakistanis, eroding savings and pushing more people below the poverty line. In our next lesson, we will delve deeper into this human cost as we move to the next learning outcome: "Analyze the dimensions of poverty and unemployment in Pakistan and evaluate the effectiveness of current alleviation strategies."