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THEORETICAL FRAMEWORK

Inflation as a key indicator provides important insight on the state of the economy and the sound macroeconomic policies that govern it. A stable inflation not only gives a nurturing environment for economic growth, but also uplifts the poor and fixed income citizens who are the most vulnerable in society. The Government needs to be cautious about inflation and thus has taken various steps to release demand pressures on the one hand and enhance supplies of essential commodities on the other. To ease demand pressures, the State Bank of Pakistan (SBP) has continuously tightened the monetary policy over the last three years and more so in the current fiscal year, while to enhance supplies, the Government has relaxed its import regime. The CPI is the main measure of price changes at the retail level. It indicates the cost of purchasing a representative fixed basket of goods and services consumed by private households. In Pakistan, the CPI covers the retail prices of 374 items in 35 major cities and reflects roughly the changes in the cost of living of urban areas.

The monetary policy in Pakistan aims at stabilizing the domestic and external value of the currency to stabilize economic growth.

The high degree of dependence on oil producing countries and any irregularities in prices and supplies has a pervasive effect for an economy that imports crude oil to cater to its often fragile industry. Following the sharp surge in oil prices since 2003, developing countries that rely heavily on oil imports, are now faced with an increased threat to macroeconomic instabilities, with Pakistan as no exception. This brief note provides an overview of international oil price trends witnessed since 2002. Observations are also made on how domestic furnace and high speed diesel oil price trends move in consonance with the international oil prices. The need to focus on furnace oil and high speed diesel oil prices trends arises from the fact that of the total production by oil refineries of major components of crude oil, diesel constitutes the highest share of 31% with furnace oil comprising the second largest share of 29.4% in Pakistan (2006 to 07 estimates).

DETERMINANTS OF INFLATION

DEMAND PRESSURE

The demand pressure is one of the major determinant of the inflation. It is the combination of expansionary monetary and fiscal policy. The increased domestic demand due to remittances from abroad outpaced the domestic production creating a positive output gap which results an increased in prices and as a result inflation occurs.

GROWING GAP

Secondly the growing gap between domestic demand and domestic production was filled by a sharp rise in net imports. The imports increases more as compared to exports. So as aresult trade deficit occurs. A rising trade deficit results an increase in high prices in future. So the growing gap is one of the indicator if inflation.

FISCAL POLICY

Third, fiscal policy has remained expansionary in the last few years. Expansionary fiscal policy fuels domestic demand and puts pressure on the current account deficit. In other words, it widens the investment-saving gap, which has to be financed externally. Moreover, financing of fiscal deficit t