Effects of inflation and other variables on economic growth

The research that I have conducted basically enlightens the effect of inflation on economic growth along with three more variables; Interest rates, Growth of money supply and FDI. Regression is run on the variables and the results show that three of the four variables are holding significant affect whereas one of the variables, i.e., FDI is insignificant. Moreover, the results are analysed looking at the T-Statistics and conclusion is made on the basis of this. In addition, the Adjusted R square shows a very favourable value of 82.917%. Data of 10 years had been used i.e. from 1997-2007. Stat graphics is used to run the analysis.

Introduction

Pakistan is a developing economy that is facing major issues like political instability, inflation, less economic growth and high interest rates. Due to the global credit crunch, the developing and the under developed countries had to face innumerable problems. But Pakistan is lucky enough to recover from the bad patch. It is on its recovery stage and hope to pull through it soon.

The research topic is about the economic growth of Pakistan. The data collected is from 1997 to 2007 which shows an overall increase till 2005 and then a slight fall. The variables that may affect the economic growth are inflation, investments, broad money supply and interest rates. They are measured too in order to see their relationship with economic growth.

By economic growth, it is meant economic progress and advancement that may be achieved through various ways like development of infrastructure, increase in productivity levels and growth in the overall economy.

Moreover the economic growth is a measure of the rate of change that a country’s gross domestic product goes through from one year to another .It can be measured through the following formula:

Economic Growth Rate

Pakistan’s economy has shown great ups and downs because of the destructive earthquake, but the future growth forecasts for the economy are good. Pakistan needs to increase the quantity and quality of investment in the future in order to maintain rapid growth over an extended period of time. For this to happen, it should encourage productivity of labor and innovation. The economic rate is an indicator of general direction and magnitude of growth for the overall economy. Developed and fast growing economies are likely to see rates of growth as high as 10% or more. But this growth rate is unlikely to be maintained over the long run. Therefore, it lasts for the short run.

In the research conducted, economic growth is affected by inflation. A few more variables instigate inflation due to which there is significant impact on the economic growth of Pakistan. Inflation is the rate at which the general level of prices for goods and services is rising and causes a fall in the purchasing power of the consumers. Central banks attempt to stop the harsh inflation, along with severe deflation, so that they can keep the sky rocketing prices to a minimum. The variables that might cause a negative or a positive impact on the economic growth are as follows:

Interest rates

Investment (foreign direct investment)

Growth in Broad Money

Inflation

The variables can turn out to be the prospects of inflation which can further affect the economic growth. The variables can be easily measured to reach a regression model which makes it easier to analyse the situation.

Literature review

Abdul Qayum attempts to examine the relation between the excess money supply growth and inflation in Pakistan in his article, ‘Money, Inflation and Growth in Pakistan’ (2006). The results indicate that there is a positive association between the two variables. The money supply growth firstly affects the real GDP growth and further affects inflation in Pakistan. The important point to be noted here was that the excess money supply growth has drastically caused a rise in inflation during the study was being conducted. This could be because of the loosening of monetary policy that was adopted by the State Bank of Pakistan to show the high priority of growth objective. The inflation of Pakistan can be controlled if State Bank of Pakistan tightens the monetary policy. The article on the whole concludes that inflation in Pakistan is by no doubt a monetary phenomenon.

Min Li in his article ‘Inflation and Economic growth: Threshold effects and Transmission mechanism’ talks about the adverse results that high rates on inflation have on real economic growth in the long run. Economists say that high rates of inflation can be problematic for the aggregate economic performance. The paper firstly examines the relationship between inflation and the economic growth by the use of data that comprises of 90 developing countries along with 28 developed countries. The results show that the relationship is nonlinear. Moreover it shows that there is a difference in the nonlinearity of the developed and the developing countries.

Mohsin S.Khan and Axel Schimmelpfennig in their article ‘Inflation in Pakistan’ (2006) inspects the factors that enlighten and help project inflation in Pakistan. An inflation model that is simple in nature may include variables like money supply, interest rate and the exchange rates. The model calculates on monthly basis and the results show that recent inflation is effected by monetary factors. These factors affect the inflation with a lag of about one year. Moreover, private sector credit growth and broad money can predict the developments in inflation. A long run relationship exists between CPI and private sector credit. Therefore, State Bank of Pakistan should set its monetary policy an year before meeting its inflation target.

‘Relationship between Inflation and Economic Growth’ (2004) was a paper written by Vikesh Gokal and Subrina Hanif which talks about the economic growth in Fiji. Several different theories were reviewed to determine consensus on economic growth. Supply side theories are recalled here which emphasises on the need to save and invest if the nation’s economy is to grow. The paper also reviews already published literature by Sarel, Andres and Hernando which provide some supervision for Fiji policymakers on the importance of maintaining low inflation so that higher economic growth can be encouraged. .Varied theories are discussed in the paper like the Classical growth theory and the Keynesian Theory. Moreover the article talks about the level of inflation after which there could be a change in the economic growth. Michael Sarel’s paper gives a evidence that a structural break at 8% gives a negative impact of inflation on the economic growth.

Omoke Philip Chimobi in his study “Inflation and Economic Growth in Nigeria” (2010) determines the existence of the relationship between Inflation and Economic growth in Nigeria.CPI and GDP was used to measure inflation and economic growth respectively. A variety of studies were reviewed and the results showed that inflation has never been favourable for the economic growth. The study was conducted from 1970-2005 during which there was no co-integrating relationship existing between economic growth and inflation which resulted in no long term relationship between the two variables. But what concluded was that high inflation is never good for economic growth.

M.Ali Kemal in his article ‘Is Inflation in Pakistan a Monetary Phenomenon’ (2006) talks about the relationship between money supply and inflation. He says that a boost in money supply over the long run can result in a higher rate of Inflation. The article says that Inflation is for sure a monetary phenomenon. The money supply takes about 9 months to have an impact on Inflation. On the other hand the study might take longer than this to converge to the equilibrium if shocks persist in any of the three variables that are; GDP, money supply and prices. This shows that it doesn’t quickly influence the price levels. Co-integration technique is used to check the long run relationship between the two variables. Moreover, Engle-Granger approach and the Johansen co-integration technique is used.

Erman Erbaykal and H. Aydin Okuyan study the relationship between inflation and economic growth in Turkey in the article ‘Does Inflation Depress Economic Growth?'(2008). A Bound Test is developed in the study that results in a co-integration relationship between inflation and economic growth. Moreover, a significant negative short term relationship was found between the ARDL models. No long term relationship has been found. Policies that provide cost stability are apparent for a steady and upheld growth.

Yasir Ali Mubarik wrote an article ‘Inflation and Growth: An estimate of Threshold Level of inflation in Pakistan (2003). The study estimates the threshold level of Inflation for Pakistan and suggests 9% as the threshold inflation level at which inflation is an alert for the economic growth. The Granger Casuality test is used in the study that defines casuality direction from inflation to economic growth. Inflation target can possibly be set by policymakers by using the results for the test. However the study doesn’t estimate that at what levels the inflation is too low for economic growth.

Haider, Adnan and Khan , Safdar Ullah , Research Department , State Bank of Pakistan analyses the impact of unpredictability in government borrowing on Inflation in Pakistan in the article, ‘Does Volatility in Government Borrowing Leads to Higher Inflation?'(2009). The Generalized Auto Regressive Conditional Hetroskedasticity (GARCH) model is used to estimate volatility in government borrowing from central bank. The evidence suggests that there lies some volatility in government borrowing from central bank and domestic inflation. The study further helps in understanding inflation in different developing economies like Pakistan.

Methodology

Research Type

In order to understand the impact of inflation on the economic growth of Pakistan, quantitative research is carried down.

Data Type

Secondary data is collected from various websites and data bases.

Source of Data

In order to collect the secondary data, websites are consulted.

Techniques

Regression analysis will be used as the statistical technique in this research after gathering secondary data. Once the data have been collected results will be analyzed through regression analysis.

Sample

Data is collected from 1997 -2007 for all the variables from the WDI website.

Theoretical Framework

Foreign direct investment

Inflation

ECONOMIC GROWTH

(Dependent)

Growth in Broad Money

Interest Rates

Functional form:

Y=f (x1, x2, x3, x4)

Economic Growth=f (Interest rates, Inflation, FDI, Growth in broad money)

Multiple Regression would be run to see the relationship of various variables and to identify the variables which are significant affecting the dependant variable.

Definitions and relation of variables.

Economic Growth:

It is the increase of gross domestic product (GDP) , described as the annual rate of change in real GDP. Economic growth is derived by a change in productivity, which means producing more goods and services with the same inputs i.e labour, capital, materials etc. Economists say that there lies a difference between short-term economic growth and long-term economic growth. But the topic of economic growth is primarily concerned with the long run.

Inflation:

It is an increase in the cost of commodities that are vital for humans to live , such as bread, milk, cheese, oil, shelter, clothing, medical services, cotton, electronics, etc or a decrease in the value of money so that it takes more currency to buy the same goods and services it did in the past.

Higher rates of inflation are going to have adverse effects on the economic growth. There is less economic growth when there is high inflation usually.

Interest rates:

A rate which is charged for the use of money or the price for borrowing money is known as an interest rate. An interest rate is expressed as an annual percentage of the principal. Interest rates often change as a result of inflation and Federal Reserve policies. Interest rates may vary causing a change in other factors. If inflation is higher it will result in higher risk and investors will be considering higher interest rate to lend their money. Therefore, when the interest rates are likely to rise, it gives an increase to inflation resulting in less economic growth. People will save more and invest less as they are likely to earn more profit on their savings.

Investment:

Investment is the use of money in a way that it earns you more money. Or it can be termed as the process of investing funds in an asset that is likely to earn you great money in the future. Gains that might come from the asset invested in could be in the shape of interest, income or an appreciation in the value of the asset over the time. Foreign direct investment is defined as a business or a concern from one country making a physical investment into another country. The direct investment in buildings, machinery and equipment with making a portfolio investment, is considered an indirect investment. Foreign direct investment plays a positive role in the process of economic growth.FDI helps in developing new products and technologies faster than local firms. This is one of the causes why developing countries are keen to attract FDI.

Broad money:

Broad money is a gauge of the money supply that includes more than just physical money such as currency and coins .It includes demand deposits at commercial banks, and any dues held in easily reachable accounts. Components of broad money are still very liquid, and can usually be converted into cash very easily.

The most commonly used measure of broad money is M2, which includes currency and coins, and deposits in checking accounts, savings accounts, and non-institutional money market accounts. This is the major measure of the money supply, and is the economic indicator usually used to assess the amount of liquidity in the economy. With the loosening of money supply by the Federal Bank, there’s going to be a rise in inflation leading to slow economic growth in most of the cases. But if the money supply is loosened for a shorter time period, there is a likelihood that economic growth would raise.

Research Hypothesis

The objective of this study is to measure the impact of inflation on the economic growth

H0: Inflation does not have an impact on Economic growth

H1: Inflation does have an impact on Economic growth

H0: B1 = 0

H1: B1 =/= 0

The objective of this study is to measure the impact of broad money on economic growth

H0: Broad money does not have an impact on Economic growth

H1: Broad money does have an impact on Economic growth

H0: B2 = 0

H1: B2 =/= 0

The objective of this study is to measure the impact of interest rates on economic growth.

H0: Interest rate does not have an impact on Economic growth

H1: Interest rate does have an impact on Economic growth

H0: B3 = 0

H1: B3 =/= 0

The objective of this study is to measure the impact of FDI on economic growth

H0: FDI does not have an impact on Economic growth

H1: FDI does have an impact on Economic growth

H0: B4 = 0

H1: B4 =/= 0

The regression model is run with one dependant variable namely Economic Growth and four independent variables .The sample size is the data from 1997-2007.

Regression Summary:

The equation of the fitted model is:

Economic growth = 16.1883 – 0.143151FDI – 0.296885Growth in broad money +0.541243Inflation – 0.655153Interest rate

Since the P-value in the ANOVA table is less than 0.01, there is a statistically significant relationship between the variables at the 99% confidence level.

The R-Squared statistic indicates that the model as fitted explains 89.7502% of the variability in economic growth. The adjusted R-squared statistic, which is more suitable for comparing models with different numbers of independent variables, is 82.917%.

The standard error of the estimate shows the standard deviation of the residuals to be 0.893445. This value can be used to construct prediction limits for new observations. The mean absolute error (MAE) of 0.584784 is the average value of the residuals.

The Durbin-Watson (DW) statistic tests the residuals to determine if there is any significant correlation based on the order in which they occur in your data file. Since the DW value is greater than 1.4, there is probably not any serious autocorrelation in the residuals.

In determining whether the model can be simplified, notice that the highest P-value on the independent variables is 0.7805, belonging to FDI. Since the P-value is greater or equal to 0.10, that term is not statistically significant at the 90% or higher confidence level. Consequently, FDI should be removed from the model.

Analysis of Findings

The Adjusted R squared explains the percentage of variation in the dependant variable because of a variation in the dependant variable. Therefore, there is 82.917% of variation in the dependant variable if there comes any variation in the independent variables.

Significance of Regressors

Foreign direct Investment

The T-Statistic is -0.29148 that is less than +/- 1.64. This shows that it has 10% significance level. It would not be considered as it does not have a significant impact on economic growth. As a result we will accept H0.

Growth in broad money

The T-Statistic is -3.40215 that is greater than +/- 2.58. This shows that it has 1% significance level. It would be considered as it has a significant impact on economic growth. As a result we will reject H0.

Inflation

The T-Statistic is 2.92753 that is greater than +/- 2.58. This shows that it has 1% significance level. It would be considered as it has a significant impact on economic growth. As a result we will reject H0.

Interest Rate

The T-Statistic is – 5.26932 that is greater than +/- 2.58. This shows that it has 1% significance level. It would be considered as it has a significant impact on economic growth. As a result we will reject H0.

Limitations of the Study

Time constraint was a major factor.

Deriving values from different data bases and websites was tough as they usually varied.

One of the variables is showing an insignificant relationship i.e. FDI. This is because its T-statistic is showing a value than does not fall between the required ranges. This may be because there is less foreign direct investment in the country because of the prevailing political instability.

Conclusion

The study reveals various important and significant factors that have an impact on the economic growth of Pakistan. Inflation is the root of all the problems. The study finds reasons that how economic growth is affected, negatively and positively. We come to a conclusion by analysing the regression model that inflation has a direct and positive relationship with economic growth. Whereas, interest rates, FDI and growth in money supply has a negative relationship with economic growth. Three of the variables except for FDI have a significant relationship with the dependent variable which means that a variation in any of the variables can lead to a change in the economic growth.

Appendix

Figure 1.1

Fig 1.2

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Fig 1.3

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Pakistan Inflation rate (consumer prices %)

Fig 1.4