2013

Impact of Macroeconomic factors on GDP

Term Paper
Submitted to : Sir Akseer Solangi

By: Omair Ali Shaikh

BBA VII-A Term Paper 10/12/2013

Introduction:
Basically in this study we are analyzing the impacts of different macro economic variables or factors on the GDP of Pakistan or the economic vigor of Pakistan. There are many factors which influence the GDP in both positive and negative manner respectively. The results generally depend on the relationship of the factors and GDP individually and in combination of certain factors. If we look at the GDP of Pakistan of past two decades that in 1991 Late Benazir Bhutto became Prime Minister of Pakistan GDP was about 5.42% and continuously triggered the development. After that twice the government was shifted to PPP and PMLN which disturbed the economy or development a lot that many ups and downs are seen in the graph. It shows that GDP was encouraged in 2004-06 may be due to due to economic reforms by the Musharraf government in 2000. In 2005, the World Bank named Pakistan the top reformer in the region and among the top 10 reformers in the world. Besides several reasons behind this constant GDP growth during this period, low inflation is one of them. During this period, the inflation rate was 7.944% to 7.921%, which is very low compared to the current rate of inflation. Along with that earth quake occurred in 2005-06 which increased the aids from all over world to Pakistan but much of the funds were utilized in the development of Pakistan. But this economy could not maintained the decorum and went in crisis due to international crisis occurred in 2008-9 which increased the oil prices, exchange rate and unemployment rate in the whole and also affected the GDP growth of Pakistan heavily.

Objective:
This study is conducted on a basis to analyze the relationships of two macro economic factors inflation and interest rate on GDP of Pakistan. Although there are many other factors which can affect the GDP in a positive as well as negative manner. But so far we have analyzed the effects of just two factors. The results will help us to understand that how economy responds and what suitable measures should be taken or policies and strategies should be developed in order to minimize the adverse effects and boost the economy with the constructive one.

Literature Review:
As the economy is not concerned with only an individual, in fact it impacts the whole country at the same time. Likewise the GDP is also affected by many macro economic factors which influences sometimes hardly any other times softly. Those factors could be ; interest rate, inflation rate, exchange rate, national income, government consumption etc. But as we have just considered only two factors inflation and interest rate so our focus would be on that.

GDP and Inflation:

So far many studies are done in knowing the proper relation between the inflation and GDP, and what we find that basically there are two school of thoughts in which one states that there is a positive relation between both as inflation decreases then GDP increases by Structuralist. And the other one states that there is a negative relation between GDP and inflation by monetarists. For example, the works of Mallik and Choudhry (2001) and Bruno and Easterly (1998) are the works that are harmful inflation to economic growth of a country. Findings of these works verify the results of Dornbusch (1993), which had concluded that there outliers affecting the relationship between economic growth and inflation. By extreme values that are not meant either very high inflation or very low rate of inflation. Therefore, Bruno and Easterly ( 1998) examined only cases separate high inflation with a critical value of 40 percent and higher. They analyzed and concluded that economic development growth of any country severely decreases during high inflation and improve immediately after when lower inflation rate. Inflation not only matters to people, but creates difficulties and problems in the whole sector of the economy of a country. Gregorio ( 1993) and Barro ( 1995) also verified the negative relationship between economic growth and inflation. In a similar study of Smyth (1992 , 1994, 1995 ) it was concluded a one percent increase in inflation may cause a reduction in the

growth rate of 0.223 % . This relationship is negative but insignificant at low inflation rates, while inflation in higher rate has a significant negative effect on economic growth. Blejer ( 2000 ) and Qayyum (2006) also reached similar conclusions with high inflation implacable in the economy, the economic growth of any country is suffering and the government faces difficulties management policies smoothly. Besides the reduction in economic growth, inflation uncertainty also promotes in the economy. Due to the risky nature of inflation, central banks on world have extended the idea of stability first and declared as one of the main functions of monetary policy. Blejer (2000) and Qayyum (2006 ) also say that monetary policies of the country need to be addressed since the main reasons for high inflation in Pakistan is a loose or in other words monetary policy excess supply of money growth.

Interest rate and Inflation:

According to some studies we have found that real interest rate impacts positively on the economy or GDP of any country. Our data from 1990 to 2011 is showing that as the interest rate lowers the GDP shows a very positive impact and as interest rate get higher the economy shows the negative signal. Same study was under taken by World Bank in 1993 and it also showed the same result. But this is only validating when there is an absence of inflation rate because as the inflation is included the coefficient on interest rate does not show significant relationship. De Gregorio and Guidotti (1995) concluded that very low value of real interest rate causes financial disturbance in the economy that in turn reduces economic growth. As my based article also found the impact of exchange rate on the GDP but many studies were done and still there is no clear cut or proper relationship is found between exchange rate and GDP. Although exchange rate influences a lot GDP in terms of growth but most probably to the developing countries rather than developed country. And above all the impact varies from country to country.

Data and methodology:

In this study a data from 1990 to 2011 was taken In order to analyze the impact of interest rate and inflation rate on GDP. Although whole data was taken from three different sources World Bank, Trading economies website and hand book of State Bank of Pakistan. To study the relationship we have used E-views software to run the regression of this data, where the dependent variable is the GDP and the independent variables are interest rate and inflation rate. The model or equation is:

GDP = b1 + b2Interest rate + b3Inflation +

Where: GDP (gross domestic product) indicates the sum of goods and services produced in the country in one year. Inflation shows a consistent rise in price level. In this study, CPI (consumer price index) of Pakistan is taken as measure of inflation. Rate of interest is taken as the real one that is the lending interest rate adjusted for inflation.

DATA:
Year GDP 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 4.46 5.06 7.71 1.76 3.74 4.96 4.85 1.01 2.55 3.66 4.26 1.98 3.22 4.85 7.37 7.67 6.18 5.68 1.6 3.6 4.14 2.4 Interest Rate Inflation Rate 0.76 9.05 -5.56 11.79 -3.16 9.51 -0.12 9.97 -1.93 12.37 -2.83 12.34 0.51 10.37 1.14 11.38 4.43 6.23 1.96 4.14 4.93 4.37 4.62 3.15 3.2 3.29 1.11 2.91 -2.72 7.44 -5.6 9.06 -0.05 7.92 0.49 7.6 -2.51 20.29 0.54 13.65 -0.42 13.88 0.22 13.9

Results:
Variable C I F R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood Durbin-Watson stat Coefficient 7.056563 -0.598683 -0.308524 0.604313 0.562662 1.277437 31.00506 -34.99084 2.617775 Std. Error 0.766799 0.114434 0.077380 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion F-statistic Prob(F-statistic) t-Statistic 9.202627 -5.231678 -3.987144 Prob. 0.0000 0.0000 0.0008 4.214091 1.931660 3.453712 3.602491 14.50887 0.000150

In the above model the value of adjusted R square is 0.56 which means that 56.26%% of dependent variable - GDP is explained through independent variables which are interest rate and inflation of the country. This value is normal because GDP of any country depends on various factors like political stability, government consumption, exports and imports of a country etc. In order to find the overall significance of the model F-Statistics was analyzed. It shows that the F- statistics of the model is 14.5 which conclude the econometric model is significant. Analysis of coefficient of inflation rate tells us that there is negative relationship between growth and inflation. It further reveals that 1% change in inflation rate will bring 30.85% change in GDP rate of Pakistan. From the above model it is also clear that an increase in 1% of the interest rate there will be decrease in 59.86% of GDP.

Conclusion:
In this study we empirically investigated relationship among interest rate, inflation rate and GDP in case of Pakistan. We have concluded that the extremes value of inflation either low or high badly hits the economic growth of the country. Therefore, the central bank should emphasize the price stability in a country and should adopt tight monetary policy. Whereas our study has concluded that there exists a significant negative relation between inflation and economic growth. It means that an increase in inflation will bring about decrease in economic growth. Findings of our study show that there is negative but significant relationship between interest rate and GDP. But simultaneously our findings contradict the findings of these two studies in terms of direction of relationship. Some studies revealed that there exists positive relationship between economic growth and interest rate whereas our study shows that in case of Pakistan low interest rate boosts the investment which directly effects the economic growth positively.

References:
Journal of Management and Social Sciences Vol. 9, No. 1, (Spring 2013) 40-48C

Exploring Impact of Macro Economic Variables on GDP of Pakistan by Sidrat Jilani, Farooq-E-Azam Cheema, Muhammad Asim
Barro, R. J. (1995) Inflation and Economic Growth, Bank of England Quarterly Bulletin 35: 166-176. De Gregorio, Jose. & Guidotti, P. E. (1995) financial development and economic growth. World Development, Vol. 23(3), pages 433-448 Mallik, G. and Chowdhury, A. (2001). Inflation and Economic Growth: Evidence from four South Asian Countries. Asia-Pacific Development journal, 13 Qayyum, A. (2006) Money, Inflation, and Growth in Pakistan. The Pakistan Development Review, No.2: pp. 203-212.