Professional Documents
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OCTOBER 2018
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Table Contents
Chapter 1........................................................................................4
THEORETICAL FOUNDATION..............................................................................................................4
1.1Introduction..............................................................................................................................4
1.5 Hypothesis...............................................................................................................................6
Chapter 2......................................................................................14
METHODOLOGY...............................................................................................................................14
2.1 Introduction...........................................................................................................................14
2.7 Chapterisation........................................................................................................................16
Chapter 3......................................................................................17
ANALYSIS OF DATA, DISCUSSIONS AND FINDINGS...........................................................................17
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3.1 Introduction...........................................................................................................................17
3.5 Summary................................................................................................................................26
Chapter 4.....................................................................................27
CONCLUSIONS AND RECOMMENDATIONS......................................................................................27
4.1Introduction............................................................................................................................27
4.2 Conclusions............................................................................................................................27
REFERENCES 30
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Chapter 1
THEORETICAL FOUNDATION
1.1 Introduction
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(2008) argues that since 2002 much more effort has been geared towards
ensuring a transparent monetary policy that is able to influence inflation
expectations. The monetary policy in Botswana pursues the objective of
price stability by aiming to achieve low and sustainable levels of inflation.
To achieve this goal, the Central Bank used interest rates with the aim to
influence the demand conditions which would then affect inflation in the
economy.
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The decline was caused as a response to the world recession, but at this
level, the monetary policy still remained tight. Nonetheless, the policy rate
increased alongside the inflation rate for three years and yet, by the end of
the third year inflation was still significantly above the inflation objective.
Hence, inferences can readily be made about the ineffective monetary
policy in Botswana. This motivates the main research question: How strong
is the impact of interest rates (monetary policy) on inflation in Botswana?
1.5 Hypothesis
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1.6. Scope of the study
This study explores the impact of interest rates on inflation in the economy of
Botswana .It covers the period of fifteen years: 2000 to 2015. The data sources are
mainly Bank of Botswana data bases and other previously published sources
Interest rate is the rate at which a central bank will advance short term
loans to commercial banks. Changes in bank rate are reflected in the prime
lending rates offered by commercial banks (to their best customers), which
in turn affect investments such as bank deposits, bond issues, mortgages.
This term has largely been replaced by newer terms base-rate and prime
rate. The interest rate guides economic rationale because it is a vital tool of
monetary policy. The interest rate is taken into account when dealing with
economic variables such as investment, inflation, and unemployment.
Central banks usually reduce the interest rate to increase investment and
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consumption in the country's economy. The interest rate directly impacts
economic choices such as spending, investment, and consumption.
1.8.1 Introduction
This section will review published literature from different researchers and
authors concerning the issue of the impact of interest rate on inflation as to
what they say about the causal relationship. The relationship between
interest rates and inflation has been frequently explored in both its
theoretical and empirical dimensions by many scholars. Although the
definitions of interest rates differ to include real interest rates, nominal
interest rates, deposit rates, and money market rates, many studies try to
define the interaction between the rates and the inflation.. An increase in
inflation is undesirable. Economic authorities in developing countries and
emerging economies develop monetary policies that promote stable growth
and low inflation. There is a very close relationship between interest rates
and the inflation level. Any change in interest rates will likely have an
impact on consumption and, therefore, will create a shift in inflation levels.
On the other hand, any increase in price levels will oblige central banks to
adjust interest rates. This phenomenon forms the basic equation of
regulation for central bank
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1.8.2 Empirical Review
In this section the study turns to the empirical literature to review the
findings from different researchers regarding the applicability of the
monetarist determinants of inflation approach. The empirical literature
shows that like many other macroeconomic theories, the subject has
received much attention from economics researchers throughout the world.
The Quantity Theory of Money (QTM) theorem among others motivated
empirical researchers to examine the validity of a possible linkage between
inflation and growth of money supply.
Graude and Polan ( 2005) examined the link between money supply and
inflation in160 countries using 30 years data range. The empirical analysis
was conducted using quarterly time series data on inflation and interest
rates in those countries. Although they accepted that inflation is a monetary
phenomenon, they claimed that the link between inflation and money
supply is much stronger only in the countries with high inflation rates. They
further noted that in countries with a relatively low inflation rate the long
run linkage cannot be easily identified.
Thornton (2008) in his study found evidence to support Graude and Polan
(2005) claim, after employing panel and cross section analysis to
empirically estimate the applicability of QTM on 36 countries in Africa. His
studies concluded that, money supply strongly determines inflation in
countries with more than 10 percent inflation and money growth rates.
However the findings of Us (2004) contradict this claim after he detected a
zero correlation between money supply and inflation in countries with high
inflation rates. In his study Us used the correlation coefficient to determine
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the strength of the relationship between inflation and interest rates.
According to Us (2004), for more than 30 years Turkey has been facing high
and increasingly inflation rates. His empirical findings suggest that the
higher rates of inflation are mainly as a result of the depreciating of the
country’s currency and increase in the prices in the public sector rather
than due to monetary supply.
Pennachi (1991) also examined the relation between real interest rates and
inflation. He employed a model that is estimated as a state-space system
that includes observations on Treasury bills with different maturities and
NBER-ASA survey forecasts of inflation for the period between 1968 and
1988. The study supports the idea that real interest rates and expected
inflation are significantly negatively correlated. Furthermore, real interest
rates also display greater volatility and weaker mean reversion than does
expected inflation. Using error correction model (ECM) based panel co
integration tests, Westerlund (2006) provides evidence in favour of the
Fisher hypothesis for 20 OECD economies for the period 1980-2004. Ling et
al. (2008) test the Fisher hypothesis for East Asian economies using panel
unit root tests and find empirical evidence to support the validity of the
Fisher hypothesis in this context. Sathye et al. (2008) test the same
relationship in the context of the Indian financial market. They find that
expected inflation and nominal short-term interest rates are co-integrated
in the Indian context.
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evidence in favour of approximately constant real interest rates, as implied
by the Fisher hypothesis. In contrast, Summers (1983) rejects the Fisher
hypothesis for the period before the 1990s, a period for which the Fisher
hypothesis has been subjected to empirical tests that take the potential non
stationary and co integration of the involved time series explicitly into
account (Mishkin 1992).
The positive affiliation between nominal interest rates and inflation was
carved in stone by Fisher (1930). Fisher (1930) explains that nominal
interest rates move positively with the nominal interest rates while the real
interest rates remain constant in this transaction.
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O’Sullivan, Sheffrin, 2003). According to the Keynesians, increased private
and government spending, natural disasters, or increased prices of inputs,
and price/wage spiral are the causes of inflation. However, Ezirim (2005)
has shown with the aid of econometrics that monetary factors cause
inflation in emerging markets like Nigeria and other developing countries.
To conclude it can be said that many contributions to the literature test for
the existence of the Fisher effect and also try to determine the relationship
between interest rates and inflation. Better information on the behaviour of
interest rates would greatly benefit economists. The literature shows that
inflation and interest interact differently not only in different economies
but also at different times as well. In this study, similar to other studies in
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the literature, the researcher examines whether an interaction between
interest rates and inflation exists in the Botswana context and whether
monetary policy is a determinant of inflation.
Chapter 2
Methodology
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2.1 Introduction
This chapter will present the research methodology that is to be used in the
study. The chapter will attempt to address issues related to sampling
scheme, period covered by study, procedure of data collection, processing
and source of information, limitations of the study and chapterisation.
Methodology, according to Mertens (2002) and Dunn (2002), is a plan that
includes description of methods such as document review, interviews and
questionnaires used to generate relevant information about a particular
study.
A 11-year period between 2000 and 2010 was selected on which the
research is based. The period was chosen because it gives the study the
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opportunity to determine the effect of various economic conditions on this
causal relationship.
Data collected for the research will be from secondary sources mainly
government institutions like the Bank of Botswana and Statistics Botswana.
Secondary data will be useful in building the model and conducting tests
thereon.
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2.6 Limitations of the Study
One major limitation of the study is that it does not take into account the
impact of other economic variables on the causal relationship between
interest and inflation rate. Other economic variables like GDP and the
government economic policy framework may have an impact on this causal
relationship but their impact is not explored by this particular study.
2.7 Chapterisation
Chapter 2: Methodology
Chapter 3
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3.1 Introduction
This chapter presents the results of the study and discussions thereof. This
study uses records from 2000 to 2010 on Botswana’s economic data. The
primary source of data was the Bank of Botswana publications (Botswana
Financial Statistics, Bank of Botswana Research Department) accessed
through the Botswana National Archives and Records Services (BNARS).
Data was analyzed using quantitative method; the data was then presented
using various statistical tools such as percentages and graphs. The study
used a simple linear regression formula to get the correlation between
interest rates and inflation rates. Linear regression was used to model the
relationship between the two explanatory variables.
Table 1
Summary Statistics
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Variable Observatio Mean Maximu Minimum Standard
n m Deviation
Interest rate 44 14.14 17.0 9.33 3.82
Inflation rate 44 6.86 14.5 1.9 4.21
Table 1 shows the summary statistics on the variables used in the study.
The data ranged from year 2000 – 2010.For each variable quarterly data
was used. This means that for the eleven year period there total number of
observations were 44 per each variable. Interest rate had 44 observations
with a mean of 14.14 and a standard deviation of 3.82. The interest rate
ranged from 9.3% to 17.0%. The results show that inflation rate had 44
observations that ranged from a low of 1.9% to 14.5% with a mean rate of
6.86 and a standard deviation of 4.21
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Time Period
The rate of inflation was rising steadily from 2000 and it reached its peak in
the first quarter of 2003. Thereafter the annual rate of inflation saw a
marked decline in the last two quarters of year 2003 reaching a minimum
of 1.9%.Year 2004 a steady rise in the inflation rate and this trend
continued up until the second quarter of 2008 where the rate reached its
peak. The end of 2008 the rate went on a decline and started stabilising in
the third quarter of 2009. The interest rate on the other hand was stable
from 2000 to the third quarter 2005.Thereafter it rose by about a
percentage point reaching a peak in the third quarter of 2008. The rate
started declining and lost about five percentage points by 2010.
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3.3 Regression Analysis
Table 3 Coefficients a
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Constant
(Interest
rate)
0.154 0.031 0.067 0.2378 0.0221
Inflation
Hypotheses
H0 : = (Interest rate is not a useful predictor of inflation.)
H1 := (Interest rate is a useful predictor of inflation.)
The significance level is less than 0.05 and therefore the null hypothesis can
be rejected. This means we have to accept H1, that is the rate of interest is a
useful predictor of the inflation rate in Botswana. Importantly, note that the
b coefficient is positive number which means that higher rate of interest is
associated with higher rate of inflation.
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Model Summary
b
Fig 4
Inflation/Interest Scatter Diagram
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Inflation Rate
Interest Rate
Each point represents an (x,y) pair (in this case the interest rate, and the
rate of inflation). Note that the independent variable is on the horizontal
axis (or X-axis), and the dependent variable is on the vertical axis (or Y-
axis). The points on the scatter diagram form a general positive linear
pattern ie an increase in both variables. This therefore points to the
existence of a direct linear relationship between inflation and interest rate.
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3.4 Discussion of Findings
Previous studies have shown evidence of both the existence and non-
existence of the Fisher Effect using different methodological approaches.
Interest rates are part of monetary policy, money supply reflected in the
market and can be used as a means of neutralizing inflation (Asghapur et
al., 2014). Asghapur, Kohnehshahri and Karami.(2014) agreed that interest
rates have a negative relationship to inflation. Ghazali (2003) found that
there is no significant relationship between interest rates with inflation.It is
also supported by Kandel, Ofer, and Sarig (1996) which states that interest
rates negatively correlated to inflation.
The significance level of 0.0221 is less than 0.05 and therefore the null
hypothesis can be rejected (Table 3) .The results therefore suggest that
interest rate in Botswana has a significant impact on the rate of inflation.
However, different results have been attained in many studies. While the
lack of a statistically significant relationship between the two variables
remains theoretically plausible from the standpoint of the extant literature,
the role and impact of other variables like GDP, exchange rates and
government policy cannot be ruled out. Dwyer & Hafer (1988), for example,
stressed that the relationship between interest rate and inflation may hold
for short run circumstances therefore a long run relationship test is
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attached with a probability of no positive association between the
variables. This study used an eleven year period and the results showed an
association between the two variables over that time period.
In the short run, monetary policy influences inflation and the economy-
wide demand for goods and services--and, therefore, the demand for the
employees who produce those goods and services--primarily through its
influence on the financial conditions facing households and firms.
Movements in short-term interest rates also influence long-term interest
rates--such as corporate bond rates and residential mortgage rates--
because those rates reflect, among other factors, the current and expected
future values of short-term rates. In addition, shifts in long-term interest
rates affect other asset prices, most notably equity prices and the foreign
exchange value of the Pula. For example, all else being equal, lower interest
rates tend to raise equity prices as investors discount the future cash flows
associated with equity investments at a lower rate.
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In turn, these changes in financial conditions affect economic activity. For
example, when short- and long-term interest rates go down, it becomes
cheaper to borrow, so households are more willing to buy goods and
services and firms are in a better position to purchase items to expand their
businesses, such as property and equipment. Firms respond to these
increases in total (household and business) spending by hiring more
workers and boosting production. As a result of these factors, household
wealth increases, this spurs even more spending thereby raising the
inflation rate.
3.5 Summary
The descriptive results showed that there has not been a very high volatility
in both interest and inflation rates since 2000. The regression results
showed that interest rate has a significant influence on inflation rate. It can
be therefore be concluded that the study found out that the impact of
interest on inflation in Botswana is statistically significant.
Chapter 4
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Conclusions and Recommandations
4.1 Introduction
This chapter presents the conclusions made from the study, limitations of
the study, recommendations for policy and practice, and areas for further
research.
4.2 Conclusions
This study explored the impact of interest rates on the rate of inflation in
Botswana.. The study concluded that interest rate does have a significant
influence on the inflation rate in Botswana as the results of the regression
and hypothesis tests showed. Therefore, the fluctuations in the interest
rates over the recent past have had a major impact on the levels of inflation
rate in Botswana. The implication of this is that the rate of inflation is
largely affected by the prevailing interest rates. The findings points to the
possible influence of other economic variables on the inflation rate in
Botswana.
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The study did not expand the list of control variables in order to gather
more determinants of inflation rate in Botswana. The focus of the study was
on the impact of interest rate only but this may not be adequate to explain
the fluctuations in the rate of inflation. The period under study was affected
by a recession and the study did not explore the possible impact of this on
the rate of inflation. The currency exchange rate, GDP and government
economic policy may also have had an impact on inflation rate. There is also
need to use a combination of both primary and secondary data in order to
gather qualitatively the issues that may affect the levels of interest and
inflation rates in Botswana as such methodologies have not been explored
in this study.
The other limitation may also be found in the regression analysis method
used in this study. The correlation coefficient is a dimensionless number
since it is a proportion. A low correlation does not necessarily imply that
the variables are unrelated, but simply that a straight line poorly describes
their relationship. A nonlinear relationship may well exist. Pearson’s
correlation coefficient does not identify non-linear association. A
correlation does not necessarily imply a cause and effect relationship but it
is merely an observed association between the two variables.
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improve annually so as to keep interest rates low and this will lead to
enhanced economic activities in the country. The study has shown that
there is a need to have a holistic approach in the management of economic
variables that have an impact on inflation because interest on its own does
not have a significant impact on inflation as shown by this study. The use of
interest rates to influence inflation must be done in tandem with other
macroeconomic variables if effective management of inflation is to be
realised.
REFERENCES
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1. R. Adalid and C. Detken. Liquidity shocks and asset price boom/bust
cycles. Working Paper Series 732, European Central Bank, Feb. 2007.
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10.Polan, M., & Grauwe, De. P. (2005). Inflation is always and everywhere
a monetary phenomenon. Scan.J. of economics 107(2), 239–259, 2005
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