Economics analysis for managers

Relationship between Interest rate and Inflation rate

Research Report

5/21/2014

Submitted By:

Rafia Masood 0344Muqaddas Israr 2671

Submitted To:

Sir Tehseen Iqbal

Abstract:

Purpose- The purpose of this study is to investigate the relationship between Interest rate and

Inflation rate in Pakistan.

Design/Methodology/approach- In this research paper secondary data has been considered from

different sources. It mainly employed quantitative methods. In this research paper, 11 years of

data was analyzed and it was tested in SPSS. The research tool which was applied is Regression

in order to understand the relationship between these variables.

Findings- The result showed that there is a significant relation found between inflation and

interest rate.

Keywords: Interest rate, Inflation rate, Pakistan.

1. Introduction:

For economic growth, Interest rate plays a very important role as it will initiate investment in an

economy. In theory inflation and interest rate are linked in Macro economics. Inflation rate is

referred to the rate at which prices of goods and services are raised whereas interest rate is the

rate which is charged by the lender from borrower for the assets which is used. While studying

macroeconomic different research studies showed that there is a relationship found between

inflation rate and interest rate. One of the famous studies which show relationship between

interest rate and inflation rate is Fisher equation. According to Irving Fisher there is a

relationship found between nominal and real interest rate and inflation. It is observed that when

interest rate is low people are able to take loans from banks which increased the consumption of

the people which cause growth in economy and cause increased in inflation rate as well. Certain

increase in interest rate can increased consumption, employment rate, growth rate but can

increased demand pull inflation which ultimately caused cost push inflation too.

In Pakistan, Government announces different policies in order to improve economic

condition and to control inflation. The reasons of not controlling inflation in Pakistan are the

address of right problem, inconsistent economics policies, basic infrastructure and

implementation of policies.

In Pakistan, interest rates decisions are taken by the State Bank of Pakistan. Currently in

Pakistan the interest rate is 10 %. Interest Rate in Pakistan averaged 12.58 Percent from 1992

until 2014, reaching an all time high of 20 Percent in October of 1996 and a record low of 7.50

Percent in November of 2002. Interest Rate in Pakistan is reported by the State Bank of Pakistan.

Whereas inflation rate in Pakistan was recorded at 9.18 percent in April of 2014. Inflation Rate

in Pakistan averaged 8.04 Percent from 1957 until 2014, reaching an all time high of 37.81

Percent in December of 1973 and a record low of -10.32 Percent in February of 1959. Inflation

Rate in Pakistan is reported by the Pakistan Bureau of Statistics.

The rest of the paper is organized as follows: Section 2 discusses the theoretical and

empirical literature on the effect of foreign direct investment and domestic investment on

economic growth. Section 3 describes model data and methodology. In section 4 results are

interpreted. Final section comprises of conclusion and suggestion.

2. Review of Literature

Traditionally it has been considered that interest rate has negative relationship with inflation rate

of recipient country. It is traditionally expected that interest rate will primarily produce a number

of favorable economic effects on the recipient countries. Basically interest rate is positively

related to consumption, investment and employment rate but is negatively related to inflation rate

as due to increase in purchasing power of recipient country.

2.1 Theoretical Background:

Alvarez, Lucas and Weber (2001) have studied that relationship between interest rate and

inflation rate. In order to study these variables, they have considered Taylor rules (John Taylor,

1993) within Keynesian framework but with an assumption of an economy with segmented

markets. By considering this model they tested that inflation can be reduced by increasing short

term interest rate. The result showed that by increasing short term interest rate inflation can be

reduced by using segmented markets model.

Maki (2005) has studied the asymmetric adjustment of the equilibrium relationship

between the nominal interest rate and inflation rate. A threshold cointegration approach was

applied on the Engle-Granger method. The data was considered of Japan. The result showed that

long run equilibrium was found between the nominal interest rate and inflation rate with

asymmetric adjustment.

Cox, Ingersoll and Ross (1985) have examined the theory of the term structure of interest

rates. In order to study the term structure of interest rates intertemporal general equilibrium

assets pricing model was used. In determination of bond prices anticipation, risk aversion,

investment alternatives and preferences about the timing of consumption are considered. The

model led to formulas for bond prices which are suitable for empirical testing.

Crowder and Hoffman (1996) have examined the long run relationship between nominal

interest rate and inflation. In order to investigate the relation he considered Fisher equation. The

data was collected from year 1952 to 1991 of USA. Anova was applied on the data to test the

claim. The result showed that in long run positive relationship found between nominal interest

rate and inflation rate.

Ireland (1996) has studies the long-term interest rate and inflation. In order to test the

relation between these two he has considered two thing Fisher theory and Lucas’s model. The

data was collected of USA from year 1969 to 1995. The result showed that long term rate is

reflected changes in long-term inflationary expectations.

3. Methodology:

In order to test the relation between interest rate and inflation rate, data was collected of

Pakistan. Dependent variable is inflation rate and independent variable is interest rate. 11 years

of data was collected from secondary source. The data was tabulated into SPSS and then

regression was applied to test the claim. Thus, hypotheses are:

H1: Interest rate has significant relationship on inflation rate.

H2: Interest rate has not significant relationship on inflation rate.

4. Estimation and ResultsDependent Variable: INFMethod: Least Squares

Sample: 2002 2013Included observations: 11

VariableCoefficient Std. Error t-Statistic Prob.  

C 9.784006 1.587371 6.163655 0.0002INT 0.064523 0.396664 0.162664 0.8744

R-squared 0.002931     Mean dependent var 9.786277

Adjusted R-squared-0.107854     S.D. dependent var 5.001689

S.E. of regression 5.264510     Akaike info criterion 6.322819Sum squared resid 249.4356     Schwarz criterion 6.395164

Log likelihood-32.77550     F-statistic 0.026460

Durbin-Watson stat 1.029803     Prob(F-statistic) 0.874376

Above table shows that C is constant and its value is 9.784006. Coefficient amount for variable

Interest rate shows that if there is one unit increase in Interest rate, Inflation rate will decrease by

6.45% others things remains same. P-Value of Interest rate probability is greater than 0.10 which

is 0.0000 so interest rate has negative and significant effect on inflation rate. R-squared value

indicates that 0.2931% of the variance can be predicted from the independent variable. F-

statistics value is 0.874376. Prob (F-statistics) shows that there is a combined significant effect

of independent variables on dependent variable.

5. Conclusion and Recommendation

From the beginning of globalization it has been argued that interest rate has a negative effect on

interest rate. Studies have found that interest rate has negative impact on inflation rate. The

objective of this study is to empirically test the effect of interest rate on inflation rate of Pakistan

by using time series data from 2002-2013. Least squares technique has been used. Result shows

that interest rate has negative significant impact on economic growth of Pakistan. It is suggested

that government should take care while making changes in policy. Concretionary monetary

policy is suggested in Pakistan context in order to control inflation. Government should follow

policy consistently. Interest rates on loans must be increased to reduce inflation rate.

References:

Alvarez, F., Lucas, R. E., and Weber,W. E. (2001), “ Interest rate and

Inflation”, The American Economic Review, Vol. 91 No. 2, pp. 219-225.

Maki,D. (2005), “Asymmetric adjustment of the equilibrium relationship

between the nominal interest rate and inflation rate”, Economics Bulletin,

Vol. 3, No.9, pp. 1-8.

Cox, J. C., Ingersoll, J. E., and Ross, S. A. (1985), “ A theory of the term structure of

interest rate”, Econometrica, Vol. 53, No. 2, pp. 385-407.

Crowder, W. J., and Hoffman, L. H. (1996), “The long-run relationship between nominal

interest rates and inflation: The fisher Equation Revisited” Journal of Money, Credit and

Banking, Vol. 28, No. 1, pp. 102-118.

Ireland, P. N. (1996), “Long-Term Interest Rates and Inflation”, Federal Reserve bank of

Richmond Economic Quarterly, Vol. 82, No. 1.