CHAPTER: 1 INTRODUCTION

1.1. BACKGROUND

Interest rate is one of the important macroeconomic variables, which has an impact on economic

growth. Generally, interest rate is considered as the cost of capital, means the price paid for the

use of money for a period of time. a borrower point of view, interest rate is the cost of borrowing

money (borrowing rate), from a lender’s point of view, interest rate is the fee charged for lending

money (lending rate). Good investors always look for investing in an efficient market. In an

inefficient market few people are able to generate extra ordinary profit causes of confidence

losses of general people about the market. In such cases, if the rate of interest paid by banks to

depositors increases, people switch their capital from share market to bank. This will lead to

decrease the demand of share and to decrease the price of share and vice versa. On the other way,

when rate of interest paid by banks to depositors increases, the lending interest rate also increases

lead to decrease the investments as a result production decreases which will become the cause of

lower gross domestic product. Theoretically there is inverse relationship between high interest

rate and GDP. Among macroeconomic correlations, interest rate and gross domestic product

relationship places a fundamental role.

Gross Domestic Product

The measure of aggregate output in the national income accounts is Gross

Domestic Product (GDP) according to Blanchard (1997). He stated that there

are three ways of thinking about an economy’s GDP.

These are that:

GDP is the value of the final goods and services produced in the economy

during a given Period.

GDP is the sum of value added in the economy during a given period.

GDP is the sum of incomes in the economy during a given period.

When the government increase interest rate consumers will consume low and save high amount of their income which also affect the multiplier effect. In the developed countries the government

is pursing the policy of low interest rate to encourage investors to invest more to produce more goods.

The resulting low or negative interest rates discourage saving mobilization and channeling of the

mobilized savings through the financial system. This has a negative impact on the quantity and

quality of investment and hence GDP. Therefore, the expectation of interest rate reform was that

it would encourage domestic savings and make loan able funds available in the banking

institutions. The critical question, therefore, is whether real interest rates have any positive effect

on economic growth in Pakistan. The purpose of this study is to investigate the relationship

between real interest rates and GDP in Pakistan. This is important because the behavior of interest

rates, to a large extent, determines the investment activities and hence GDP of a country.

There is no doubt a theoretical link exists between interest rates and the financial structure of

firms. Lower real interest rates in a pure market economy will boost investments and so also

increase productive capacity.

Higher interest rates reduce the growth of consumer spending and economic growth. This is

because:

More incentive to save in a bank rather than spend.

More expensive to borrow, therefore less spending on credit and less investment.

1.2. Purpose of the study:

I am conducting research to find out the impact of interest rate on GDP in Pakistan.

1.3. Scope of the study:

The scope of this research not only limited on the combination of interest rate and GDP but it

also give the opportunity to other researchers to find an impact of interest rate with the other

microeconomic variables.

1.4. Objective of research:

To find out the Impact Of Interest Rate on GDP.

CHAPTER:2 LITERATURE REVIEW

Oresotu (1992) explains that the basic functions of interest rates in an economy in which

individual economic agents take decisions as to whether they should borrow, invest, save and or

consume, are summarized by International Monetary Fund (IMF) under three aspects, namely

interest rates as return on financial assets serve as incentive to savers, making them defer present

consumption to a future date interest rates being a component of cost of capital affect the demand

for and allocation of loan able funds, and the domestic interest rate in conjunction with the rate

of return on foreign financial assets and goods are hedged against inflation. These broad roles of

interest rates according to Oresotu (1992) emphasize their significance in the structure of basic

prices and indicate the need for study about their determinants under a flexible regime.

Sundararajan (1987) examined the linkages among interest rates, the debt equity ratio of firms,

the overall cost of capital, savings, investment and growth in the Korean economy during 1963–

81. He used a dynamic framework that recognizes the complex interactions among these

variables. According to him, a change in the administered interest rate affects the unregulated

rate, the overall cost of capital, the real interest rates and the debt equity choice of firms. This

thereby sets in motion a chain of responses influencing the desired level of the capital stock and

its profitability, as well as the availability of savings and the consequent speed of adjustment of

the actual capital stock to the desired level.

Rate of interest has always been featured as one of the important considerations in explaining the

saving behavior of individual. Saving, according to Classical economists, is a function of the rate

of interest. The higher the rate of interest, the more money will be saved, since at higher interest

rates people will be more willing to forgo present consumption. Based on utility maximization,

the rate of interest is also at the center of modern theories of consumer behavior, given the

present value of lifetime resources. For a net saver an increase in the rate of interest will have an

overall effect composed of two partial effects: an income effect leading to an increase in current

consumption and a substitution effect leading to a reduction in current consumption

(Hadjimatheou, 1987).

Lanyi and Saracoglu (1983) also find a positive and significant relationship between interest

rates and the rate of growth of real GDP. The World Bank also finds a positive relationship

between real interest rates and economic growth in 33 developing countries, for the period 1965-

85 (World Bank, 1989). Roubin and Sala-I-Martin (1992) use a more sophisticated method to

examine the link between financial liberalization and growth. The authors conclude that financial

repression tends to lower growth. However, Gibson and Tsakalotos (1994) cast doubts on the

Roubin and Sala-I-Martin (1992) results. The authors argue that, just as in other empirical work

in this area, the results of Roubin and Sala-I-Martin (1992) could suffer from omitted variable

bias because each measure of financial repression is added individually. Khatkhate (1988) finds,

in a sample of 64 developing countries, that there is no difference in average real GDP growth

between countries having below-average and above-average real interest rates. Likewise, De

Gregorio and Guidotti (1995) conclude that interest rates are not a good indicator of financial

repression or distortion. The authors suggest that the relationship between real interest rates and

economic growth might resemble an inverted U-curve: “Very low (and negative) real interest

rates tend to cause financial dis-intermediation and hence tend to reduce growth”, as implied by

the McKinnon-Shaw hypotheses. On the other hand, very high real interest rates that do not

reflect improved efficiency of investment, but rather a lack of credibility of economic policy or

various forms of country risk, are likely to result in a lower level of investment as well as a

contraction in excessively risky projects (De Gregorio and Guidotti, 1995:437). Gupta (1984,

1986), however, finds conflicting results between interest rates and economic growth in two

studies. On the one hand, Gupta‟s (1984) cross-section study of 25 Asian and Latin American

countries finds an unfavorable effect of higher interest rates on the rate of economic growth. On

the other hand, Gupta (1986) finds evidence that higher real interest rates raised economic

growth in India and Korea.

Other channels through which the interest rates influence the financial structure of firms include

the neoclassical rental-wage ratio by which higher interest rates raise the relative price of capital

and thereby encourage more intensive use of capital and capitallabour substitution. Another is

the project evaluation mechanism by which higher real interest rates may improve the quality

and efficiency of bank credit rationing, thereby weeding out projects that were profitable only

with lower interest rates and encouraging those with higher yields. The financial deepening that

directly influences factor productivity through higher real rates of interest is another channel, and

finally there is the portfolio choice that diverts savings from low-yielding, self-financed

investments to the acquisition of financial assets, through higher yields (McKinnon, 1973 at el).

From all indications, however, the link between the interest rates and corporate capital structures

as well as the pattern of influence of corporate financing strategies on the effectiveness of

interest rate policies, warrant attention because of its implication for resource mobilization,

production and growth.

CHAPTER.3 METHODOLOGY

3.1. Hypothesis

H: Interest rate has a significant impact on GDP.

3.2. Data Required

For the analysis annual data of Interest rate and annual of data GDP were used.

3.3 . Sources of Data

The data of interest rate have been taken from ministry of finance and state bank of Pakistan and

the data of GDP have been taken from state of Pakistan.

3.4. How to use that data

Interest rate data with respect to banks and GDP of Pakistan from secondary sources have been

taken .

3.5. Sample Size

Sample size is 45; annual data of interest rate and GDP contribution from year 1960 to 2005 is

used.

3.6 . Statistical Technique

Regression Analysis Technique is used to check the dependability of GDP by interest rate and

examined how much both are associated with each other.

3.8. Statistical Tool:

SPSS software is used to analyze the data.

CHAPTER 4 DATA ANALYSIS

Statistical analysis involved summarizing data variable of GDP in relationship with interest rate. Values

of Gdp and interest rate data were put in the regression model and later on linear regression method was

used to test the relationship between interest rate and GDP. The level of statistical significance was P <

0.05.

4.1 Regression

Regression analysis was adopted to verify the hypothesis. This method can describe the

relationship between one continuous criterion (i.e. dependent) variable and two or more

continuous predictor (i.e. independent). Dependent variable is GDP and the independent variable

is interest rate.

4.1. Result:

Model Summaryb

.804a .647 .638 678416.652 .647 78.649 1 43 .000 1.729Model1

RR

SquareAdjustedR Square

Std. Error ofthe Estimate

R SquareChange

FChange df1 df2

Sig. FChange

Change Statistics

Durbin-Watson

Predictors: (Constant), INTERESTRATEa.

Dependent Variable: GDPb.

This table gives us the R-value (.804), which represents the correlation between the observed

values and predicted values of the dependent variable GDP, confidence interval used is 95%.

R-Square is the coefficient of Determination which gives the accuracy of the model. In model-1

it is .647 it means that the independent variable can predict the dependent variable by 64.7%.

Here the value of adjusted R-Square is 0.638 which means the independent variable in the

model can predict 63.8% of the variance in dependent variable. Adjusted R-Square gives the

more accurate information about the model fitness if one can further adjust the model by his

own.

ANOVAb

4E+013 1 3.620E+013 78.649 .000a

2E+013 43 4.602E+011

6E+013 44

Regression

Residual

Total

Model1

Sum ofSquares df Mean Square F Sig.

Predictors: (Constant), INTERESTRATEa.

Dependent Variable: GDPb.

F-value is calculated by dividing regression mean to residual mean, in this case F-value is

78.649 and the p-value is given by 0.000 which is less that 0.05 therefore I can say that R-square

is significant.

Coefficientsa

-7767942 1080106 -7.192 .000

699177.5 78838.769 .804 8.868 .000

(Constant)

INTERESTRATE

Model1

B Std. Error

UnstandardizedCoefficients

Beta

StandardizedCoefficients

t Sig.

Dependent Variable: GDPa.

Now we test our hypothesis, we see that the p-value for regression coefficient of interest rate is

given by 0.000, which is less than 0.05; therefore null hypothesis is rejected so that I can say the

regression coefficient is not zero and there is dependency between two research variables that are

interest rate and GDP in Pakistan.

4.2CHARTS

Regression Standardized Residual3210-1-2

Fre

qu

en

cy

10

8

6

4

2

0

Histogram

Dependent Variable: GDP

Mean =1.15E-15Std. Dev. =0.989

N =45

Regression Studentized Deleted (Press) Residual3210-1-2

GD

P

5000000

4000000

3000000

2000000

1000000

0

Scatterplot

Dependent Variable: GDP