chapter: 1 Introduction<br />1.1. BACKGROUND<br />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.<br />Gross Domestic Product <br /> 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. <br />These are that: <br />GDP is the value of the final goods and services produced in the economy during a given Period.<br />GDP is the sum of value added in the economy during a given period.<br />GDP is the sum of incomes in the economy during a given period.<br />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.<br />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. <br />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. <br />Higher interest rates reduce the growth of consumer spending and economic growth. This is because:<br /><ul><li>More incentive to save in a bank rather than spend.
More expensive to borrow, therefore less spending on credit and less investment.</li></ul>1.2. Purpose of the study:<br />I am conducting research to find out the impact of interest rate on GDP in Pakistan. <br />1.3. Scope of the study:<br />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. <br />1.4. Objective of research:<br />To find out the Impact Of Interest Rate on GDP.<br />chapter:2 Literature Review<br />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<br />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.<br />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. <br />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).<br />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. <br />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.<br />chapter.3 Methodology<br />3.1. Hypothesis<br />H: Interest rate has a significant impact on GDP.<br />3.2. Data Required<br /><ul><li>For the analysis annual data of Interest rate and annual of data GDP were used.
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.</li></ul>3.4. How to use that data<br />Interest rate data with respect to banks and GDP of Pakistan from secondary sources have been taken . <br />3.5. Sample Size<br />Sample size is 45; annual data of interest rate and GDP contribution from year 1960 to 2005 is used.<br />3.6. Statistical Technique<br />Regression Analysis Technique is used to check the dependability of GDP by interest rate and examined how much both are associated with each other.<br />3.8. Statistical Tool: <br />SPSS software is used to analyze the data.<br />chapter 4 Data Analysis<br />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.<br />4.1 Regression<br />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.<br />4.1. Result:<br />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%.<br />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%.<br />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.<br />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.<br />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. <br />4.2CHARTS<br />