ECONOMICS ANALYSIS FOR MANAGERS

Relationship between
Interest rate and
Inflation rate
Research Report

/2014

Submitted By:
Rafia Masood

0344

Muqaddas Israr 2671

Submitted To:

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 Lucass 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 Results

Dependent Variable: INF

Method: Least Squares

Sample: 2002 2013

Included observations: 11

Variable

Coefficie
nt
Std. Error

t-Statistic

Prob.

9.784006 1.587371

6.163655

0.0002

INT

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

6.322819

Sum 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. Fstatistics 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.