EFFECT OF PRICE INSTABILITY ON ECONOMIC GROWTH IN

PAKISTANAn Econometric Approach

By

HASSAN BIN TARIQ

Student of MBA (III)Section: B

Roll no. 1014142

In the guidance of

M.A JALILSenior lecturer (Research Synopsis)

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Federal Urdu University of Arts, Science & Technology, KarachiCampus: Abdul Haq

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TABLE OF CONTENTS:

Page No. ABSTRACT ………………………………………………………. 3

SECTION – 1 >>> INTRODUCTION 4 to 5

1.1. Background ……………………………………… 41.2. Significance of study ………………………….. 41.3. Objective of research ………………………….. 5

SECTION – 2 >>> REVIEW OF LITERATURE 6 to 8

2.1. Introduction ……………………………………. 62.2. Literature Reviews…………………………….. 6

SECTION – 3 >>> TREND ANALYSIS 9 to 12

3.1 . 1 s t Period ………………………………………. 9 3.2. 2n d Period ………………………………………. 113.3. 3 r d Period ……………………………………….. 11

SECTION – 4 >>> DATA AND METHODOLOGY 13 to 15

4.1 Introduction …………………………………… 134.2 Choice of variables …………………………… 134.3 Methodology ………………………………….. 14 4.3.1 Regression analysis ………………………. 14

CONCLUSION ………………………………………………… 15

REFERENCES …………………………………………………. 16

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Abstract:

Pakistan is in the really big trouble which is the war against terror. Due to this unintended war, allocation of developmental funds with in the country has been disturbed and Pakistan has to approach IMF (International monetary funds) to restore its economy in November 20008. In this environment, there is no question of any new investment by local or foreign investors. More significantly the current government is not serious in solving the problems of deprived people.

This research focuses on the impact of price instability on economic growth. To achieve this objective, many economic variables have been selected which includes

>> Consumer expenditure on durable and non-durable goods and services (food, products, health care and so forth).>> The sum of all expenditures on investments (such as housing, retail inventory, structures and capital).>> Government spending on goods and services (military equipment and official salaries, for instance).>> The difference between products that are imported and products that are exported.

The data period covers from 1980 to 2008. Econometric models have been constructed to Identify main effects of price instability on economic growth. Proposed results are in favor of negative relationship between price instability and economic growth.

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SECTION- 1

Introduction1.1 . Background

Due to war on terror, Pakistan is paying high economical and social cost. The current government has to face enormous challenges at economic and social fronts, due to the policies of past government. These economic problems have become more crucial with the continuity of previous government policies by the present government. Secondly government is not making any appropriate policy formulation to rectify the major issues like energy crises price instability, low exports, low foreign exchange reserves and other social and political issues which are giving negative impact on economic growth of Pakistan.

Price instability and economic growths are momentously affected by the war on terror. These variables are directly inter\linked with one another. Price instability exposes an unstable economy in which the values of goods depreciate with time to time. Employees demanding high wages to overcome there increasing cost of output. That’s why, manufacturers in turns to raise the price of their selling goods to cover the increase of wages of employees.

When the demand of wages increase and the price of goods increase than inflation rate is also increases. Inflation include deficit financing, decrease in foreign remittance, dependency on economy on foreign economic assistance, terrorism or fear of terrorism, devaluation of rupee, decrease in foreign direct investment large scale manufacturing industry, effects imports exports and balance of trade, agriculture and e.t .c.

1.2 . Significance of study:

The increase in inflation cause decreasing the economic growth. Inflation rate increased in Pakistan during fiscal year (2010-11) is very high which 11.0% is. It is creating the dangerous situation for the consumers and producers. And now we are facing the energy crises. Industrial sector is really very affected and particularly daily wagers are getting unemployed which is reducing the quantity of consumption along with decrease inn overall economic activiti8es of our country.

The significance of the study is to explore the reasons that caused increasing the current prices and its direct effect on economic growth.

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Pakistan is full of poor peoples living below the poverty line are affecting most by this high inflate ion rate. The quantity of poor peoples is increasing day to day. The difference between rich and poor is become so high after being an ally in war on terror. People could not save their income, which create a very bad condition for economy. In the budget 2009-10, Pakistani government ha imposed value added tax, which intensified inflationary pressure on poor peoples.

1.3 . Objective of research :

The main objective of research is: - The impact of price instability on economic growth of Pakistan.To achieve this objective econometric model has been developed to see the impact of price instability on economic growth. Some variables have been selected for this purpose.

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SECTION – 2

REVIEW OF LITERATURE

2.1 . Introduction :

This section analyzes relationship between price instability and economic growth. Several studies have highlighted negative effects of price instability on economic growth.

2.2 . Literature reviews.

Barro (1995)He has examined the relationship between economic growth and inflation. He has observed 5 year average data of 100 countries during the period from 1960-1990. The author has used the instrumental variables estimate result that showing increase in inflation by 10 percentage point per year slows the growth of per capita GDP by 2 to 3 percentage points per year. The author found that inflation has an adverse effect on economic growth with small magnitude but has long term effects on standards of living with greater scale.

Peter Rousseau and Wachtel (2002)They found that, there is negative relationship between inflation and economic growth and positive relationship between economic growth and financial development. The authors examined the triangle of relationship between financial development, inflation and economic growth with the data from 84 countries covering the period of analysis from 1960 to 1995. Literature suggests that finance and growth relationship is stronger than inflation and economic growth relationship.

Vaibhav, Dholakia and kumar (2008)They has discussed interrelationship between inflation, economic growth and saving rate for southeast and south Asia in synchronized equation framework using two stage least squares. The relationship between saving rate and economic growth has found positive. Inflation has positive effect on saving rate and considerably negative effect on economic growth. This research shows that at lower rate of inflation relationship is positive but high rate of inflation describes negative effect on economic growth.

Bruno and Easterly (1998)

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They have described negative relationship between inflation and economic growth in the long run.

Khan and Senhadji (2001)They analyzed the effect of inflation and economic growth using the data of 140 developed and developing countries. The period of analysis has covered from 1960 to 1998. The authors have used several models for for various level of inflation. If inflation is known, ordinary least square (OLS) model is used for estimation. But if inflation is not known, it has measured with other regression parameters.

Huybens and smith (1998-99)They has analyzed that expected increase in the rate of inflation can slow down economic growth by interfering with the ability of the financial sector to allocate resources efficiently. Number of theoretical studies has attempted to explain that how expected changes in the rate of inflation affect financial system and long term economic growth.

Erman and Aydin (2008)They analyses the relationship between economic growth and inflation. There are different views of economists about the relationship between inflation and economic growth. Accordance with policies, increased in demand has caused an increase in production as well as inflation. Phillips curve hypothesizes that inflation positively affect growth by creation of low unemployment rate.

Kannan and joshi (1998)Analyze trade off between economic growth and inflation. This research examines threshold inflation rate for India using the methodology of sarel (1996) with a sample (1981-1996). Main results are that inflation more than 6 percent per annum would have considerable downward impact on growth in India. Research results shows that inflation rate below the threshold inflation have some positive effect on growth. This positive influence is available up to maximum upper limit of 6 percent.

Gylfason and herbertsson (2001)Their research demonstrates that inflation is monetary phenomenon. Economists find it unlikely that inflation and economic growth is studied. An econometric model is used to determine the potential impact of inflation on economic growth with the help of following variables like saving and real interest rates,financial development,budget deficit,inflation and efficiency in production.

Osama (2004)

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He depicts how inflation effects economic growth. The data is collected from Jordan using negative structural break point method. One of the aspect of the research shows that inflation has positive low up to 2% after that the effect becomes negative.

M. khan (2002)He estimated nonlinearity in the relationship between inflation and economic growth. This relationship occurs from the existence of threshold effect of inflation growth. There is significant level of inflation which effect growth and inflation hinder economic growth. Higher inflation increases credit ration and condensed expansion of bank credit so this phenomenon reduced investment and decreased economic growth.

Gillman and Harris (2004)They portray a considerable negative effect of inflation on growth rate. Moreover the results repeat the substantial positive inflation and economic growth relation when inflation rate is low for emerging countries. Result of instrumental variable show negative effect of inflation on economic growth.

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SECTION- 3

TREND ANALYSISINFLATION AND G.D.P 1981-2008

This study divided three following periods:

3.1. 1 s t Period:

First period starts from1981 to 1997. In this duration inflation rate in Pakistan was in double digits as given in the table 3.1.1. Economic growth or GDP was slow down because of the double digit inflation in country. Due to this increase in inflation the supply of products was not fulfilling the demands in the country and cause of price increasing.

To measure the price level, economists select a variety of goods and construct a price index such as the consumer price index (CPI). This is one measure of inflation. The CPI measures inflation as experienced by consumers in their day-to-day living expenses; it is the ratio of the value of a basket of goods in the current year to the value of that same basket of goods in an earlier year. By using the CPI, the inflation rate can be calculated. This is done by dividing the CPI by the beginning price level and then multiplying the result by 100.

Inflation rate = (ACPIcy – ACPIpy) x 100 ACPIpy

The GDP deflator is another very important measure of inflation as it measures the price changes in goods that are produced domestically. Its formula is:

GDP Deflator = (Nominal GDP / Real GDP) x 100

The main reason of high inflation rate in economy was more supply of money to the public. This incident was occurring by state bank of Pakistan. State bank wants to achieve macro economics goals by this attempt. This plan supports economic growth and reduces unemployment for short run. But it creates high decrease in economic growth in long run. The growth rate of CPI and GDP has been mentioned in the table 3.1.1

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Table 3.1.1 : Growth rates of inflation rate and GDP

Year CPI% GDP% Year CPI% GDP%1980-1981 13.8 6.4 1990-1991 12.7 5.42

1981-1982 11.1 7.56 1991-1992 10.6 7.57

1982-1983 4.7 6.79 1992-1993 9.8 2.1

1983-1984 7.3 3.97 1993-1994 11.3 4.37

1984-1985 5.7 8.71 1994-1995 13 5.06

1985-1986 4.4 6.6 1995-1996 10.8 6.6

1986-1987 3.6 5.81 1996-1997 11.8 1.7

1987-1988 6.3 6.44

1988-1989 10.4 4.67

1989-1990 6 4.44 Source: Federal Bureau of statistics

When we consider inflation rate and economic growth we find that, the trend of CPI is very volatile and it is ranging from 3.6% to 13%with in 17 years. Comparatively, overall there is negatively relation between CPI and economic growth. In 1995-1996 CPI is 10.8% and economic growth is 6.6%. In 1996-1997 CPI increase up to 11.8% and economic growth rapidly decrease to 1.7%. The table shows that, inflation supports economic growth in short run but in long run it caused great declining in economic growth.

If the government formulates any policy changes to support economic growth like an increase in wages rates of employees then consumption level of population will improve along with an increase in production level, boost economic growth and reduced unemployment. But the effect increasing money supply in the economy on inflation was negative so the inflation rate increased gradually.

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3.2. 2 nd period:

The second period for trend analysis is from 1998 to 2004. in this period government took some steps to control inflation by making some changes in fiscal policies. Due to these changes in monetary fiscal policies and take stricked action by the government, there is increase in GDP rapidly and inflation rate decrease respectively.

Table 3.2.1 : Growth rates of inflation rate and GDP

Year CPI% GDP%1997-1998 7.8 3.491998-1999 5.7 4.181999-2000 3.6 3.912000-2001 4.4 1.962001-2002 3.5 3.112002-2003 3.1 4.732003-2004 4.6 7.48

Source: Federal bureau of statistics

According to the table 3.2.1, as CPI goes down up to 4.4% then it has negative impact on economic growth. The relationship between CPI and economic growth become positive if the inflation decrease up to certain lowest extent. In 2000-01 CPI increase from 3.6% to 4.4% and economic growth decrease from 3.91% to 1.96%. In 1998-99, inflation rate decreases from5.7% to 3.6% which has negative impact on economic growth.

3.3. 3 rd Period:

In the third period, growth rate of inflation and GDP of 2004-2008 has been mentioned in the table 3.3.1

Table 3.3.1: Growth rates of inflation rate and GDP

Year CPI% GDP%2004-2005 9.3 8.96

2005-2006 7.9 5.82

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2006-2007 7.8 6.81

2007-2008 12 4.1Source: Federal bureau of statistics

This period shows that, inflation rate during this time period shot up dramatically in 2007-08 and the effect of double digit inflation decreased economic growth. The main reason behind this inflation is the shortage of supply of goods in the market which doesn’t meet demand requirements. Another reason is severe shortage of electricity in different industries which have negative impact on economic growth in Pakistan. When the demands are not fulfilled domestically then government imports the goods and commodities, which causes an increase in inflation rate and decrease in GDP growth rate.

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SECTION – 4

DATA AND METHODOLOGY

4.1 .INTRODUCTION:

This section focuses on methodology used to determine the effect of price instability on economic growth. This section also discusses study design, choice of variables and regression analysis.

4.2 .CHOICE OF VARIABLES:

The variables, used in this study are as follow:

>> Consumer expenditure on durable and non-durable goods and services (foods, products, health care and so forth).>> The sum of all expenditures on investments (such as housing, retail inventory, structures and capital).>> Government spending on goods and services (military equipment and official salaries, for instance).>> The difference between products that are imported and products that are exported.

This research expresses the relationship between CPI (inflation) and GDP growth. To achieve this objective a regression equation has been developed to see the impact of price instability on GDP growth. Price instability has been measured through CPI. The sources of data are statistical bulletins published be federal bureau of statistic (FBS), Economic surveys of Pakistan, state bank of Pakistan publications, Asian development bank (ADB) annual reports and development indicators.

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4.3 .METHODOLOGY:

To analyze the impact of price instability on economic growth a linear econometric model has been developed. Simple OLS (ordinary least square) method has been used to see the relationship of the variables.

The following equation is explaining the effect of inflation on GDP.

4.3.1 REGRESSION ANALYSIS

To analyze the effect of price instability on economic growth following econometric model has been developed

Y = βo + β1C + β2I + β3G + β4NX

Where:Y : Gross Domestic Product (GDP)C : Consumer Expenditure on durable and non-durable goods

and services.I : Investment G : Government spending on goods and services.NX : Difference between imported products and exported

products (NX=exports - imports)

To analyze the impact of price instability on GDP different variables have been selected. Like consumer spending, government spends, countries business spending on capital (investments) and import exports.

All variables have significant effect on GDP like consumer expenditure, because when inflation (CPI) becomes high then consumer expenditure increase and purchasing power decrease. And prices of goods are very high. All this process consumption level is decline. CPI has the negative impact on GDP.

Investment grows at much faster pace then consumption or GDP irrespective of interest rate movements. Consistent increase of interest rate would drastically worsen the cost of existing loans for past

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investment. Disappointment from demand grow may combine with this effect to reduce investment dynamics. Positive expectations towards the economy may also bring leading firms to invest earlier than the through. Investment has the positive effect on GDP.

Government programs provide valuable “public goods” such as education and infrastructure. They also claim that increase government spending can bolster economic growth by putting money into people’s pocket. The increase in government expenditure on public cause increases in manufacturing and decrease the unemployment. The effect on GDP of government expenditure is positive.

Imports have negative effect on economic growth because there is outflow of money. If a country prefers to import finish goods then there are two main losses for the economy, one is outflow of money and the other is damages of local industry.

Exports have the positive effect on GDP growth. When exports of manufacturing and agricultural goods are increase, unemployment decrease and the purchasing power of peoples increase. This situation enhances the living standard of population and GDP growth.

CONCLUSION:

In this research, the effects of price instability on economic growth in Pakistan are discussed. We know that, Pakistan’s economy is in the big trouble. There is a lot of social and economic problems in which high poverty rate, poor health facilities, low literacy rate, high inflation rate, unemployment, low economic growth, political crises and e.t .c. government is not taking any serious action to control this declining of Pakistan’s economy and increasing inflation.

To achieve the objective of this research, an econometric model has been developed. The variables have been selected for analysis. The data period covers from 1980 to 2008.

The important result of this research is in the favor of negative relationship between price instability and economic growth. The main reason behinds this negative relation is that, when inflation increase, purchasing power of consumers decrease than the consumption level automatically decreases because the real income and real value of money reduce according to the proportion of changes in prices. Consumption has

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direct relationship to GDP. It means when GDP decreases than consumption will also decrease and vise versa. Due to this relationship and other variables of regression equation to the GDP prove that, Price Instability has significant effect on GDP and there is negative relationship.

REFERENCE

Barro, Robert, 1995, “inflation and Economic Growth” NBER working paper

Bruno.M. and W. Easterly (1996) “Inflation and Growth: In search of Stable Relationship” Federal Bank of St. Louis Review Vol. 78 No 3

Bruno, M. and Easterly, W. (1998) “Inflation Crisis and Long-Run Growth,” JME 41, 3-26

E. Erbaykal and H. A. Okuyan (2008) “Does Inflation Depress Economic Growth? Evidence from Turkey” International Research Journal of Finance and Economic, ISSN 1450-2887 Issue 17

Erman Erbaykal Sr. and H. Aydin Okuyan (2008) “Does Inflation Depress Economic Growth? Evidence from Turkey” International Journal of Finance and Economics, Vol, 13, No. 17, 2008

Ghosh and S. Philip (1998) “Inflation, Disinflation, and Growth” IMF Working Paper No.WP/98/68 Washington, D.C; IMF.

Huybens, E. and B. D. Smith, (1999) “Inflation, financial market and long-run Real activity,” Journal of Monetary Economics

Kannan, R. and Josh, H. (1998), “Growth-Inflation Trade-off; Empirical Estimation of Threshold Rate of Inflation for India”, Economic and Political Weekly, October.

Khan M.S. and S.A. Senhadji (2001) “Threshold Effects in the Relationship between Inflation and Growth” IMF Staff Papers Vol.48 No. 1 pp. 1-22

M. Gillman, M. Harris and L. Matyas (2004) “Inflation and growth; Explaining a negative effect” Empirical Economic

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Peter L. Rousseau, Paul Wachtel (2002) “Inflation Thresholds and the Finance-Growth Nexus” Journal of International Money and Finance SSRN-id315967-pdf

Vaibhav C. R. H. Dholakia and B. Kumar (2008) “Inter-Relationship between Economic Growth, Saving, and Inflation in Saia”

Y. A. Mubarik (2005) “Inflation and Growth: An Estimate of the Threshold Level of Inflation in Pakistan” SBP-Research Bulletin Volume 1, Number 1, 2005

Web-sites:

>> majalil .yolasite.com/ >> en.wikipedia.org/wiki/Inflation>> www.unicef.org / >> www. sbp .org.pk/ >> pkeconomists.com/>> data.worldbank.org/>> www.statpak.gov.pk/>> www.cbr.gov.pk/>> www.finance.gov.pk/ survey / >> www. dawn .com/

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