REGENT UNIVERSITY COLLEGE OF SCIENCE AND TECHNOLOGY

THE RELATIONSHIP BETWEEN INFLATION AND INTEREST RATE IN GHANA

BY VICTORIA NAA TAKIA NUNOO (0220208)

DISSERTATION SUBMITTED TO THE SCHOOL OF BUSINESS AND ECONOMICS IN PARTIAL FULFILLMENT OF THE REQUIREMENT FOR THE AWARD OF A BACHELOR OF SCIENCE DEGREE IN ECONOMICS WITH COMPUTING SEPTEMBER 2011

DECLARATION

CANDIDATE I hereby declare that this project report is the result of my own original research and that no part of it has been presented for another degree in this University or elsewhere

Candidates signature ..

Candidates name: Victoria Naa Takia Nunoo

Date

SUPERVISOR I hereby declare that this preparation and presentation of the project report was supervised in accordance with the guidelines on supervision of project work laid down by Regent University College of Science and Technology.

Supervisors signature .

Supervisors name: Mr Bernard Nyarko Boahen

Date

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PROJECT ABSTRACT The research, firstly seeks to examine and study the possible existing relationship between Inflation and Interest rate within the Ghanaian economy, as well as the trends of the variables over the stipulated period of time (1960-1995). A background of the study is talked about, giving a clear picture of what the research will entail. Furthermore, the work critically looks at the works consulted for the writing of this thesis constituting the Literature Review. An in depth analysis of the variables under study, is also explored and given by aid of graphs and charts for further understanding as well as conclusions drawn and recommendation made.

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ACKNOWLEDGEMENTS First and Foremost, thanks go to the Almighty God for his unending protection and wisdom for the completion of this thesis. A big thank you also goes to my supervisor Mr Bernard Boahen for his selfless support throughout the writing of this work. Secondly, I would like to thank Mr Godson of Ghana Statistical Service for finding time out of his busy schedule to help with data search. I also thank Sedik Adams as well as all Staff of Multi Tech Services who helped in any way to make this work a success. Last but not Least, many thanks go to my family and all programme mates, Clara, Wendy, Julia, Albert, Vidalyn, Amponsah, Seth, Baffour for the love and support.

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TABLE OF CONTENTS 1. INTRODUCTION 1.1 Background 1.2 Problem statement 1.3 Main objective 1.4 Research Questions 1.5 Justification of the study 1.6 Organization of the study 2. LITERATURE REVIEW 2.1 Introduction 2.2 What does Inflation mean? 2.2 1 Categories of Inflation 2.3 How inflation affects Investment 2.4 What does Interest rate mean? 2.5 What effects has Interest rate on consumption 2.5.1 Irving fisher consumption model 2.6 Relationship between inflation and interest rate 2.6.1 Irving Fisher Inflation equation 3. METHODOLOGY 3.1 Introduction 3.2 Research design
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PAGE 1 3 4 4 5 5

6 6 7 10 12 13 15 16 18

19 19

3.3 Data description 3.4 Research model 3.5 Regression analysis 4. DATA ANALYSIS 4.1 Introduction 4.2 Summary statistics 4.3 Graphical presentation 5. CONCLUSION AND RECOMMENDATION 5. 1 Introduction 5.2Conclusion 5.3 Recommendation REFERENCES

19 20 21

23 23 29

34 34 35 36

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LIST OF FIGURES

FIG 1.1 INFLATION GRAPH FIG1.2 INTEREST RATE GRAPH FIG 1.3 SCATTERED DIAGRAM FOR INFLATION AND INTEREST RATE FIG 1.4 INFLATION AND INTEREST RATE GRAPH

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LIST OF TABLES TABLE 1.1 Table showing the Inflation and Interest rate rates of Ghana from 1960 to 1995 TABLE 1.2 Table showing the mean values for the independent(X) an the dependent(Y) Variables. TABLE 1.3 Table showing the correlation between X and Y variables TABLE 1.4 Tables showing the Dickey Fuller test for unit root.

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CHAPTER ONE INTRODUCTION 1.1 Background Interest rates can have substantial impacts on both individuals and the economy. The impact of increases in interest rates depends upon the current level of economic activity. If an economy is under a speculative attack or is outperforming its optimal capacity, an increase in interest rates can be a suitable monetary policy. However, increasing interest rates can also lead to unexpected inflation, reduced investment and lower confidence among individuals and investors .Economists refer to the interest rate banks charge as nominal interest rate and the increase in purchasing power as real interest rate. If (i) denote

nominal interest rate, (r) denotes real interest rate, and as the rate of inflation, then the relationship between the three variables can be written as r=i- The real interest rate is the difference between the nominal interest rate and the rate of inflation. Inflation is, by definition a historical concept. Inflation is a persistent and appreciable increase in the general price-level over a period of time. Whether the period of time is a year, month, week or a day depends on what we are using the rate of inflation for. Fixing of Interest rate is one of the tools in the arsenal of the Bank of Ghana in its attempt, together with the fiscal authorities, to shape the economic landscape in Ghana. . Nevertheless, to the extent that it reflects the cost of capital, the interest

rate conveys important information to investors and dealers on the financial market. Inflation is the cost of holding cash while the rate of interest is, crudely, the cost of holding wealth in any other asset. Thus as the rate of inflation rises those holding their wealth in the form of cash lose. On the other hand capital becomes more costly as the interest rate rises. An investor will normally like to balance out his options for gaining or losing by holding cash and or alternative assets. Such an investment decision involves planning, which depend on expectations. Fixing of interest rates by the central bank is to influence such expectations. People form expectations in different ways. If you have perfect knowledge, then of course, you do not need any historical inflation data or you do not need to be a wriggle watcher to modify your expectation s (Sowa, 2001). You will theoretically be so current and up-to-date in your expectations formation that perfectly weigh your options at any moment in time. Alternatively, your expectation may be formed taking into consideration all available information on the market; that is, to be rational about your expectations. . Also with inflation, when prices increase, the cedi gets to buy less. Over time, prices tend to steadily increase. Hence, your one cedi today is not necessarily equivalent in value to your one cedi tomorrow. A case in point: Some time back in Ghana, one could buy two loaves of bread with one cedi, but guess what? You can't even buy one these days at that price. That is inflation. So how is this related to interest rates? Investors, try to preserve the value of their money by investing in activities that have yields that are either equivalent or higher than the inflation rate. Let's say that the local interest rate is pegged at 6.5%; the money that you earn, save and invest should

be able to at the very least, match that rate. Why, because at the end of the year, if your money stayed inside the piggy bank or under ones bed, its value would've been eroded by that rate. So if you save 100 cedi at the start of the year, at the end of the year its worth would've been eroded by 6.50 cedis leaving your 100 cedis worth only 93.5 cedis. In developed economies, bank savings interest rates normally equal that of the inflation rate. If competition is fierce between banking institutions then you will get higher interest rates thus more yield for your money. To wrap up, inflation is one of the factors that affect interest rates. When inflation moves up or down, the tendency is to increase or decrease the benchmark interest rate as well.

1.2 Problem statement The economic schools of thought have since time seen many prominent economists like John Keynes, Thomas Malthus, Irving Fisher and so many others delve into the study of important economic variables like consumption unemployment among many others. Research has examined the possible existing relationship between rate of inflation and interest rate. Famous economist Irving Fisher (1867-1947), studied the two variables and came out with the Fisher Hypothesis, which looks at the relationship between Inflation and Interest rates. The Fisher Hypothesis states a one for one relationship between Inflation and Interest rates and this has been subject to much empirical research, though little research has been done to verify the Fisher hypothesis in Ghana.

The researcher wishes to know the relationship between these two variables in Ghanas economy and for that matter; verify if the Fisher hypothesis exists within the Ghanaian economy. 1.3 Objective of the Study The main objective of the study is to ascertain if there is any direct or inverse relationship between inflation and interest rates in Ghanas economy. The specific objectives are: To know the trend/ pattern of the variables under study To determine the factors that contributes to their behaviors. To examine the degree of their relationship using a simple regression model. To make certain whether Irving Fishers one for one relationship between Inflation and Interest rate exists within the Ghanaian economy for the stipulated period of time. To facilitate policy recommendations. 1.4 Research questions What are the trends of the variables under study? What factors contribute to the behaviors of Inflation and Interest rates? What is the degree of the relationship that exists between Inflation and Interest rates? Does Irving Fisher one-for one relationship between Inflation and Interest rates exist in Ghana? What policies can be recommended after the study of these variables?

1.5 Justification of the study. 1. It is extremely essential to know and comprehend the actual nature of the relationship that exists between these variables, since it can be used in predicting future values or trends of inflation on interest rate. 2. This study will also come in handy with formulation of policies within the country. The research will serve as a reference material for economists and policy makers within the country, as well as future researchers as they delve more into its study. 3. The study will also serve as a guide and provide information for both foreign and local potential investors. 1.6 Organization of the study The research constitutes five chapters, and chapter one gives an introduction and a general background of the study. It also includes the problem statement, objectives, significance, scope, justification and a general organization of the study. Chapter two looks at the works consulted to present review of literature on Inflation, Interest rate, consumption, and investment, whereas Chapter 3 consists of the various methods to be used or employed in the data analysis. Chapter 4 simply entails the data gathered and how the data is analyzed using Stata data package with chapters 5 concluding the whole thesis, as well as making recommendation.

CHAPTER TWO LITERATURE REVIEW 2.1 Introduction This chapter functions as the core of the research conducted. Literature review, seeks to investigate the works consulted to understand and investigate the research problem. It is also be a critical look into existing research that proves significant to the work currently carried out. This chapter presents a thorough review on what is meant by Inflation as well as, how Inflation affects other variables specifically investment, aside Interest rate. It also explains what interest rates are and how Interest rate affects other variables specifically Consumption, aside Inflation rate. 2.2 What does Inflation mean? Inflation is generally the persistent rise in the general prices of goods and services; however the simplest definition of inflation is little money chasing goods. Inflation is also said to be the average increase in the prices of goods and services (Mankiw, 1998). When there is a rise in general price level for all goods and services it is known as inflation. An inflationary movement may be due to the rise in any single price or a group of prices of related goods and services. (Miller, 2009) Over the years inflation has become a global problem that most economies are dealing with. Zimbabwe still remains a good example of countries battling with the rate of inflation. It is mind boggling to buy box of chocolate for two cedis only to return some days after and realize that the same box of chocolate bought
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for two cedis earlier now costs five cedis. An example of this case of Hyper Inflation occurred in 1923 in Germany, where Lenders run at heavy losses because Inflation rendered the money borrowers paid worthless. (McMahon, 2007) This may be the simplest explanation of inflation. Inflation in itself is not the rise and fall of individual prices in an economy, Inflation occurs when most prices are rising by some degree across the whole economy. 2.2.1 Categories of inflation Inflation takes many forms, but is generally grouped into two main categories; Cost-push and Demand- pull inflation. Demand- Pull inflation describes inflation that occurs for the most basic of economic reasons, that is when prices of goods increase because demand for the product exceeds supply. This is what is simply termed as more money chasing few goods.

Diagrammatically,
AS

P2 P1

AD

AD2

From the graph above, as firms increase production to meet increased demand, additional cost is incurred which is represented by an increase in price, form P1 to P2.
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Cost-Push Inflation: By the definition, cost push inflation Cost-push inflation basically means that prices have been pushed up by increases in costs of any of the four factors of production (labor, capital, land or entrepreneurship) when firms are already running at full production capacity. With higher production costs and productivity maximized, companies cannot maintain profit margins by producing the same amounts of goods and services. As a result, the increased costs are passed on to consumers, causing a rise in the general price level. (Wenzel, 2009)

AS2

AS1 P2

P1

Q2

Q1

From the graph, increases in production cost will cause AS (aggregate supply) to decrease from AS1 to AS2, thus causing an increase in price level from P1 to P2. This is due to the fact that firms would want to maintain their profit margins thereby increasing prices. (Barro, 1994.) Aside categories of Inflation, various types of inflation exist in economies, but the most commonly known are creeping, chronic and hyper inflation. Creeping inflation is when Inflation moves at a mild rate and may be considered as a
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natural rate of Inflation which is almost impossible to eliminate. (Grilli, 1994). Chronic inflation also occurs when high Inflation rate persists for some time, with little or no reduction. This type of Inflation mostly precedes hyper Inflation. Last but not Least, hyper inflation, also known as galloping or runaway Inflation usually occurs during or soon after a countrys economic failure or disturbance. A typical example was in 1923 when the Inflation rate in Germany averaged 322% per annum .Interestingly, this type of Inflation is normally short-lived. 2.3 How does Inflation affect Investment? Inflation indicates a situation where the demand for goods and services exceeds their supply in the economy (Hall, 1993). Generally, prices as said in chapter 2.1 are linked to inflation. Several causes of inflation can be attributed to different reasons, which may include increases in cost of production that is; increases in prices of imported raw materials. Whatever the cause, Inflation will not persist until accompanied by an increase or decrease in money supply, thereby making inflation a monetary factor. But what the actual link between Inflation and Investment? Inflation causes much distortion in every economy. It affects fixed income pensioners. It also discourages savings because; money is worth more presently than in the future. This expectation negatively affects growth since savings are needed to finance other investments that boost economic growth. Inflation also creates uncertainty in Business fields due to the fact that, businesses may not find it easy to decide how much to produce because of fluctuations in Inflation rate. Truthfully, Inflation posses much threat to investors. It deprives them of the actual value of their investments.

The value of 5cedi note today will not be the same tomorrow or even in a couple of years. That is the more reason why it is vital to include measures of expected inflation when calculating return on investment. In this current Ghanaian economic condition, savings is very necessary, a cosy trasaaco home and retirement benefits should be enough inspiration for an individual to save. Inflation eats away ones purchasing power if money is placed in a piggy bank or under a mattress. For that matter, it is extremely crucial to be aware of these effects of inflation, thus investing in real goods such as a home which is insulated from the snare of Inflation. This is due to the fact that its value is determined to a large extent by its intrinsic value, as opposed to money which is valued only by what it can be traded for. In the long run, a companys revenue should increase at a fairly same rate as Inflation. Inflation discourages investments and reduces the confidence of investors. An effect of Inflation on investment is that it increases transactions costs thereby inhibiting economic growth. This is such that when nominal values become uncertain thanks to inflation; contractors find it difficult to sign contracts with inflation rate almost unpredictable, thus reducing investments and economic growth.(Hellestein, 1997) Diagrammatically,

High Inflation

Reduced Investment

Reduced economic

growth for that matter, financial recession.

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High inflation will lead to financial repression because the government may resort to the usage of interest rate ceilings to control inflation and such controls may lead to inefficient allocations of capital that also hinder economic growth (Morley, 1971). Generally, fixed income investors are the most to suffer from Inflation. Consider this case; an investor buys a 1000 cedi treasury bill that yields 10%. Assuming inflation was 3% that year, after claiming 1100 cedi, his investment is not real. Why? By the fisher equation, (Nominal interest rate Inflation rate = Real interest rate. If the nominal interest rate is the growth rate of the investors money, whereas the real interest rate is the growth of his purchasing power, the investors real interest rate is calculated as r = i - , r = 10% - 3% r = 7% Where r is real interest rate, i is nominal interest rate and is inflation rate. From this shave, it is seen that the investors purchasing power has decreased (Fisher, 1947). To conclude, these low returns interfere with the functioning of financial markets and investment allocation .As a result higher inflation decreases supply of credit reduces investment and shrinks economic growth. (Blume, 1978) 2.4 What does Interest rate mean? Interest rate may be defined as the rate charged for the use of money, and this is often expressed as an annual percentage of the principal. There exist different types of interest rate. In Ghana, two main types of interest rate are widely known; the prime rate and the base rate.

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The prime rate is the rate that the central bank charges on loans to commercial banks, whereas the base rate refers to the rate at which commercial banks give loans to individuals and organisation. Interest rate really affects purchasing and consumption decisions made by consumers, firms and government. This is because individuals may base their consumption decisions on the current interest rate. (Begas, 2000) During instances of recession, central banks may reduce nominal interest rate in order to boost investments. Some economists say a zero nominal interest rate may be due to a liquidity trap (Lars, 2003). When expected returns from investments are low, the rate of investment falls plunging into a recession. People may tend to hold cash since they expect spending and investment to be low. (Keynes, 1936).

2.5 What effects has Interest rate on consumption? As said by Adam Smith, consumption is the sole end and purpose of all production. Consumption and interest rate are important concepts of macroeconomics, among other factors like Gross Domestic Product and Inflation. The subject of effects of interest rate on consumption has been subject to much controversy. The controversy began with famous economist (Keynes, 1936) who saw income as the main determinant of consumption. Keynes based his analysis under three conjunctures; firstly that Marginal Propensity to consume is between zero and one. Secondly, that average propensity to consume fall as income rises. Keynes believed that saving was a luxury; therefore as income rose, consumption also rose but not as much as the rise in income. His third conjuncture was income was the primary determinant of

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consumption, although he admitted that interest rate could somewhat influence consumption. Consumption decision is both decisive and vital in the long-run analysis, due to its role in economic growth and in the short-run analysis, due to its function in determining aggregate demand. In Ghana, Consumption forms a large portion of Gross Domestic Product (GDP); therefore, fluctuations in Consumption levels are key elements of booms and recessions in most economies. A higher interest rate tends to attract more savings and encourages individuals to delay consumption. This increase in savings provides for a healthier economy in the long run as people tend to save more for retirement and unexpected expenses. However, a substantial cut in consumption can affect the economy adversely with a decrease in consumer spending and heavy losses for companies as well as the government. Interest rate plays a major role in measuring consumers expected future earnings and thus his expected consumption behavior. (Modigliani, 1953). High interest rate may also trigger recession due to decrease in consumption, which may lead to considerable amount of job losses. The economy can be influenced easily by changes in interest rates. When interest rates are high, people do not want to take loans out from the bank because it is more difficult to pay the loans back, and the number of purchases of cars and homes goes down. The opposite is also true. (Wright, 1967) The effects of a lower interest rate on the economy are very beneficial for the consumer and for the government as a whole, since there would be higher levels of consumption. When interest rates are low, people are more likely to take loans out of the bank in order to pay for things like houses and cars. When the market for those things gets strong, price decreases and more people can purchase these
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things. This also bodes well for investors, who perceive less risk in taking out a loan and investing it into some business, because they would have to pay less back to the bank. When people do not have to spend as much money on bank payments, they have more disposable income to put toward things they want to purchase. Suddenly, a trip to the popular mall is not so much of a budget crunch and a weekend at the spa seems more doable and affordable. (Heien, 1972). 2.5.1 Irving Fisher Consumption Model The economist Irving Fisher did not only look at current consumption and current income, he was of the view that when people decide how much to consume they consider both the present and the future. He thereby introduced a model with which consumers make intertemporal choices. Consumers face a budget constraint and(less income as against spending) and deciding how much to consume today and save tomorrow or in the future brings them to an intertemporal budget constraint. There are two periods involved; the first and the second period. In the first period, savings equal income(Y) in the first period and Consumption (C) in the first period.
S Y1 C1

The equation for the second period is also given as;

C 2 (1 r )S Y2

Where r represents interest rate on savings, C 2 and Y2 represents consumption and income in second period respectively. The consumers budget constraint can

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be derived by combining the two equations while substituting the first equation for S, given as;
C 2 (1 r )(Y1 C ) Y2

Rearranging the terms and dividing by both sides by (1+r) will give
C1 C 2 / 1 r Y1 Y2 / 1 r

This is the standardized way of expressing the consumers intertemporal budget constraint. (Mankiw, 2006)

An increase in the interest rate will cause a rotation in the budget line. This increase makes savers better off (they will be on a higher indifference curve) and borrowers worse off. When the interest rate increases, current consumption becomes relatively more expensive (the interest rate represents the "price" of current consumption), thus the individual will tend to substitute away from current consumption. This movement is known as the substitution effect. However, assuming that present and future consumption are both normal goods, an increase in the interest rate will increase relative income leading to what is known as income effect. For a net-saver this increase in relative income will thus induce him to "buy" more current consumption.

2.6 Relationship between inflation and interest rate.

Inflation again refers to the average price of the cost of goods and services in the country. It is also the ratio of payment of interest to the principal amount borrowed. (Barro, 1998).

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Inflation has good and bad effects, and there is the need to get rid of the perception that inflation is always bad. Some negative effects of inflation are it causes unemployment, social disturbance and reduces investment; however positive effects of inflation also exist. High inflation tends to wipe out debt. Secondly, high inflation complements the Mundell-Tobin effect: This is a complex effect related to inflation. Moderate inflation has a tendency to cause firms holding onto money to start lending.

This excess of lending capital will cause interest rates to fall. This in turn makes it easier for firms to get loans for further investment and economic growth. Thirdly a positive effect of interest rate is it offsets the negative effect of inflation; Deflation might sound good on the surfacean increased value of your money. In reality, however, deflation often leads to short, sharp jags of hyperinflation.()

When the economy is strong, the rate of inflation tends to be high. When the economy is weak, the rate of inflation is generally either low or stagnant. Neither situation is beneficial to the economy. One of the Governments goals for inflation adjustments is to keep the rate of interest at a steady pace. There exist two main types of interest rate; Real Interest rate and the nominal interest rate. The

nominal interest rate refers to one that has not been adjusted for Inflation, but the real interest rate has been adjusted for inflation. (Kim Petch, moneycrashes.com).

2.6.1 The Irving Fisher Inflation Equation Fisher equation in financial mathematics and economics estimates the relationship between nominal and real interest rates under inflation. It is named after Irving fisher who was famous for his works on the theory of interest. In

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finance, the Fisher equation is primarily used in YTM calculations of bonds or IRR calculations of investments. In economics, this equation is used to predict nominal and real interest rate behavior. Letting r denote the real interest rate, i denote the nominal interest rate, and let denote the inflation rate, the Fisher equation is: r = i- From the fisher equation above, the real interest rate is the difference between the nominal interest rate and the inflation rate. (Mankiw, 2006). This is a linear approximation, but as here, it is often written as equality: i=r+ The equation written in the above way can be referred to as the fisher equation, which shows that changes in nominal interest rate is due to changes in real interest rate and changes in inflation rate. According to the Fisher equation, a one percent increase in inflation will cause a one percent increase in nominal interest rate, and this is one for one relationship is simply the fisher effect. (Dornbusch et. al, 1998).

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CHAPTER THREE METHODOLOGY 3.1 Introduction This chapter includes a descriptive analysis of the data, the analytical methods employed in carrying out the research. It also entails an ample description of the source of data as well as the type of data. Inflation and Interest rate will be the variables to be discussed in this chapter. Attached is an in-depth analysis of the research design, which looks at the different graphs and models, employed to aid in the research. The data to be used in this study is a secondary data that will be critically analysed in the summary statistics to verify the main objectives of the study, which is to determine the relationship between Inflation and interest rates in the Ghanaian economy. 3.2 Research design The collected data went through transformation to go well with the regression model. A theoretical model was employed to make possible an estimated effect on Y, if there is a change in X. The researcher with the aid of Stata data package generated time series data, regressed the data generated and analysed the findings.

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3.3 Data description There are different types of data used in econometrics study but, annual time series data over a thirty-five year period from 1960 to 1995 of the selected variables, which represents data on inflation and interest rate of the country, will be employed. Time series data is used due to its flexibility in comparison. This is to help research, both intensively and extensively as indicated in the research question and further to help assesses literature on the relationship between the two variables. Data is collected from a secondary source, a non experimental type of data, which is the 2006 Budget Statement and Economic Policy of Government of Ghana, page 377. The data gathered could have covered a wider span of say 50 years. The two prominent economic variables will be regressed against each other to assess the correlation between them. The data collected had to be transformed into y= a + bx + u to be able to make economic sense. 3.4 Research model The theoretical model generally accepted for estimating the relationship existing between the dependent and independent variable to be used takes the shape; y = a + bx + u. Where a = intercept, which shows sensitivity of a change in Y to a change in X. Y = Dependent variable, which is Interest rate X = independent variable, which is Inflation rate.
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u = the error or disturbance term The regression model therefore can be written as;
r 0 1 t u

Where t Inflation Rate r = Interest rate

0 = intercept on the y axis

1 = slope or gradient that measures
u = error term or disturbance 3.5 Regression analysis In this section, the trends or pattern of the variables will be examined and the summary statistics for the data explained. Moreover, the correlation between the two variables will be looked at and Durbin Watson and Dickey-Fuller tests will be run to test for serial correlation and unit root respectively. Finally, the data will be regressed and the results interpreted, thus the regression equation shows the estimated effect of interest rate(Y) due to a change in Inflation(X). The estimated effect is 1 , the slope of the equation from the regression equation.

r 0 1t u .

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The equation shows a positive slope which means a 1% increase in the Inflation rate(X) lead to a 1% increase in Interest rate(Y). However, when there is zero inflation, the value of the intercept becomes the rate of Inflation.

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CHAPTER FOUR

DATA ANALYSIS 4.1 Introduction This chapter displays or looks at the outcome of the data analysed in table, graphs as well as figures, to determine the relationship between the two economic variables. This was done with the aid of Stata software package. Data analysis constitutes five sections in this chapter. In the first section, there would be graphical representation (trends and pattern) of the variables under study, which is followed summary statistics. Furthermore, a Durbin Watson test is done to check for serial correlation. After this, a Dickey Fuller test for unit root will be employed to determine how stationary the time series variables (Inflation and Interest Rates are.) To conclude, regression analyses will be done to know the relationship between the variables under study. 4.2 Trends and Pattern of Inflation and Interest Rates. This sector seeks to analyse and explain the behavioural pattern and trend for the variables, Inflation and Interest rate (1960-1995).

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x
140 120 100 80 60 40 20 0 -20 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 x

Fig 1.1 A graph of Inflation rate

Source: The Budget Statement and Economic Policy of Government of Ghana for the financial year 2006, page 377.

The diagram above shows the variations and fluctuations in inflation over a period of time (1960 1995). It is clearly seen from the graph, the trend of Inflation rate over the stipulated period of time. Inflation rate begun to rise steadily, fell and rose again higher till it got to the peak and started to fall steeply. It is easily noticed, the oscillation in its trend. The oscillation from the graph may be due to other factors that affect Inflation Rate categorized below under Cost Push Inflation and Demand Pull Inflation Cost Push Inflation

Rising imported raw material cost: This causes inflation due to the fact that Ghana depends heavily on imported goods and raw materials. There is an influx of foreign goods on the Ghanaian market.

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Increase Labour cost: This may arise when wages increase more than productivity. Wage inflation in the long run tends to move along side price inflation.

Higher taxes: This happens when government imposes higher taxes on individuals, example Value Added Tax (VAT). A rise in VAT will cause a rise in a range of products to which VAT is applied, definitely leading to inflation.

Demand Pull Inflation

Depreciation of exchange rate- This increases prices of imports and reduces the foreign price of Ghanas export.

Reduction in taxes- A reduction in taxes will increase the real disposable income of consumers, which will also cause demand to rise. Since there would be rapid growth of money supply, inflation will set in.

y
45 40 35 30 25 20 15 10 5 0 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 y

Fig 1.2 A graph of Interest rate (Y)

Source: The Budget Statement and Economic Policy of Government of Ghana for the financial year 2006, page 377.

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The graph of interest rate (1960 1995) as seen above in fig 1.2 can be vividly seen and analysed. Interest rate was fairly constant during the early years, begun to rise and fell to being somewhat constant. Thus was its trend till the interest rate shot down steeply only to rise again. Generally, it can be seen from the graph that there has been much ebb and flow in the interest rate trend due to several reasons some of which are listed below. High credit demand- When the number of people borrowing increases, the tendency to also increase interest rate also increases. Anti- Inflationary monetary policy- Since Interest rate is used to control inflation, fluctuations in Inflation will lead to fluctuations in Interest Rate.

45 40 35 30 25 20 15 10 5 0 -50 0 50 100 150 Series1

Fig 1.3 A scattered diagram for inflation and interest rates

Source: The Budget Statement and Economic Policy of Government of Ghana for the financial year 2006, page 377.

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The diagram above represents a scattered diagram that further explains how much of variations in interest rate is explained by Inflation. From the graph, it can be clearly seen that the plotting is somewhat concentrated on the left corner. This means that the independent variable (Inflation), explains some portions of the variations in the dependent variable (Interest rate), though a greater part of the deviation is included in the error term (U). To conclude, the diagram exhibits a positive weak correlation between Inflation and Interest Rates.

140 120 100 80 60 40 20 0 x y

1968

1990

1960

1962

1964

1966

1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1992

-20

Fig 1.4 Inflation and Interest rate trend.

Source: The Budget Statement and Economic Policy of Government of Ghana for the financial year 2006, page 377.

It can be seen from the graph above that during the early years that as Inflation rate increased, Interest rate also increase though not as much as inflation rate. From 1966, the rate of Inflation fell steeply preceding a slight decrease in Interest rate. During the subsequent years (1970- 1978) it is clearly seen from the graph that Inflation rate saw a high level of increase with Interest rate also following the pattern of increase. 1978 saw a sharp fall in the rate of Inflation though Interest

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1994

rate rose fairly. From the years 1980- 1995 it is generally seen the variability that exists between the variables under study. Graphically, it can be concluded that Inflation rate (X) and Interest Rate (Y) are positively related. This means that an increase in Inflation rate leads to an Increase in Interest rate, and a decrease in Inflation rate leads to a decrease in Inflation rate. 4.3 Summary statistics Tab 1.2

Variable x y

Obs

Mean

Std. Dev. -9.7 4

Min 122.8 41.5

Max

37 31.49722 31.70811 37 14.7 10.15937

The mean for the variable Inflation Rate(X) is 31.49722; meaning on the average, Inflation rate is 31.49 annually. Inflation exhibiting the min value -9.7 and the max value 122.8, means that the mean is closer to the min value thus most of the values for Inflation are skewed to the min value. Furthermore the mean for the variable Interest Rate(Y) is 14.7, meaning that on the average, Interest rate is 14.7 annually Interest Rate exhibiting the min value 4 and max value 41.5, means that the mean is closer to the min value thus most of the values for Inflation are skewed to the min value. The standard deviation (Std Dev) for Inflation is 31.70811, showing that about 31.70811 of the values deviate from the mean (31.49722), and the standard deviation (Std Dev) for Interest rate is 10.15937 showing that about 10.15937 of the values deviate from the mean (14.7)
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Table1.3

. correlate x y (obs=37) x x y 1.0000 0.2337 1.0000 y

The correlation between Inflation rate (X) and Interest rate (Y) is 0.2337. This exhibits a weak positive relationship between the variables.

Augmented Dickey- Fuller test was carried out to test for the presence of stationary and the results are as follows: Table 1.4

. dfuller x Dickey-Fuller test for unit root Test Statistic Z(t) -3.877 Number of obs = 36

Interpolated Dickey-Fuller 1% Critical 5% Critical 10% Critical Value Value Value -3.675 -2.969 -2.617

MacKinnon approximate p-value for Z(t) = 0.0022

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The rule for Dickey- Fuller test for unit root states that, Test statistics must be greater than the critical value which would mean the absence of unit root thus will be significant. From the Dickey- Fuller test above, the t-stats (-3.877) is greater than the critical value (-2.969), thus it is significant.

. dfuller d.y Dickey-Fuller test for unit root Test Statistic Z(t) -11.701 Number of obs = 35

Interpolated Dickey-Fuller 1% Critical 5% Critical 10% Critical Value Value Value -3.682 -2.972 -2.618

MacKinnon approximate p-value for Z(t) = 0.0000

From the Dickey-Fuller Test above, the first differential was taken in order to satisfy the Dickey Fuller test for unit root. The test proved significant because the t-stats (-11.701) was greater than the critical value (-2.972).

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Stata Regression Results.

0 20.77561 1 0.73 Y 0 1 X u
The regression equation is

Interest rate = 20.77561 + 0.73(Inflation rate) No of observation = 37,

R 2 = 0.05

With 2.28 as the t value for 0 and 1.42 as the t value for 1 . From the regression equation it can be deduced that, a predicted change in Interest rate can be written as a change in Inflation rate. This means if Inflation(X) increases by 1, then interest rate is expected to increase by 0.73.

R2 :

This measures the goodness of fit of the estimated simple regression

equation in terms of the proportion of variations in the DV explained by the sample regression equation. Using the R 2 reported from the Stata output, it is seen how much of variations in interest rate is explained by the Inflation rate within the economy. Hence it can be concluded therefore that Inflation explains approximately 5% of variations in Interest Rate for the sample data of Inflation and Interest Rate from1960- 1995. This means that about 95% of interest rate changes may be due to other factors that affect Interest rate aside Inflation rate which are included in the error term (u).

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A Durbin Watson test for auto or serial correlation between the variables from the time period was done, which initially exhibited serial correlation. Due to this, the dependent variable (Interest rate) was lagged on the independent variable (Inflation) to correct the problem of serial correlation. The results then displayed; Durbin Watson Statistics = 2.235529. DW = 2.2 means the residuals from the estimated regression models are positively correlated. This is accepted, though not perfect because according to the classical assumption, the ideal value of DW stats should be 2.00 to indicate absence of autocorrelation.

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CHAPTER FIVE CONCLUSION AND RECOMMENDATION

5.1 Introduction This chapter looks at the conclusion drawn from this thesis based on chapter 4, as well as make recommendation. 5.2 Conclusion It can now be concluded that the trend of the variables Inflation and Interest rate are positive sloped, and the main objective of the research (To make certain if there is any direct or inverse relationship between inflation and interest rates in Ghanas economy) can now be answered. Yes, there actually is a relationship between Inflation and Interest Rate within the Ghanaian economy. From the regression analyses, there exists a positive relationship between inflation and interest rates. From the slope coefficient (1) in the data analyses, an increase in inflation of 1% on the average leads to an increase in about 0.73 increase in interest rate. From the regression results, when Inflation increases, interest rate also increases. This result may be due to the period in which the data was collected. It may be due to the unfavorable economic conditions that were present during the period (1960 1995). Furthermore, the historical trends of the variables Inflation rate and Interest rate have been seen as well as the reasons for their behavior of the variables under study. The research could have yielded better results if the data collected had covered a longer period of time. To wrap up, it is seen from the research that famous economist, Irving Fishers one for one

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relationship existed in the Ghanaian economy for the stipulated period of time (1960 -1995). 5.3 Recommendations
The Researcher recommends that, government and for that matter policy

makers device means to better control and stabilize Inflation rate which in turn may help stabilize interest rate to some extent, ceteres paribus. Data collection is almost a non- fruitful task in Ghana. Researches need to search high and low in order to get access to statistics for various fields. It can be the most stressful task and discourages research into some areas of interest. The researcher recommends that the Government as well as all institutions under the government example Ghana Statistical Service put in more effort to simplify and make easy the trouble of data search. This will go a long way to boost research conducted as well as help policy makers and the nation as a whole.

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REFERENCES Barro, R & Grilli, V (1994), European macroeconomics, p 39 Barro, R (1997) Macroeconomics, Cambridge. Blume, M, (1978) Inflation and Capital Market. Ballinger, Cambridge Budget Statement and Economic policy of Government of Ghana, (2006), pp 377. Chen X, Ender B.P, Mitchell, M, & Well, C.(2003) Regression with Stata, www.ucla.edu. David, S (2004) Inflation and Interest rates, The Sunday Times, London Dornbush, R, Fischer S, Richard Startz,(1998) Macroeconomics, 7th ed Hall, R (1993) Macroeconomics, New York, Norton, 637. Hall, R. (1982) Inflation causes and effects. University of Chicago Press, Chicago. Hellerstein, R (1997) The impact of Inflation, Regional Review, winter, vol 7. Lars, E.O, Svensson,(2003) Escaping from Liquidity trap and Inflation. Journal of Economic Perspective, p 145-166 Mankiw, G, N (2006), consumption, Macroeconomics pp 87, 456- 468) Mankiw, G, N (2010) Bernanke and the beast 2010. New York Times. McMahon, T (2007) who does Inflation hurt most? www.Inflation data.com McMahon, T (2008) Inflation Cause and Effect, www.Inflation data.com Miller, R (2009) US needs more Inflation to Speed, www. Inflation data.com Morley, S. (1971) The economics of Inflation. Dryden Press, Hinsdate. Mundell, (1963) Inflation and Interest rates. Journal of Political economy.

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Rasmussen, K & Tetteh, D (2007).Impact of Inflation on Business and Trade. retrieved from www.essays.se/essay/70645cb1do Senring, L, C Analyst in money banking, Economics division. Sowa, N, K (2003), Inflation and Interest Rate fixation in Ghana, The Ghanaian Times. Usip, Dr (2001) Simple Regression and Correlation, Economics. Retrieved from www.people.ysu.edu/eeusip/regression.htm Wenzel, R. (2009) Mankiw Calls for greater Inflation, Economic Policy Journal.com Yeboah, K (2001) Interest rate, Inflation and the Ghanaian Economy, modernghana.com www.Bank of Ghana.org www.Princeton.edu www.Sunday times.co.uk www.times.co.uk www.bls.gov/cpi/cpifaq.htm www.Investorguide.com www.SSRN.com www.tutor India.com www.Worsleyschool.net

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