RELATIONSHIP AMONG THE ECONOMIC GROTH,

INFLATION, AND THE TRADE OPENESS; A CASE

STUDY OF PAKISTAN
Abstract:

It is demonstrated by a large number of studies that openness accelerated the process of economic growth.
This paper look at this relationship of growth with trade openness and inflation and found that openness is
helpful in expediting positive effects on growth while inverse is the situation for inflation in Pakistan
amid the period of 1985 to 2016 .ARDL technique was applied.so government should take a serious view
towards openness keeping in mind the end goal to expand its output.

Keywords:

openness ,Growth, Inflation, ARDL

INTRODUCTION:

The effect of globalization is by all accounts fluctuating from economy to economy, contingent on the
nature, structure and level of transparency of the economy. Since 1980’s there has been a huge increment
in FDI and worldwide exchange streams (IMF, 2006) and all the open economies are influenced by this
liberalization procedure. Burger and Krueger (2003) also revealed that expansion in the aggregate income
level through openness lead to the greater level of economic growth. The more elevated amount of
consolidation and advantages can be achieved by lowering the obstacle to worldwide trade .Hypothesis
recommended by new theory of growth that openness brings reduction in the unemployment and expands
output by generating new activities that demands enhancement of knowledge and human capital stream
among nations. But with all these benefits costs are also linked with globalization. Developing countries
confront approximately 10 to 18 percent reduction in the revenue of the government, when it allows free
trade and eliminate import quotas. Only instrument they have, to maintain its existing level of revenue is
to enact more and more indirect taxes.

The connection between trade openness and Inflation is a great bewilder in literature of economics. It is
necessary that inflation should stay under control for a stable and better economy. Inflation is a procedure
of a continuous ascent in prices in an economy. Disturbance in demand and supply elements produce
inflation. Overall prices of oil and supply stuns in items such as food create inflation. Costs of other ware
for shoppers also increase with the increase in Cost of oil. This trauma in supply is unpredictable and
bring tremendous changes in cost of oil and sustenance. High Inflation is observed in developing
countries than the advanced and developed countries. Fiscal and monetary policies are useful to tackle
this complication. Inflation create numerous financial issues unequal circulations of riches, destitution,
balance of payments deficiency, a high rate of joblessness, and social wrongs like stockpile and
smuggling. Flatness of price mechanism also shudder due to inflation.

High rate of Inflation has greater turbulence, and this is basic obstacle in venture assessment and
gainful utilization of available assets and backs of the procedure of growth. Friedman (1977) discovered
two main reasons for this reverse impact of unusual inflation on financial effectiveness. It causes long
haul contracts more costly and because of that future estimation of dollar installments is more
questionable. Second, information about the movements in relative prices cannot be passed on to the
members because it brings down the capabilities of business sectors. In the short run it expand the
joblessness rate and slow down the economic growth by decreasing the effectiveness of financial growth.
This outcome is also encouraged by Samimi and Shahryar (2009).It is also trusted that economic growth
and development can be heighten if the rate of inflation is modest and stable. To spare the poor from
troublesome impacts of inflation and to maintain macroeconomic solidity inflation free economic growth
is mandatory (Ashra, 2002).
There are two different conceptual perspectives about the liberalization on rate of inflation,
according to the spillover theory openness backs off the inflation rate while cost push theory believed that
opposite is the case. Romer (1993) the economies that are open in exchange their inflation rate would be
bottommost. Carneiro and Loureiro (2003), Lane (1997), Farvaque and Shah (2009) support the Romer.
In this paper time series data is utilized, intended to look at the idea of connection by using distinctive
measures of transparency and inflation in Pakistan’s case.

Objectives

I. My objective is to inspect the connection between openness and inflation for the
Pakistan’s case. Whether it is according to Romer’s idea or his idea is not
validate for the enquiry of Pakistan. Inflation and openness has a great influence
on the growth of a country. So in this paper try is made to correlate inflation and
openness.
 ● To inspect the influence of openness on Pakistan.
● Utilizing time series data to check the sort run as well as long run
relationship among inflation, openness and growth
● To probe validity of the finding of the Romer
Null hypothesis is that there is negative link between inflation and openness of trade

Literature Review

Badinger (2009) say that globalization has a powerful role in lessening the overall rate of inflation and the
countries who wants to make this possible should implement the policies that are in favor of reducing the
rate of inflation .He use the sample of 83 countries and inspect the period of 1985-2004 and he used
different variables like real GDP, Real Inflation rate, Short run rate of interest, Trade openness, Financial
openness. But his findings not discovered legitimate for the OECD economies

Afzal (2013) in his paper tested that in case of Pakistan the findings of Romer about negative relationship
between openness and inflation are valid or not. He used the data from the time period of 1970-71 to
2008-2009 and used ARDL technique and found that in short run as well as in the long run there exist the
negative relationship between rate of inflation and openness .He also perceived that both in short run and
long run the relationship between GDP and Inflation is positive.

Hanif and batool(2006) scrutinize this relationship empirically by analyzing the period of 1973 to
2005, and they found that variables like growth rate of GDP( in real terms),Interest rate ,and also include
wheat support price, trade to GDP ratio as a proxy of openness of trade, Monetary growth affects
negatively on the domestic price growth.so their results were in favor of hypothesis posited by Romer
that low rate of inflation is observed in open and relatively small economies.

Two instruments through which inflation instability can be declined were introduced by Bowdler and
Malik (2005) is by limiting huge assortment in the benchmark of utilization and by erecting incitement so
that policy makers choose firm strategies, in this way openness backs off the volatility of inflation. They
apply dynamic panel data and discovered with proof of reverse connection among these two.

Zakria (2010) tried the linkage between openness and inflation by utilizing time series data and apply
GMM technique and discovered solid positive connection between these two for the instance of Pakistan.
Manni et.al (2012) inspected the relationship among openness with gross domestic product by utilizing
OLS estimation as their outcomes demonstrated that gross domestic product increases with the expansion
in openness and he found no impact of trade openness on inflation.

Al Nasser et al. (2009) found that the Terra's (1998) condemnation about the negative connection among
inflation and openness in intensively indebted economies did not hold in the mid 1990’s’, he inspected
this connection by for152 nations over the period 1950-1992.Their outcomes Bolstered the Romer's
(1993) findings.

Mukhtar (2012) used yearly data for the span of 1960 to 2007, used co-integration test and found that
greater the degree of openness decreased inflation in Pakistan.

Harrison, A.E. (1996) did time series analysis for less developed countries in his paper and also includes
cross country analysis and discovered that a large range of openness accelerated economic growth.

Jin (2006) review the impact of openness on the output and inflation rate for South-Korea and set up that
openness expedites solid negative effect on output and inflation.

Alfaro (2005) scrutinize the period of 1973-1998 by using panel data for 130 economies and found that in
short run openness did not have a crucial part in controlling the rate of inflation

Kim and Beladi (2005) evaluated that openness and inflation tied directly in more advanced states. They
also upheld the fundamental findings of Romer about the reverse relationship among openness and
inflation.

Gruben and Mcleod (2004) found backward connection in countries with floating exchange rate among
openness and inflation. They dismissed the Terra’s speculation and favored the Romer that inflation has a
crucial influence in less obligated states.

Wynne and Kersting (2007) gave prove on the hearty negative connection amongst Inflation and
exchange transparency, prove on the hearty negative connection amongst Inflation and exchange
transparency crosswise over nations over the long haul (LR) as Romer (1993) expressed. Moreover, they
expressed that it was not just the Inflation which diminished the Inflation rate yet receptiveness to capital
streams and receptiveness to work additionally diminished the Inflation rate.

Model specification:
This model was planned for researching the relationship among growth and Trade openness and inflation.
We first take trade openness as dependent variable and inflation and GDP growth as an explanatory
variable but then trial test of normality gave insignificant results, after including real and nominal interest
rates separately to tackle this issue but then problem of correlation arise. Sabina (2017) utilizes real per
capita growth as dependent variable and her explanatory variables were tariff rate, log of GDP per capita,
investment at domestic level, openness as aggregate of exports and imports and then divide it to GDP.so
then we take LPCY as dependent as the proxy for growth and trade openness (TO), Exchange Rate (ER),
Foreign Direct Investment (FDI) and inflation its proxy was GDP Deflator. After deciding the model, the
next stage was to investigate the stationarity of the data of variables and in light of that outcome test of
ARDL appeared to be sensible.so the model is

LPCY=GDP Deflator+ TO+ ER+ FDI%OF GDP

LPCY=Log of per capita income (this was used by Sabina (2017) as a proxy for economic Growth).

GDP Deflator=Proxy for inflation (the proxy has been utilized by Afzaal (2013), Alfaro (2005).

TO=Aggregate of imports and exports then divided by GDP (this proxy was utilized by Hanif and Batool
(2006), Zakaria (2010).

ER=Exchange Rate (this was use by Mukhtar (2012)

FDI=Foreign Direct Investment

Data and Methodology:

This paper utilizes time series data on the variables that are included in the model, ranging the span of
1985-2005.Data of PCY, GDP Deflator, TO, FDI was grasped from WDI, and data of Exchange rate was
from Global Economy.

There are an extensive variety of estimation strategies. But we utilize ARDL due to the reason of level of
integration of variables. Some of them were stationary at level and some of them were stationary after
taking the first difference. Diagnostic test revealed that there are no complications in the model. ECM was
highly significant which revealed emergence of the dependent variable toward the equilibrium in the long
run in the reaction of change in independent variable. Test to check the stability also demonstrate stability
in model.

Table: 1-unit root test

The role of unit root test is very vital because it indicates that which econometric structure can be applied
after investigating data and integration order. Table 1 exhibits the Augmented Dickey Fuller test. It
demonstrates that LPCY, Trade openness and Exchange rate are stationary at first difference; GDP
deflator and FDI are level stationary. This suggests the likelihood of long-run relationship between the
variables. So ARDL technique will be appropriate. In lag length criteria we follow the SBC on the ground
that chances of error in prediction is low in SBC. Next trial was F bound test which indicates the
existence of long run connection between variables.

Variables ADF (AT LEVEL) ADF (AT 1ST DIFFERENCE)

LPCY 0.9565 0.0329**
GDP deflator 0.0263* 0.0000
Trade openness 0.3976 0.0017**
FDI 0.0637* 0.0224
ER 0.9725 0.0039**
Note: * indicates level stationary

**indicates 1st difference stationarity

ADF stands for Augmented Dicky and Fuller test

Table: 2 Lag selection criteria

Now the next step is to investigate the maximum lag length. Akaike Information and Schwarz Bayesian are
two famous criterions for this purpose. AIC and SBC, both of them gives different maximum lag lengths,
so we follow the SBC on the ground that chances of error in prediction is low in SBC. So optimum lag
length is1.

Lags AIC SBC

0 9.649263 9.882796
1 2.208329 3.609527*
2 1.899313* 4.468175
Note:

 AIC stands for Akaike information criteria

  SBC stands for Schwartz Bayesian criteria
 * indicates the minimum lag length

Table: 3 bound test for long run relationship

We apply the bound test to explore the long run relationship among the variables and as should be
obvious that estimation of F-Stat both at 5% as well as at 1% is more than upper bound so we can infer
that there is long run connection between variables.

F-statistics I(0) I(1)

10.56920 2.2 3.09
2.56 3.49
2.88 3.87
3.29 4.37
Note:

 I (0) indicates lower bound

 I (1) indicates upper bound

Table: 4 ARDL estimates for long-run coefficients using Schwartz Bayesian criterion, LPCY is
dependent variable

Subsequent to finding the presence of co-integration between the factors, we additionally investigate the
long-run impacts of ER, FDI, GDP deflator as a proxy for Inflation, and trade openness on LPCY which
is proxy of monetary development by utilizing ARDL, the coefficient of ER is observed to be statistically
insignificant given P-Value is equivalent to 0.4692 even after taking lag it is 1.574 clearly the
interpretations about the magnitude of ER with LPCY is that 1 percent increase in ER , overall
,diminishes LPCY by 0.000569% over the long haul given all other things constant. No solid conclusions
can be drawn and cannot be utilized in policy making. FDI is also found insignificant statistically in the
L-R. But GDP Deflator which is the proxy of inflation it is highly significant after taking lag its p-value is
0.0087,which demonstrate that 1 percent increment in GDP-Deflator or inflation ,decreases LPCY by
0.001535 %.But trade openness is also significant and we can interpret it as 1 percent increase in TO will
bring increment in LPCY by .015826%.

Variable Coefficient Std. Error t-Statistic Prob.*

LNPCY(-1) 0.952560 0.066779 14.26444 0.0000
ER -0.000569 0.000772 -0.737052 0.4692
ER(-1) 0.000978 0.000667 1.466203 0.1574
FDI 0.002526 0.005523 0.457403 0.6521
FDI(-1) -0.005831 0.004228 -1.379128 0.1824
INFLATION_GDPDEFLATO
R -0.000745 0.000587 -1.268195 0.2186
INFLATION_GDPDEFLATO
R(-1) -0.001535 0.000530 -2.895322 0.0087
TO 0.078524 0.066746 1.176467 0.2526
TO(-1) 0.015826 0.076583 0.206650 0.0383
C 0.505339 0.690991 0.731325 0.4727

Table: 5 diagnostic tests results

Table 5 demonstrates distinctive indicative tests for checking the normality of the data and to investigate
either there is issue of serial correlation or heteroscedasticity and to check whether functional form is
correct or not. However, these outcomes show that there is no issue of hetro and auto. Further it verify
that our functional form is right and about the normality of the data.

Problems Applicable tests Probability values

Normality test Jarque Berra test 0.996536
Serial correlation LM test 0.2625
Heteroscedasticity White test 0.5881
Functional form Ramsey’s RESET test 0.8386

Table: 6 Estimated long run coefficients, ARDL selected based on Schwartz Bayesian criterion,
LPCY is dependent variable

By applying ARDL technique, this table demonstrates long-term connection of variables. Their impacts
or signs are according to our expectations. Exchange Rate is significant and we can interpret it as in the
long run 1 percent increase in ER leads to increase the growth of the economy by 0.008621 percent.
While impact of FDI is opposite.in the long run it affects growth of the economy negatively means
reverse connection among FDI and economic growth same is the case of GDP deflator which is proxy for
inflation. While TO and Growth of the economy re positively tied.

Variable Coefficient Std. Error t-Statistic Prob.

ER 0.008621 0.004674 1.844460 0.0793

FDI -0.069659 0.158671 -0.439012 0.6651
INFLATION_GDPDEF
LATOR -0.048059 0.068326 -0.703380 0.4895
TO 1.988817 3.456647 0.575360 0.5712
C 10.65213 0.757754 14.05750 0.0000

Table: 7 Error correction regression, for the selected ARDL model, ARDL selected based on
Schwartz Bayesian criterion, trade openness is dependent

It is helpful in assessing not only short run but also long run impacts of one series of time on another one.
ECM specifically evaluates the speed at which a dependent variable comes back to balance after a change
in different factors.we can see that our term of ECM is highly significant. This demonstrates the
emergence of the dependent variable toward the equilibrium in the long run in the reaction of change in
the independent variable. It is equivalent to -0.947440 and is significant at the level of 1

% and it is the verification that variables are co-integrated and in the case of divergence from equilibrium
economic growth level in the current period of time will be adjusted by 0.047440%in the upcoming
period of time.

Variable Coefficient Std. Error t-Statistic Prob.

D(ER) -0.000569 0.000684 -0.832229 0.4146

D(FDI) 0.002526 0.005649 0.447163 0.6593
D(INFLATION_GDPD
EFLATOR) -0.000745 0.000351 -2.118641 0.0462
D(TO) 0.078524 0.091396 0.859159 0.4000
CointEq(-1)* -0.047440 0.005354 -8.860816 0.0000
R-squared 0.558440
Adjusted R-squared 0.490508

Durbin-Watson stat 2.275784

15

10

-5

-10

-15
96 98 00 02 04 06 08 10 12 14 16

CUSUM 5% Significance

Figure: 1 plot of cumulative sum of recursive residuals

1.4

1.2

1.0

0.8

0.6

0.4

0.2

0.0

-0.2

-0.4
96 98 00 02 04 06 08 10 12 14 16

CUSUM of Squares 5% Significance

Figure 2. Plot of cumulative sum of squares of recursive residuals

The graphs displayed the solidness or stability of the model and LR relationship among the variables

Since plots of CUSUM and CUSUMSQ remain within 5% significance level.

Conclusion and Policy Recommendations:

Principle in the Study was to check the relationship among the growth of the economy and inflation and
trade openness.TO has a positive impact on growth while inflation has a reverse link with growth, In the
case of Pakistan. ARDL test was utilized and empirical evidence was found about the negative connection
between inflation and economic growth. Most of the studies were made to investigate the Romer’s
hypothesis i.e. existence of inverse connection among inflation and openness but we also explore their
relation with growth of a developing economy like Pakistan not only in short run but also in long run. as
And as portrayed earlier that inflation has a negative impact on PCY, while openness of trade brings
healthier impacts on growth so State bank of Pakistan and Pakistan’s government both of them should
take concrete choices in curbing the rate of inflation, and they hey ought to embrace genuine conduct
towards boosting in financial development and ought to wipe out the trade confinement that can make a
healthy competition in the economy which will thus make business openings and opportunities of
employment which can yield to accelerate economic growth.