Effect of real interest rate on investment in Pakistan (1981-2010)

Submitted To:

Dr. Gulzar Ali

Submitted By:

Muhammad Shoaib

DEPARTMENT OF ECONOMICS

Islamia College Peshawar

SESSION: 2017_2021
 APPROVAL SHEET
It is recommended that the Thesis prepared by MUHAMMAD SHOAIB, Entitled “Effect of real interest rate on
investment in Pakistan (1981-2010)”. Be accepted as fulfilling this part of the requirement for the degree of
Bachelor of Science in economics.

Supervisor: ________________________________

Dr. Gulzar Khan

External: _________________________________

Chairman: ________________________________

Mr. Faheem Khan

DEPARTMENT OF ECONOMICS

Islamia College Peshawar

SESSION 2017_ 20121

 ACKNOWLEDGEMENTS

First of all, I am grateful to ALLAH ALMIGHTY who enabled me to carry out my research work successfully.
I am immensely grateful to my honorable and respectful research supervisor Dr. Gulzar Ali, whose valuable
guidance and encouragement enabled me to satisfactory completing my research work. He really supported and
blessed me with his valuable suggestions during the course of my research work. With a deep sense of gratitude
I would like to thank the whole staff of department of Economics Islamia College Peshawar, for their kind
support in providing me valuable books whenever I needed them. I am also thankful to my dear Sir Mr. Ashtar
Hussain who gave me his precious time, knowledge and motivated me to end up the work. Last but not the least;
I am very thankful to my parents who blessed me with their prayers at every stage of life.

Muhammad Shoaib
Title

 Approval Sheet
 Acknowledgements
 List Of Contents
 Abstract

Contents
Chapte
r Topic Page No.
1 Introduction
2 Literature Review
3 Methodology
4 Data Analysis
5 Summery. Conclusions and Recommendations
6 References
 ABSTRACT

This report empirically examines the changes in the interest rates and its effects on investment expenditure in
Pakistan. There is a negative relationship between interest rate and investment, which means that as interest rate
falls investment rises, and when interest rate raises investment declines in the economy. Real interest rate helps
to determine the trend of investment in an economy. When the interest rates are high, borrowing becomes quite
expensive for the investors so they make less real investment. The high interest makes it difficult to cover their
expenditure because their products become less competitive in both the domestic and international market.

We have used the data taken from the economic survey of Pakistan and world development indicators (WDI)
from 1981 to 2010 on real interest rate, GDP and investment. The estimated regression line (6.002) shows that
there are other factors due to which investment is affected. i.e. (weather conditions, law and order situation etc.)
or it is the autonomous investment and (0.135) shows that one billion increase in GDP will leads to (0.135)
billion increase in investment and (-0.166) shows that if 1% increase in rate of interest it will leads to (-
0.166) billion decrease in investment in Pakistan.
Further I have checked the estimates of normality, autocorrelation and heteroscedasticity. The residuals were
found to be normally distributed. Also there was no autocorrelation and heteroscedasticity.
So the empirical results support the economic theory. Hence we conclude that investment in Pakistan is interest
elastic, because a tiny decrease in the interest rate may lead to a huge change in investment level in Pakistan.
Chapter-1

INTRODUCTION

1.1. BACKGROUND OF THE STUDY

“Interest is a price paid for the use of money or credit”
Or
“Interest is a price paid by borrowers to the lenders for the use of credit for a certain period of time”.
Economic performance of a country can be measured by a number of indicators. These economic indicators lead
us to know whether the economic activity within the nation is stable or not. We can measure it by the rate of
inflation, employment level, national income etc. One of the most important policies formulated by these
intermediaries that influence the economic status of the country is the interest rate policy. Because interest rate
is the only determinant of investment in a country. The current thought is that if interest rate increases across the
board, and then investment will decrease, causing a fall in the national income. Lower the rate encourages more
saving and thus more investment and more jobs to increase production for increasing profits. Higher rates
discourage economically unproductive lending such as consumer credit and mortgage lending. Interest rate is
also the cost of borrowing money. When interest rate increases the overall investment will reduce. Most of the
businesses invest partially or wholly is credited. When there is increase in the interest rate, companies have to
put more resources to payoff this investment cost.

Government institutions, usually a central bank lend money to financial institution to influence their
interest rate, which is the main tool of monetary policy. Usually central bank interest rate is lower than
commercial banks interest rate. Since banks borrow money from central bank and then lends that money at
higher rate to individuals to generate most of their profit.

Changes in interest rates can significantly affect different types of investments. Some stock prices may
decline as companies pay more for loans and raw materials, causing lower profits.

“An investment is the purchase of goods which are not used at present but are used in the future to
generate wealth”. (Sulaiman & Ghulam, 2013). For instance it includes railroad, machinery, factory
construction etc. On the job training or costs Rate of Interest and its Impact on Investment of schooling are
called investment in human capital. The increase of goods inventories is inventory investment; it may be
negative or positive, and it may be unintended or intended. Gross investment consists of residential investment
(only new houses etc.), Non-residential fixed investment (new machinery and new factories etc.) and inventory
investment. If depreciation is deducted from gross investment resultant "Net investment". The net raise in the
value of capital stock annually is the Net fixed investment. So investment is change in capital stock in a certain
time period. Investment theory as well explains that investment is a flow different from capital, which is a stock.

Investment is considered to be an important factor in economic growth (Al- Tarawneh, 2004). So,
economists and policy makers have been interested in studying the major determinants of the investment level.
One of the prospective determinants is the real interest rate.

Investment is the monetary worth of the entire goods and services produced generally within a year in
an economy. This income is as well the earning of all factors of production of the economy.

Investment is frequently said as a function of interest rate and income which are as follow

I = ƒ[R -ive , Y +ive]

A high interest rate might lower investment because it turns out to be extra expensive to have a loan of money,
while a raise in income promotes high investment. Still if a firm decides to employ its personal finance in an
investment, the interest rate in this stands for an opportunity cost of investing those finances rather than
providing out that quantity of money for interest rate.
The flow of increase in investment can be shown through the block diagram:

Increased in Investment

Capital Formation

Short Run Effect Long Run Effect

Rise in Working Capital Rise in Fixed Capital

Rise in Business Activity

Increased Welfare

Source: Tabulated by Author

1.2. SIGNIFICANCE OF THE STUDY

This study examines whether changes in interest rate may affects investment expenditure in Pakistan. Investors
and potential investors will get to understand whether changes in interest rate affect returns of investment or not.
How investment in the real sector affects by changes in the real interest rates.

The findings of this study will help the country and government to decide on which sector of the economy will
need special attention, in terms of attracting direct foreign investment and earning much revenue. In addition to
being useful as a source of information, it may also arouse interest for further studies in this or related areas
concerning the activities of both foreign and local investors.
1.3. RESEARCH QUESTIONS
Following are the main questions of this research:

Q1: Is there any relationship between investment and rate of interest in Pakistan?

Q2: Whether the relationship between interest rate and investment in Pakistan has changed over time?

1.4. OBJECTIVES OF THE STUDY

This study aims to explore the determinant of interest rate in Pakistan focusing on its fluctuations and its effects
on investment expenditure in Pakistan. As economic theory says that interest rate and investment have negatively
relationship to each other.
1. The changes in the interest rates may influence the cost of capital that in turn affects the level of
consumption and investment in the economy
2. To investigate the factors which affect Foreign Direct Investment
3. The effects of Foreign Direct Investment upon Pakistan Financial situation
4. To identify the risks if which the foreign investors bear while investing in Pakistan
5. To investigate the relationship between investment and rate of interest in Pakistan
6. Examine aspects which effects investment and rate of interest in Pakistan

1.5. HYPOTHESIS OF THE STUDY

The central hypothesis of this study is that the real interest rate has a negative impact on the investment level as
H0: interest rate has negative effect on investment

H1: interest rate has positive effect on investment

1.6. ORGANIZATION OF THE STUDY
The study consists of five chapters as follows:
Chapter-1 comprises on introduction and background of the study, objectives of the study, significance of the
study, limitations and organization of the study.
Chapter-2 presents a review of the relevant literature on changes in interest rate and its effect on investment that
will form the theoretical framework for the study.
Chapter-3 gives detail research methodology. It delineates the sources of data, an empirical design. Chapter-4
reports the empirical results. It covers data presentation, analysis and discussion. Here secondary data obtained
using various means outlined in the methodology is organized into a meaningful data format, analyzed and
discussed in order to draw conclusions.
Chapter five presents the findings from the data analysis and offers conclusions and recommendations.

1.7 LIMITATIONS OF THE STUDY

Obtaining and collating data for the research was one of the mitigating factors for this Research. I have taken
data from economic survey of Pakistan from January 1981 to December 2010 which may not reflect the whole
effects of the Interest rate on investment since the data is limited to the year 2010.
CHAPTER-2

LITERATURE REVIEW

This literature review comprises of changes in interest rate and its effect on investment and growth level in
Pakistan. I have mentioned the determinants of interest rate, that what are the variables which determine the
interest rate in the economy. Besides the changes in interest rate I have also discussed the effects of changes in
interest rate on investment and growth level of Pakistan and other countries as well. Most of researchers wrote
articles on the fluctuation in interest rate and its consequences on economic activities of nations. So some of the
articles I have mentioned below:

Joshua and Delano (1990) conducted a study on “determinants of private investment in Less Developing
Countries (LDCs)” on 23 less developing countries for the span 1975 to 1985. They confirm the result that the
real interest rate is inversely related to investment.

Hyder and Ahmed (2003) investigate that “why private investment in Pakistan has collapsed and how it can be
restored”. They explored that increase in real interest dampens the investment level.

James E. Larsen (2004) study “the impact of loan rates on direct real estate investment Holding period return” in
United State, they found that real estate investment has inversely related to interest rate.

Aysan et al. (2005), investigate “the determinants of unsatisfying private investment growth in the Middle East
and North Africa (MENA)” during the 1980s and 1990s. The result shows that real interest rate inversely effect
on a firm investment projects.

Wang and Yu (2007) observed “the role of interest rate in investment decisions for firms in Taiwan”.

Friedrich A. Lutz (December 1945) has explained the interest rate changes in a dynamic economy that a change
in the short term interest rate will not affect the calculation of traders (or manufacturer) in such a way to induce
him to reduce or increase his inventory holdings. He explained further that a change in the long run interest rate
is not likely to influence investment decisions in manufacturing industries, but under certain circumstances that
a change in the long run interest may affect investment decisions in case of public utilities including railroad
and residential construction. Under certain condition the level of interest rate or change in interest rate may
affect the readiness of financial institutions to grant credit or to float bonds and stocks so in such a case the
interest rate may influence the volume of investment even without changing the profit calculation of
entrepreneurs.

Sergio Pereira Leit and V.Sundararajan (Dec 1990) has investigated that in order to ensure the optimum
allocation of resources the interest rate reforms should be the top concern of policy makers. The aim of such
interest rate reforms is to improve the performance of the economy. First, the lower interest rate dose not leads
to additional investment unless savings are forthcoming. Second, the expected real interest rate must be positive
in order to prevent productive hoardings of good or financing of economically unsound projects. Third, after
allowing for exchange rate expectation should be set with due consideration to interest rate differentials, taking
into account the economy’s of degrees of openness for capital movement. Forth when public sector dependence
on financial market is due largely fiscal imbalances, the services requirements of the government debt become a
major stumbling block in the path of interest reform. Interest rate liberalization will thus have to go hand in
hand with an improvement in the financial position of the government. Fifth in centrally planned as well as in
countries where public sector is a major sector of borrowing it is important that the government projects that are
carried out yield (social) rate of return that exceed those of projects that are refused financing. The government
has an important role in promoting competition, and also in insuring that its financing operations do not distort
market rates.

Maudos and Solis (2009) investigated the determinants of net interest income in Mexican banking sector for the
period between 1993 and 2005. Their sample constituted 43 commercial banks with 289 annual observations of
an unbalanced penal data. They observed high margin for Mexico, of approximately 5% vis-à-vis international
slandered. They consider various explanatory factors to explain the behavior of banking spreads. These
included operating cost volatility of interest rate, implicit interest payments, quality of management, non-
interest income, credit risk, transaction size, liquidity, cost to gross income, GDP growth and inflation rate. The
reported result reflected that expected for liquidity all other variables were significantly related to interest rate
spreads. They concluded that the high Mexican spreads are mainly a function average operating cost and
market power while non-interest income, despite of increasing over the year, has low economic impact.

Hawtrey and Liang (2008) studied the bank interest margin in fourteen OECD countries for the period 1987 to
2001. The explanatory variables they used were market structure, operating cost, degrees of risk aversion,
interest rate volatility, credit risk, scale effects (transaction size of loans and deposits), implicit interest
payments, opportunity cost of bank reserves and managerial efficiency. They used a single step panel regression
with fixed effects and found out significant coefficients for most of the variables. The transaction size and
managerial efficiency (operating 24 efficiency to gross income) were negatively related to the margins
that they attributed towards management efficacy in getting low cost deposits and extending loans at higher
interest rates resulting in higher spreads. They concluded that market power, operating costs, risk aversion,
volatility of interest rates, credit risk, opportunity cost and implicit interest payments have positive
impact on overall interest rate spreads.

Raj Chetty (Jan. 2007) has investigated the effects of interest rate on investment in an environment where firms
making irreversible investment learn over time. The main result is that at low interest rate, an increase in r
increase investment demand by enlarging a set of projects for which r exceeds the return to delay.

The empirical relevance of the model for explaining how interest rate changes affects aggregate investment
depends on the extent to which firm re-time investments in response to changes in market conditions. There is
some evidence that firm delay investment when faced with increase in uncertainty, as predicted irreversible
investment models Leahy and Whited, 1996; ulan, Mayer and Somerville, 2004; Bloom, Bond and Reenen,
2006). There is also some evi- dence that cross-sectional variation in interest rates are related to the speed of real
estate development (Capozza and Li, 2001), and time-series fluctuations in interest rates affect the timingof
IPO decisions (Jovanovic and Rousseau, 2004). In future work, it would be interesting to test whether
exogenous interest rate changes affect the timing and profitability of irreversible investments in high-risk
industries.

Munir, Awan & Hussain (2008) found that private investment is increased by saving, interest rate on deposits
further they argued that financial liberalization increased interest rates and investment which lead to decision
that reinvestment in bank deposits is more profitable than investing in low productive sector. Due to this the
supply of credit is available for more productive sector and in result GDP will increase.

Steven A. Seelig (September 1974) has showed the impact of changes in interest rates on price changes is fairly
negligible. The statistical and economic insignificance of the results does not support the hypothesis that
increases in interest rates lead to higher prices via mark-up pricing. Consequently, inflation during the period
1955-1969 cannot be attributed to higher interest rates.

What we have shown is that interest rates would have to double (which did not occur in either of the tight
money periods (1966 or 1969-1970) for there to be a noteworthy increase in price. The largest short-run impact
of such an increase in interest rates would occur in the Radio and Television industry where the price index
would rise by five per cent. If interest rates double and the new rates are maintained, the largest increase (from
Tables 4 and 5) would be in the price index for Water Transportation, and this would be an increase of only
eighteen per cent. However, as the results presented in Tables 4 and 5 show, a five per cent short-run and an
eighteen per cent long-run in- crease are the exception rather than the rule. The results do not support the belief
held by some that tight money policies and the resulting increases in interest rates cause prices to raise.

M. Aynul Hasan, Ashfaque H. Khan and S. Sajid Ali. (December 1996) have investigated the significance of
financial reforms in Pakistan introduced in the early 1990s cannot be undermined in that it has brought
about some real changes in terms of freeing interest rates, reducing the spread rates between the deposit and
lending rates, privatization of nationalized banks, and many more, what is, however, important from the public
policy point of view in this context is to know how much Pakistan's economy could have saved or gained had
the reform been introduced earlier in the 1980s. Analysis of this nature which is also known as counterfactual
exercise is useful not only in terms of getting an estimate of foregone benefits of delaying reforms in the past
but, more importantly, it provides the policy-makers with a better insight into successfully implementing the
reform in the future.

With this perspective in mind, this study develops and estimates a 24-equation medium-sized macro-
econometric model for Pakistan with a specific focus on the financial sector. Although the model constructed
does not explicitly deal with specific institutional arrangements (Privatization, NBFI, etc.) and management
side (prudential regulations, competitions, etc.), of financial reforms, analysis of this paper, nevertheless,
quantifies some of the important implications of the reform within the context of policy simulation exercise.
Three important areas of financial reform where this study has made some modest contribution are the ones
that relate to identifying the impact of more flexible market determined interest rates; reducing the spread
between the deposit and lending rates; and finally, promoting policies to improve financial deepening in the
economy.

In general, our findings suggest that the impact of all three financial sector reform policies not only reduce
financial disintermediation (McKinnon-Shaw Hypothesis) but the positive influence also permeate into the real
sector. In fact, the key finding of this study is that had Pakistan introduced the financial sector reforms in
the eighties rather than in the nineties, the economy could have enhanced its output in real terms by over Rs
16.5 billion every year. This figure is by no means a trivial amount given the size of the average annual real
output of Rs 344 billion during this period (1981-94).

Shahbaz Nasir, Mahmood Khalid and Amir Mahmood. (January 2005) they have discussed that investment and
saving rates in Pakistan could not achieve significant growth in the past three decades and resulted in slow
economic growth. A comparison with the East Asian economies reveals clearly that Pakistan has long way to
go. To be at the same level of growth with these fast growing economies Pakistan needs to finance the desired
investment through increased domestic saving without undue reliance on the foreign resources as these
introduce an element of unsustainability. So, it is essential to get the saving rate up to 20-25 percent, if we
want to follow the model of these countries. There is need to boost up the saving and investment in the country
through effective policies giving due consideration to the effectiveness of the potential determinants.

Savings in Pakistan are not significantly affected by the budget deficit and government investment, i.e. there is
no Ricardian Equivalence. However, by the increase in the Government's current expenditures more resources
are transfer towards the people in the form of increased wages, and more liabilities are cleared on the part of
Government. The study shows significant effect of economic growth on savings whereas saving behavior in the
country is insensitive to the interest rate. Most people save to cover the future expenditures, i.e. Education,
Marriages, etc. So, re-structuring of the financial market is needed to lure more saving.

Return on investment is an important determinant of investment in Pakistan Its role in investment decisions-
making carries such a weight that it outweigh negative impact of increased rate of borrowing. Expectations and
uncertainties play a major role in investment decisions in Pakistan. Whereas domestic saving is a major source
of investment, foreign saving is not effective for investment in Pakistan.

Nicholas M. Odhiambo (2008) has showed that the impact of interest rate reforms on financial deepening and
savings in Tanzania is examined using two models, namely the financial deepening model and the savings
model. Using co integration and error-correction techniques, the empirical results of this study reveal that there
is abundant support for the positive impact of interest rate reforms on financial deepening in Tanzania.
Likewise, the study finds financial deepening, which results from interest rate reforms, to have a positive
influence on domestic savings. However, the study failed to find any strong support for the direct positive
interest rate elasticity of savings in Tanzania.

Norris and Floerkemeir (2007) used bank level panel data set for Armenia to examine the factors explaining
interest rate spreads and margins from 2002 to 2006. They employed a variety of bank specific and macro
variables including overhead costs, bank size, non interest income, capital adequacy, return on assets, liquidity,
deposit market share, foreign bank participation, real GDP growth, inflation, money market rate and change in
the nominal exchange rate. Using both pooled OLS and effect regression they concluded that bank specific
factors of size, liquidity, ROA, market concentration, market power explain a large proportion of banking
spreads.

Khan (1995) discussed various initiatives taken by financial institutions in south Asia and Pakistan particular,
which may help to improve access to credit for the poor, which may in turn improve their standard of living.
The most important is to enhance the productive capacity of the poor by helping them to acquire new assets.
Due to the use of modern technology in other sector, demand for credit in other sector, demand for credit in
other sector. He suggested that further credit facilities all required to meet the upward demand for credit and
efficiency of the credit system should be improved.

Siddiqui (1996) discussed or presented critical analysis of a number of credit policies introduced by state bank
of Pakistan to facilitate economic development in the country. He highlighted of Pakistan economy, assessed
reason for tics the failure of various credit policies and discussed whether or not interest bearing finance has a
future in Pakistan. He considered participatory investment as an alternative to the conventional banking system.

Qureshi (1996) investigate that Pakistan’s credit institutions are not helping to accelerate agricultural growth
and reduction poverty. To improve performance in the rural economy and efficiency in financial institutions
rural credit must be liberalized. The state bank of Pakistan initiate following measures. Decline in interest rate
and price control must combine with the policies to stabilize the economy.

Commercial bank must operate in a competitive environment. They must be allowed to set interest rate for rural
lending that cover their transaction past.

Credit must be available to support productivity growth for agriculture, small holders and small producers of
rural non form sector, where Pakistan growth potential lies.

Mohammad Ali (1998) examined the role of interest rate in the economic development of Pakistan. The data
was based on primary and secondary source. His objective was to improve the income generation capacity of
the community and help them to repay the borrowed funds on time. There is a growing use of credit provided by
NBP, ADBP, and Federal Bank of Co-operative and other commercial banks to improve the performance of the
economy in all sectors. However the payment of loans is not satisfactory. Therefore he recommended,
establishing a credit programs with other features such as an extensions programs to find out reasons behind
repayment of loans and attempts to improve the situations of repayment.

If it was concluded that more careful screening of applicants prior to the loans will reduce repayment and after
the loans has been given more pressure on those who are able to repay, but are unwilling to do so should secure
a greater level of repayment.

Joshua and Delano (1990) conducted a study on “determinants of private investment in Less Developing
Countries (LDCs)” on 23 less developing countries for the span 1975 to 1985. They confirm the result that the
real interest rate is inversely related to investment.
Hyder and Ahmed (2003) investigate that “why private investment in Pakistan has collapsed and how it can be
restored”. They explored that increase in real interest dampens the investment level.

Bader and Malawi (2010) investigate “The Impact of Interest Rate on Investment in Jordan: A Co-integration
Analysis”. The results confirmed economic theory and various studies that real interest rate and investment is
inversely associated; by contrast, the income and investment is positively associated.
All studies confirms that investment is inversely related to real interest rate.
Or

All the results disclose that the real interest rate is important factor to determine investment.
Chapter – 3

RESEARCH METHODOLOGY

3.1 INTRODUCT1ION

The research methodology means the systematic study of methods that have been applied within a particular
procedure .The main purpose of this chapter and the research thesis is to find out changes in interest rate and its
effects on investment in Pakistan. The study usually seeks the various determinates of interest rate in Pakistan.

3.2 UNIVERSE OF THE STUDY

The whole country Pakistan is selected as universe for the present study. As such the data is collected with
respect to the changes in the interest rate and its effects on investment in Pakistan.

3.3 DATA COLLECTION

The secondary data has taken for this research study. These secondary data sources may include newspaper
articles, published research, journal papers, media etc.

The data that has undergone through statistical and mathematical changes is related to Pakistan. Reading
material, annual reports of the bank, handouts and internet were the main source of gathering detail information.

A lot of information on the current and previous situations was analyzed which help out to a great extent in
understanding the impact of the decline in the interest rate on general public and thus its effects on the economy.

3.4 SOURCES OF SECONDARY DATA

Secondary data is collected from the following sources.

a) Economic Survey of Pakistan

b) World Development Indicators (WDI)

c) International Financial Statistics (IFS)

d) Ministry of Finance, Government of Pakistan

e) Pakistan Bureau of Statistics

f) State Bank of Pakistan (SBP)

The secondary data collected through internet, which is the most advanced source. A lot of information about
the intention of the investors and their views related to the policy and its impact on the economy was available
on different websites in detail. This information helped to see the changes in the investment decision of the
people and their intentions towards savings.

3.5 TIME PERIOD:

This study has been carried on for the time period of 1981 to 2017.

3.6 OBJECTIVE OF THE STUDY:

Our main objective was to empirically examine the impact of interest rate on investment expenditure in
Pakistan. 

3.7 VARIABLES:

Variables can be defined as any value that can vary or change as a part of interaction within a theory. In other
words, variable are anything which can effect or change the result of the study. Every study has variable as these
are needed in order to understand differences.

So in this research thesis I have taken real interest rate (R=Nominal interest rate – inflation) and level of
income as independent variables and investment as a dependent variable, while the data I have collected in this
regard is from 1981 to 2017.

3.8 ORDINARY LEAST SQUARE METHOD (OLS)

Ordinary least square is the statistical technique that identifies the relationships between two or more than two
quantitative variables.
Functional form of the model I = ƒ[R -ive , Y +ive]

& Econometrical form of the model is Y=ß0+ ß1X1+ ß2X2+µ

OR

INVESTMENT = β0+β1GDP+β2Real Interest Rate+µ

Where

β0 = Intercept

β1 = Coefficient of GDP

β2 = Coefficient of Real interest rate

µ = Error term

3.9 TESTS

First of all, Augmented Dicky Fuller (ADF) Test was used to check stationarity. Before using the data for
estimation, stationarity was ensured. I have used different econometrics tests like (Normality test, Breuch-
Godfrey Test and Breusch-Pagan-Godfrey) to check normality, autocorrelation and hetroscedasticity.
Chapter-4

DATA ANALYSIS

Interest rate has always been playing a quite prominent role in an economy’s growth and sustainability.
Central bank uses the bank rate policies i.e. changing interest rate so as to control the supply of money.

Fluctuations in interest rates always affect the current condition of an economy in one way or the other.
Recently, central bank has adopted the policy of reducing the interest rates drastically, following the trends
adopted by the other countries so as to boost up Pakistan’s economic growth and development. Also the
central bank has been pressurized by the IMF and other international credit institutions to decide upon to
take this initiative of reduction in interest rates.

So the main aim of this study is to analyze the relationship between real interest rate and investment in
Pakistan as the hypothesis is that investment has negative relationship with the real interest rate.
 DATA
(RS Billions)

YEAR INVESTMENT GDP REAL INTEREST RATE

1981 12.24691 53.19733 2.809893
1982 9.29295 36.45497 5.123246
1983 9.788843 38.92603 4.345654
1984 10.29921 40.89771 3.988977
1985 11.35466 44.00271 3.567655
1986 11.89942 46.42359 3.309879
1987 12.41012 49.419 2.809879
1988 12.25691 53.18733 2.909879
1989 13.15915 55.8253 2.109899
1990 13.83515 58.31432 1.998787
1991 14.27777 61.26594 1.009879
1992 15.7108 65.98703 -1.99821
1993 16.39072 67.14692 1.030535
1994 16.2341 69.65648 -4.00569
1995 16.9336 73.11325 -0.82028
1996 17.81933 76.65675 1.026991
1997 17.1389 77.43435 0.721207
1998 16.50614 79.40911 4.536196
1999 15.76358 82.31559 4.894863
2000 16.5584 85.8223 4.204165
2001 17.29479 87.52372 5.345069
2002 17.23239 90.34586 2.236325
2003 17.93943 94.72431 -0.77496
2004 16.83976 101.7041 -0.18712
2005 19.12042 109.5021 0.008339
2006 22.92559 116.2666 3.066416
2007 23.47489 121.8856 4.169649
2008 24.55107 123.9594 -7.35029
2009 23.33369 127.4695 0.889735
2010 21.62448 129.5175 0.161361

Source: World Development Indicators (WDI) and Pakistan’s Economic Survey.

 Following are the assumption for good regression model

1) The value of R-Square should be greater than 60% i.e. (R-Square>60%).

2) The estimated values (slopes β1, β2) of the explanatory variables should be according to the economic
theory.
3) 50% of the regressor must be significant.
4) The residuals should be normally distributed.
5) There should be no autocorrelation or there should be no serial correlation.
6) There should be no heteroscedasticity.

Now explanation of the above assumption with the help of their estimated results…

Model Summary
Adjusted R Std. Error of
Model R R Square Square the Estimate
1 .967a .936 .931 1.08757
a. Predictors: (Constant), R, GDP

ANOVAb
Sum of
Model Squares Df Mean Square F Sig.
1 Regression 464.804 2 232.402 196.483 .000a
Residual 31.936 27 1.183
Total 496.740 29
a. Predictors: (Constant), R, GDP
b. Dependent Variable: INVESTMENT
 Coefficients
Unstandardized Standardized
Coefficients Coefficients
Model B Std. Error Beta t Sig.
1 (Constant) 6.002 .685 8.765 .000
GDP .135 .008 .919 17.499 .000
R -.166 .077 -.114 -2.161 .040
a. Dependent Variable: INVESTMENT

Source: Data Estimation

INVSTMENT = ƒ(R -ive, GDP +ive)

Regression Analysis:

Y = β0 + β1X1 + β2X2 + µ

OR

INVESTMENT = β0 + β1GDP + β2Real Interest Rate + µ

Estimated Regression Line:

Ŷ= 6.002 + 0.135GDP - 0.166 Real Interest Rate

EXPLAINATION OF ESTIMATED REGRESSION LINE

The above regression line shows that there is positive relationship between GDP and Investment, and there is
negative relationship between Real interest rate and investment in Pakistan, which confirms the economic
theory.

In the above regression line (6.002) shows that there are other factors due to which investment is affected. i.e.
(weather conditions, law and order situation etc.) or it is the autonomous investment and ( 0.135) shows if one
billion increase in GDP will leads to (0.135) billion increase in investment and ( -.166) shows if 1% increase in
real rate of interest will leads to ( -0.166) billion decrease in investment in Pakistan. And f-test (0.000%) shows
that the overall model is significant.

R square=0.93 shows that 93.3% of the variation in investment is explained by GDP and Real Rate of Interest
and the remaining 6.7% of the variation in investment is explained by other factors i.e. (weather conditions, law
and order situation etc.) or it represents error term.

Hence the first three assumptions are proved that our model is a good fit

1) The value of R-square is 93.3% > 60% &

2) Both repressors are significant.

3) Both the values of parameters are according to the economic theory that is (β1=.135 shows +vie
relationship between GDP & Investment & β2= -0.166 which shows –ive relationship between real
interest rate and investment).

4th Assumption of OLS is About Normality

This assumption states that all the residuals are normally distributed.

Procedure:

a) H0; the residuals are normally distributed &

H1; the residuals are not normally distributed.

b) Using Histogram Normality Test

 10
Series: Residuals
Sample 1981 2010
8 Observations 30

Mean -1.61e-14
6 Median 17.78062
Maximum 175.3512
Minimum -290.8220
4 Std. Dev. 104.9388
Skewness -0.519103
Kurtosis 3.651306
2
Jarque-Bera 1.877587
Probability 0.391099
0
-300 -200 -100 0 100 200

Source: Data Estimation

c) Critical region:

If the observed Probability of Jarque-Bera Statistics is greater than 5% we can accept H0

d) Result:

Hence the observed Probability of Jarque-Bera Statistics is greater than 5% (39%>5%) so we cannot
reject H0, so we accept H0 and conclude that the residuals are normally distributed.

The 5th assumption is about autocorrelation or serial correlation:

One of the assumption about error term is the co-variance between two consecutive error terms is zero i.e.
covariance (µi, µj) =0 If this assumption is violated then the autocorrelation problem will be existed.

Procedure:

a) H0; there is no autocorrelation.

H1; there is autocorrelation.

b) Using Breuch-Godfrey Test

Breusch-Godfrey Serial Correlation LM Test:

F-statistic 3.105726    Prob. F(2,19) 0.0681

Obs*R-squared 5.912981    Prob. Chi-Square(2) 0.0520

Source: Data Estimation

c) Critical region:

If observed probability of Jarque-Bera Statistics is greater than 5% we can accept H0

d) Result:

e) Hence the observed probability of Jarque-Bera Statistics is greater than 5% (0.052%>5%) so we accept
H0 and conclude that there is no autocorrelation.

The 6th assumption is about heteroskedasticity is

One of the assumption about error term is the variance should be constant. If this assumption is violated
then hetroscedasticity problem is existed.

Procedure:

a) H0; there is no hetroscedasticity

H1; there is hetroscedasticity

b) Using Breusch-Pagan-Godfrey

Heteroskedasticity Test: Breusch-Pagan-Godfrey

F-statistic 0.532302    Prob. F(2,21) 0.5950

Obs*R-squared 1.157986    Prob. Chi-Square(2) 0.5605
Scaled explained SS 0.538131    Prob. Chi-Square(2) 0.7641

Source Source:
Source: Data
Data Estimation

c) Critical region:

If the observed probability of Jarque-Bera Statistics is greater than 5% so we accept H0

d) Result:
 Hence the observed probability of Jarque-Bera Statistics is greater than 5% (76%>5%) so we accept H0 and
conclude that there is no heteroscedasticity.

Thus, we can use our model for the purpose of forecasting.

Chapter – 5

SUMMARY, CONCLUSION AND RECOMMENDATIONS

5.1 INTRODUCTION
This chapter intends to impart information about the major findings followed by conclusion and appropriate
recommendations.

5.2 SUMMARY
This report is basically about the changes in interest rates and its effects on investment expenditure in Pakistan.
To know how interest rate affects investment in the economy. So for this purpose we have found the
relationship between investment, real interest rate and GDP in chapter no.4. There is negative relationship
between real interest rate and investments, which means that as interest rate falls investment rises and when
interest rate rises investment decrease in the economy and there is positive relationship between GDP and
investment, as GDP increases investment also increases and vice versa.

Real interest rate helps to determine the trend of investment in an economy. When the interest rates are high,
borrowing becomes quite expensive for the investors, so they make less real investment. The high interest
makes it difficult to cover their expenditure because their products become less competitive in both the domestic
and international market.

On the other hand, if the interest rate is low, more and more investment take place in the economy which result
in more production, more employment opportunities and increase in the potential GDP. Thus the real interest
rate through their effect on investment improves growth and future living standards of a nation.

The interest rate effect different sector of the economy differently. The interest rate has been declining in order
to get certain objectives. The objectives are to get a boosting situation in the economy and to shift the
investment from bank to the real sector of the economy, flourishing the stock market position and also to attract
foreign direct investment to the country.

As we have found in our model by taking data on interest rate, GDP and investment from 1981 to 2010. The
estimated regression line 6.002 shows that there are other factors due to which investment is affected. i.e.
(weather conditions, law and order situation etc.) or it is the autonomous investment and 0.135 shows that if one
billion increase in GDP occurs it will leads to 0.135 billion increase in investment and -0.166 shows that if 1%
increase in rate of interest occurs, it will leads to -0.166 billion decrease in investment in Pakistan. And f-test
(0.00%) shows that the overall model is significant.
R square=.936 shows that 93.6% of the variation in investment is explained by GDP and Real Rate of Interest
and the remaining 6.4% of the variation in investment is explained by other factors i.e. (weather conditions, law
and order situation etc.)

Hence we conclude that investment in Pakistan is interest elastic, because a tiny decrease in the interest rate may
lead to a huge investment in Pakistan.

5.3 CONCLUSION
From the facts and figures it can be concluded that changes in the interest rate may affect the investment
expenditure of a country, as economic theory have predicted that investment and interest rate are negatively
related to each other. Low interest rate may leads to high investments in the economy, especially Investment in
production and manufacturing sector not only creates employment, but also adds to the national exchequers in
the form of taxes and utility charges. Investment in these sectors particularly for the country like Pakistan which
has an army of unemployed youth.
Despite interest rate fluctuations the Economy of Pakistan has been confronted with number of challenges either
in the form of floods/ rains, paying heavy price against terrorism activities yet a slow and sustained growth is
witnessed over the period after the global financial crises. Presently the problems affecting the economy include
energy shortages, poor law and order situation, and a host of other structural impediments that have held back
investment and growth in the country. Measures to stimulate growth will not yield full potential unless the
structural weaknesses responsible for the decline in the investment are addressed.

5.4 RECOMMENDATION
A continually declining trend in investment and economic growth rate are the key problems that have
adversely affected the economy of Pakistan in the last decade. A profound analysis of the main
determinants of investment that is Real interest rate and real income is reasonably helpful for Pakistan. To
attract investment in Pakistan institution has to keep control the interest rate.

This section discusses concrete recommendation so as to make interest rate policy more effective and acceptable
for the general public. So the following recommendations have been made in order to encourage investment in
real sector in Pakistan.

1. The businessmen should be given much more incentives to increase investment in the form of reduced
taxed, less rigid policies, proper check and balance etc.
2. If the government is serious in making Pakistan an investment friendly country and if it wants to see
investment in industry and service sector, it has to come up with incentives, reducing cost of inputs as first
step.

3. National Accountability Bureau (NAB) and higher authorities should be more responsive to the queries and
complaints of investors and there should be more accountability checks kept on the whole system.

4. To attract foreign direct investment, the Government must try to provide stable law and order situation
within the country and remove the risk and uncertainty involve in business activities.
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