Economic Analysis Research Report, Spring 2011

Submitted to: Dr.Abdul Waheed

Money Supply, Interest Rate and Inflation in Pakistan

Submitted by: Syeda Tabinda Naz (2915)

Economic Analysis Research Report, Spring 2011

Table of Contents
1. Abstract 2. Introduction

3 4 4 4 4 4 5 5 5 5 5 5 8

2.1. 2.2. 2.3. 2.4. 2.5. 3. 4. 5. 6. 7. 8.

Inflation Causes of Inflation Interest Rate Effects of Interest Rate Money Supply

Purpose of this Study Methodology Variables Sample Size Analysis Conclusion & Recommendation

Economic Analysis Research Report, Spring 2011

Abstract
The intention of writing this paper is to ascertain the changes in inflation, interest rate and money supply and relationship of these variables with one another. The data and figure has been gathered from the handbook of economics of State bank Pakistans website. We have gathered the data from year 2001 to 2010 for our analysis and applied bivariate correlation to check the relationship among them.

Keywords: Inflation, Money Supply & Interest Rate

Economic Analysis Research Report, Spring 2011

Introduction
Inflation:
Inflation is a debatable issue and an important topic in economy of Pakistan as it has serious implications for growth and income distribution. Inflation is actually continuous increase in the price levels of goods and services. Inflation is measured as a percentage change in prices. We can calculate inflation through CPI (Consumer Price Index) Government should control this unpredictable inflation because it can disturb the economy severely.

Causes of Inflation:
Inflation is caused by many things like: Government start printing excess money to deal with crises and when extra money is printed some well being groups purchasing power increases and so he prices of commodities increases with speed and it causes inflation. Rise in production cost also results in inflation means if a raw materials price increases, cost of production also increases and therefore the producers increases the price of the product because they want to overcome their cost and obtain profit.

Interest Rate:
Interest rate is a rate which is charged or paid for the use of money.

Effects of Interest Rate:

It also affects the economy; if interest rate is higher then people dont want to take loans from the banks because it will be difficult for them to pay the loans back with interest charged, and due to which purchase of cars, homes and all items bought on loan goes down. Higher interest rate also result in increase in foreign investment because these outside people want to avail this opportunity to get larger return in their investment, this results in higher dollar demand. While if the interest rate is low people take more loans to buy cars, houses etc and so the prices of these things goes down and more people can purchase these things.

Economic Analysis Research Report, Spring 2011

Money Supply:
Money supply can be defined as the total supply of the money circulating in an economy. We can also say that it is the entire quantity of bills, coins, loans, credit and other liquid instruments in a country's economy.

Purpose of this Study:

The purpose of this study is to analyze the relationship among inflation, interest rate and money supply.

Methodology:
For the collection of data we have searched web and found data on state bank of Pakistans website.

Variables:
The variables for this analysis are Inflation rate, interest rate and money supply.

Sample Size:
Sample size is based on 10 observations that is n = 10.

Analysis:
In this report we have checked the relationship between money supply, inflation rate and interest rate. We took date of 10 years of all these 3 variables For the purpose of analyzing the relationship we have used SPSS software. We fed the data into SPSS for test application. Test we have used is Pearsons Correlation. Before performing bivariate / Pearsons correlation we checked the reliability of the data, value of cronbachs alpha is 0.664 which tells us that the data is more than acceptable means the data is good and is reliable. On performing Pearsons correlation we get to know the following outcomes:

Interest rate has very weak correlation with money supply as well as inflation rate. The p- value of Interest rate for inflation and money supply is more than 0.05 means that well accept H0 means Correlation between these variables is insignificant. If we look at Money Supply, we have already noticed that it has weak correlation with Interest rate. But with inflation rate it has strong positive correlation and p-value is also less than 0.05 I.e.; 0.001 therefore well reject H0 and accept H1 which means that Correlation between Money supply and inflation rate is significant.

Economic Analysis Research Report, Spring 2011

From these outputs weve concluded that there is a strong relationship between money supply and inflation but very weak relationship between interest rate and inflation and interest rate and money supply.

RELIABILITY STATISTICS

Cronbach's Alpha .664

N of Items 4

CORRELATIONS IR
IR Pearson Correlation Sig. (2-tailed) N Money Supply Pearson Correlation Sig. (2-tailed) N Inflation Pearson Correlation Sig. (2-tailed) N 10 -.026 .944 10 -.088 .809 10 10 .866(**) .001 10 10 1

Money Supply
-.026 .944 10 1

Inflation
-.088 .809 10 .866(**) .001 10 1

** Correlation is significant at the 0.01 level (2-tailed). GRAPH OF INFLATION RATE AND MONEY SUPPLY FROM 2001- 2010
25

20

15 inflation rate 10 m oney supply(Million Rs.)

0 1 2 3 4 5 6 7 8 9 10

The Above graph is showing Inflation and Money supply on y axis and years from 2001 to 2010 on X-axis. Money supply is in Millions while Inflation rate is measured in terms of

Economic Analysis Research Report, Spring 2011

percentage. Money Supply and Inflation are in direct relationship with each other. When the circulation of money in an economy increases the inflation also increases, means when prices are higher more money circulates in the economy. The above graph shows that money supply since 2001 is continuously increasing till 2010. Inflation rate has also increases and in year 2009 its at its peak that is more than 20%. While in 2008 it was approximately 12% than it increased with a high pace in 2009 and again came down to approximately 12% in 2010. GRAPH OF INFLATION RATE AND INTEREST RATE FROM 2001- 2010
25 20 15 10 5 0 1 2 3 4 5 6 7 8 9 10

Inflation interest rate

The above graph is showing the trend of inflation and interest rate. Inflation and interest rate is plotted on y-axis and years on x-axis. If we observe the graph we can see that from 2003 to 2006 interest rate keep on decreasing and in 2006 interest rate was lower than other years but than again in 2007 it increased and keeps on increasing. Interest rate can be affected by inflation because if someone lends his money he want to earn profit on it and if the money landed is losing its purchasing power due to increase in inflation, lender want the borrower to cover that loss for him and interest rate helps to covers that loss for him.

We can see in the graph that where interest rate is higher the inflation is low and where inflation is high interest rate is low, means an inverse relationship exists between inflation and interest rate. High interest rate = low inflation Low interest rate = high inflation
It is because if the amount if money in the economy is more than people want to spend more and it results in increased prices of goods and services. While if the less money is circulating in economy than people will spend less amount and so the demand for products and services will be low so prices will also fall. Therefore if the interest rates are low, one can easily borrow the money and therefore theres more money in the economy and if the interest rates are high than it would be difficult for people to borrow money because they have to more larger amount of interest on the principal amount therefore less money circulation will be in economy.

Economic Analysis Research Report, Spring 2011

Conclusion & Recommendation

Conclusion:
From this analysis we have concluded that: 1. Inflation rate is strongly and positively associated with money supply.

Means money supply is the one who is having a strong impact on interest rate, the higher will be the money supply the higher will be the inflation and if the money supply decreases the inflation will also decrease. This shows that these two variables are directly related with each other increase in one results increase in other and vice versa.

2. Interest rate has very weak correlation with inflation rate. Interest rate is inversely related with inflation rate but has a weak relationship. It is not said that interest rate will not affect inflation it will but not mush as money supply is affecting. If interest rate is higher then it results in low inflation and if interest rate is lower than inflation will be higher. 3. Interest rate has very weak correlation with money supply Interest rate is also having weak and inverse relationship with money supply as well.
If interest rates are low than it would be easy for a person to take money from lender on low rates. If people borrow more amount of money than obviously the circulation of money increases or we can say that money supply increases and if the interest rates are higher than one is not interested in borrowing money because it would be difficult for him to pay high interest on the amount borrowed so they money circulation will decrease means money supply will be low.

Economic Analysis Research Report, Spring 2011

Recommendation:
The inflation in a society is a result of excess money supply whenever the money in the economy is easily available in quantity than one wants to spend more and when one spends more than price of commodities increases. This increase in prices of goods and services causes inflation. If we want to control the level of inflation we must have to control and should have complete command over the level of money supply. In the light of our research we can conclude and would like to suggest the policy makers of Pakistan to control the level of inflation via adapting the contractionary monetary policy.

Economic Analysis Research Report, Spring 2011

References:
http://www.ehow.com/how-does_4564447_interest-rates-affect-economy.html http://au.answers.yahoo.com/question/index?qid=20080201040435AA6gGPA

http://www.sbp.org.pk/publications/index2.asp