IMPACT OF MACROECONOMIC VARIABLES ON ECONOMIC GROWTH: EVIDENCE FROM PAKISTAN

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1 IMPACT OF MACROECONOMIC VARIABLES ON ECONOMIC GROWTH: EVIDENCE FROM PAKISTAN *Dr. Amtul Hafeez, **Muhammad Taha ABSTRACT * Assistant Professors at National University of Modern Languages, Islamabad, **Graduate from NUML, Islamabad The objective of the study is to analyze the macroeconomic variables that affect economic growth of Pakistan over the time period Augmented Dickey-Fuller (ADF) is used to check the stationary level of the variables in the model. Johanson co-integration technique is applied to check the existence of a long-run relationship between variables. The study employs Error correction model to find the short run adjustments for the economic growth in Pakistan. The results show that inflation and government expenditure have negative relation with economic growth. However, domestic saving and net exports are found to have significant and positive effect on economic growth in Pakistan. Key Words: Investment, Savings, Interest Rate, Economic Growth INTRODUCTION The main priority and purpose of each country in the world is to achieve rapid economic growth. Every developing country has mission to control poverty, to increase standards of living of the residents, to strengthen political and social institutions and consequently to achieve economic stability. Each country is required to have economic stability in order to be a developed country. Our aim and objective is to examine the growth of economy with the help of domestic investment, government spending, domestic savings, inflation, and domestic exports. The economic growth in Pakistan is not satisfactory. Various factors are liable for this insufficient GDP. For example, growth of imports over exports, high inflation rate, growing interest rate, increasing population growth and political insecurity. research indicates that there is negative relation between inflation and GDP. When inflation is on increase, it reduces the investment which has bad effect on the economic growth. The exchange rate volatility lowers the exports. The exchange rate appreciation would decrease exports and encourage imports. The interest rate and GDP have inverse relation. The interest rate volatility is strongly connected with inflation. The major reason of high interest rate is high inflation. Objectives of the Study: The main objective of the study is to investigate the impact of macroeconomics variables on GDP growth of Pakistan. Moreover, the following objectives are: 65

2 i. To check the relationship of inflation with economic growth. ii. To find out the relationship of government expenditure, net exports, domestic savings with economic growth. LITERATURE REVIEW The traditional starting point is the neoclassical economic growth model of Solow (1956). The basic assumptions of this model are: constant returns to scale, diminishing marginal productivity of capital, exogenously determined technological progress and the interchangeability between capital and labor. As a result, the model highlights the savings or investment rate as a major economic growth factor in the short term. Technological progress, when examined in the long-term importance, considered exogenous to the economic system and, therefore, is not enough for this model. Regarding the issue of convergence / convergence model growth rates based divergence says that poor economies grow faster, compared to the rich countries. Investment plays an important role in the economy of Pakistan and also its growth. Investment plays an important role in driving growth through increase in productivity levels. Developing countries like Pakistan are marked by lack of capital. The low levels of income lead to low saving rate. Therefore low levels of savings-investment spending in the economy and hence low economic growth. Mubarak (2005) was the association combines inflation and economic growth as part of the analysis. The study shows that the positive relationship between these two variables. After checking, a little inflation and small deficits are not important for continued growth over a long period. High inflation is unreliable, with a stable economic growth. If no shock is lower inflation, a significant improvement in the growth rate. Qayyum (2006) examined the impact of macroeconomic variables on GDP growth on the basis of annual data from The study found that the inflation adversely affects the overall growth. It was identified that there exist negative relation between economic growth and inflation rate. Jilan, Cheema and Asim (2010) identified the impact of different macroeconomic variables on GDP growth by using regression analysis. The study is based on annual time series data from The study found that low interest rate is likely to increase the investment level and hence the economic growth of the country. Ayyub, Chaudhry, and Farooq (2011) examined the relationship among inflation and economic growth in Pakistan. Inflation is constructive and important result of economic growth. Khan and Senhadji (2011) examined the impact of macroeconomic variables on GDP by using ordinary least square method (OLS). The annual data is used from The study concluded that inflation puts forth negative and significant effect on growth. Akram and was (2012) examined the relationship between investment and economic growth, the rate of recognition to the private sector was the principal. Thus, the assessment is that the private sector has a significant impact on economic growth in the long run. 66

3 Sabir and Tahir (2012) examined the impact of macroeconomic variables on GDP growth by using multiple regression technique. For this purpose data is taken from The study concluded that government should bring consistency in macroeconomic variables which reduce poverty, increase agriculture growth and decrease inflation. The study found that inflation has negative impact on GDP. Enu, Obeng and Hagan (2013) demonstrated the relationship between the GDP growth and inflation as negative and significant and the relationship between GDP growth and interest rate is negative and significant. Shahzad and Al-Swidi (2013) evaluated the effect of macroeconomic variables on GDP. The data is used from the period By applying the unit root test and regression analysis the study found that economic growth, exports, imports, have significant positive influence on foreign direct investment inflow. Inflation has significant and negative influence on investment. The political stability has positive relation with economic growth. DATA AND METHODOLOGY The study uses time series data for the period Graphical presentation of GDP, government expenditure, and domestic investment are given in figure 1, 2 and 3 respectively. Gross Domestic Product (GDP) GDP is the market values of final goods and services which are produced in a time period of one year and within the boundary of country by domestic resources. The GDP of any country show the development and economic growth of country. Figure 1. Gross Domestic Product Growth Source: Economic Survey of Pakistan. This graph shows downward and upward fluctuations in the gross domestic product of Pakistan. Gross domestic product of Pakistan shows increasing trend during 2003 to 2007 due 67

4 to increased private and foreign investment. Pakistan gross domestic product in 2012 is around 4 respectively. Government Expenditure Government expenditure or public spending (formerly general government consumption) includes all government current expenditures for purchasing of final goods and services. According to Keynes the expenditure of government on the purchase of final goods both domestic and foreign has a positive impact on economic growth. Figure 2. Government Expenditure Source: Economic Survey of Pakistan. Domestic Investment Domestic investment and direct investment in the reporting economy includes all assets and liabilities between resident direct investment enterprises and direct investors acquired. The domestic Investment comes from the saving of residents of a country as found by Harror- Domar (1930) model. Increase in investment increases the employment level in the country and leads to higher economic growth consequently. Figure 3. Domestic Investment Source: Economic Survey of Pakistan 68

5 Here we have the diagrammatical presentation of model. Domestic Saving Domestic Investment Inflation Gross Domestic Product (GDP) Government Expenditures Net Exports 69

6 The model of the study is presented in Table 1. Table 1. Description of the Variables Variables Description Sources Dependant variable GDP Gross domestic product (GDP) is as the measure of the total final output of goods and services for final use occurring within the domestic boundaries of a given country and within the period of one year, regardless of the allocation to domestic and foreign claims. World bank (2014) Data Independent variable Inflation Growth of the prices over time is known as inflation. Consumer Price Index (CPI) is used as an indicator of inflation, The annual percentage change in a CPI is used as a measure of inflation. World bank (2014) Data Domestic Investment Domestic investment and direct investment in the reporting economy includes all assets and liabilities between resident direct investment enterprises and direct investors acquired. It also includes the transfer of assets and liabilities between the company and foreign residents of the land, which is the ultimate control of the nonresident parent company. This is the amount of capital expenditures in GDP calculations used in measuring the nation's economic activity. World bank (2015) Data Government expenditure Government expenditure or public spending (formerly general government consumption) includes all government current expenditures for purchase of final goods and services. World (2014) bank Net Export Net exports are exports minus imports of the country. More on Net exports are the difference between the total value of exports of a country and the total value of imports. Net exports may have a positive or negative value depending on whether a country imports or exports more Economics Watch (2014) 70

7 goods. Domestic Saving Gross domestic savings is equal to GDP minus final consumption expenditure (total consumption). It is calculated from aggregate of public and private sectors savings. World bank (2013) Data Model Equation lny=α0+α₁ln(inf)+α₂ln(ds)+α₃(nx) +α₄ln(ge)+α₅(di)+ ESTIMATION AND RESULTS The Augmented Dickey Fuller (ADF) test is used to find the stationary of all variables in the model. Variables are not stationary at level because the values of the ADF test are less than the respective critical values. All the variables become stationary when ADF test is applied to first differenced values. The results are given Table 2. To check the long-term relationship between the both dependent and independent variables, we use Johansen co-integration technique for the period The results of unrestricted co-integrating rank test given in Table 3 show that there are six cointegrating equations. Table 2. Augmented Dickey Fuller Test Variable ADF (T-statistics) Critical Values Order of integration In CPI % % % In DI % % % In DS % %

8 10% In GDP % % % In GE % % % In NX % % % Hypothesized No. of (CEs) Table 3. Unrestricted Co-Integration Rank Test Eigen value Trace Statistics Critical Value 5% level None * At most 1 * At most 2 * At most 3 * At most 4 * At most 5 * Note: Trace test shows 6 cointegrating eqn(s) at the level of 5%. Normalized Co-integration Coefficient The results of normalized co-integration equation are given in Table 4. 72

9 Table 4. Normalized Co-integration Coefficient Variables Coefficients T-statistics GDP CPI DI DS GE NX Our results show that inflation has significant and negative impact on the economic growth. That is 1% change in inflation rate reduces the economic growth by 30%. This is so because the higher inflation rate negatively affect the demand for goods and hence economic growth in the country. The domestic investment of Pakistan has positive and significant effect on the economic growth of Pakistan. We find that 1% increase in domestic investment of a country increases the economic growth of Pakistan by 11%. Domestic saving has positive and significant impact on the growth of the economy of Pakistan. For example, 1% change in domestic savings leads to 57% change in economic growth. The government expenditures of Pakistan is found to have negative and significant impact on the economic growth. That is, 1% increase in government expenditures show 16% change in economic growth of our country. The net exports of Pakistan have also a significant and positive impact on the growth of economy of Pakistan. For example, 1% in net exports in 26% change in economy growth of Pakistan. As per Keynesian view the country which has higher exports than imports will automatically move towards economic growth. lny t = β 0 - β 1 ln(cpi) + β 2 ln(di) + β 3 ln(ds) + β 4 ln(ge) + β 5 ln(nx)+µ 0 lny t = *ln(CPI) *ln(DI) *ln(DS) *ln(GE) *ln(NX) +µ 0 Vector Error Correction Model (VECM) VECM is to explain the speed of adjustment of variables towards equilibrium. Negative signs of the coefficient value of error correction term indicates that the variables have a tendency to move towards equilibrium and converge in the long term. Positive sign of error correction term, shows that in the long run the variables depart from equilibrium. The results of VECM as given in Table 4 show that all the variables are significantly determining the economic growth even in the short run. 73

10 Table 4. Results of VECM Variables Coefficients T-statistics D(CPI) D(DI) D(DS) D(GE) D(NX) CONCLUSION AND POLICY IMPLICATIONS We conclude that inflation, domestic saving, domestic investment; government expenditures and net exports have an impact on the economic growth (GDP) of Pakistan. First we apply the Unit Root test (ADF) on the data to check the stationary of our variables. We apply the Johansen co-integration test for the purpose of long run analysis. For short run analysis of our study, we apply the Vector Error correction Model (VECM). We conclude that inflation and government expenditure have negative and significant impact on the economic growth. Domestic investment and net exports have strong positive impact on the GDP growth of Pakistan. We also find that variables specified in the model have strong effect on the economic growth of the country in the short run. It is suggested that government of the country may take stronger steps to further enhance the macroeconomic variables in respect of higher economic growth. REFERENCES Ayyub M. Chaudhry, I. S. Farooq, F. (2011). Does Inflation Affect Economic Growth? The case of Pakistan Pakistan Journal of Social Sciences (PJSS) Vol. 31, No. 1 pp Sabir M.H. and Tahir S.H. (2012). The impact of different macroeconomic variables on poverty in Pakistan,Interdisciplinary Journal of Contemporary Research in Business, 3(10), Qayyum A. (2006). Money, inflation and growth in Pakistan, The Pakistan Development Review,45(2), Jilan S., Cheema F.E., and Asim M. (2010). Exploring impact of macroeconomic variable on GDP of Pakistan, Journal of Management and Social Science, 6(2),

11 Enu P., Obeng P.A. and Hagon E. (2013). The relationship between growth rate and inflationary rate in Ghana: an elementary statistical approach, Academic Research International, 4(5), Shahzad A. and Al-Swidi A.K. (2013). Effect of macroeconomic variables on the FDI inflows: The moderating role of political stability: Evidence from Pakistan, Asian Social Science, 9(9), , 7. Khan M.S. and Senhadji S.A. (2011). Threshold effects in the relationship between inflation and growth, International Monetary Fund, 48(1), Solow, R. M. (1956) A Contribution to the Theory of Economic Growth. Quarterly Journal of Economics 70, The World Bank, World Data Base, data.worldbank.org Government of Pakistan (various issues). Pakistan Economic Survey, Ministry of Finance, Islamabad. 75