DEPARTMENT OF FACULTY OF BUSINESS ADMIN,

COMMERCE AND ECONOMICS

SUBMITTED BY:

ANAS KASHIF

SUBMITTED TO:

DOCTOR NAZIA

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 INTEREST RATE IMPACT ON ECONOMIC
GROWTH

ASSIGNMENT # 1

PRINCIPALS OF MACROECONOMICS (MAJOR)

(ECO 302)

Student ID: 78101

BS ECONOMICS (4 YEAR)

FUUAST federal Urdu university

of arts, science and technology

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ABSTRACT:
This study examines the non-linear relationship between fiscal development and economic
growth in Pakistan. It aims to survey the existing literature, both theoretical and empirical, on
the relationship between fiscal policy and economic growth. While the current relationship
between the two has been extensively studied, the link between the two is still inconclusive.
This paper takes a comprehensive view of the theoretical evolution of the relationship and
relevant recent empirical findings. Inflation is assumed to have a non-linear relationship with
GDP growth. The government considers inflation adjustment as the main objective in
planning and implementing policies to achieve economic stability and GDP growth.
Therefore, in the relationship between inflation and GDP growth. Determining the threshold
is an important task in order to accurately predict the rate of inflation. Economic growth can
be affected by monetary policy and other policies formulated by governments and central
banks. A number of factors determine economic growth and interest rate is one factor that
influences the behavior of borrowers to invest. and reduces financial crises. A cause-and-
effect relationship between interest rates and inflation appears. Complex empirical studies
have shown negative, positive and neutral effects on economic growth. A new monetary
policy norm, like negative interest rates, will have a positive impact on growth. The side
effect of such measures could be high inflation rate affecting household income, (RGDP) and
economic growth. Priority should be given to export promotion, investment opportunities as
well as generation of active workforce. Foreign direct investment plays an important role in
promoting economic growth, especially for developing economies. It leads to improvements
in various sectors such as education, health care industries and more jobs. The pace of FDI
inflows into Pakistan is increasing every year. In order to attract more FDI, many countries
are reframing their tax policies by introducing various tax incentives. Efforts like investment
allowances in tax holidays, exemptions, deductions etc. In this regard, the government of
Pakistan needs to reconsider its priorities while making policies in favor of FDI.

KEYWORDS:

Interest rate, Economic growth, FDI, interest rate spread, economic growth, sustainable
growth, government expenses, Economic Growth, Foreign Direct Investment Taxation, Trade
Money supply, Interest rates, Output stabilization, long run neutrality,

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INTRODUCTION:

Any country's economy gets support from several factors for its survival and growth like FDI,
inflation, trade, import, export, and tax revenue etc. Almost every government keen to invite
FDI for its country. The International Monetary Fund states that FDI refers to an investment
made to secure long-term interest by the investor in enterprises that operates in another
country. FDI is a direct investment to a foreign establishment, an individual or a set of
entities that can regulate or manage by the foreign enterprise. Interest rate is a vital variable
in the financial system. On a number of levels interest rates are important. On an individual
level, high interest rates deter one from embarking on an investment because the financing
cost would be extremely high. On the other hand, high interest rates could motivate one to
save because one can earn more interest income. High interest rates might cause a company
to postpone an investment such as purchasing a new machinery to expand operations, thus
thwarting the effort to create more jobs to foster economic growth.

Due to their significance to the economy, interest rates have drawn a lot of attention from
economists, lenders, and borrowers. The interest rate makes it easier for money to travel from
lenders to borrowers. This is what a borrower pays the lender for the usage of the funds and is
known as the cost of borrowing. Interest rates allow financial institutions, including corporate
organizations, banks, mutual funds, and insurance firms, fulfil their intermediary function by
facilitating the flow of credit into the economy. On the other hand, low interest rates promote
borrowing and economic growth since firms expect to pay a small percentage of their profits
as interest on borrowed funds, which means that the lower the interest rate, the higher the
earnings expectations (all other things being equal).

On the other hand, profit margins decrease as interest rates rise. Money is used to exchange
products and services in the modern world. Most people preserve all of the money that is left
over after paying for goods and services and could be utilized to make investments in the
economy. Over the years, the short-run and long-run impact of monetary policy on real
variables, in particular on output, has remained ambiguously at the center of research. Most
studies have focused largely on the monetary policy neutrality in the long run and on
developed countries. This paper provides an eclectic review of the international literature,
both theoretical and empirical, on the impact of monetary policy and economic growth in the

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short run and the long run. The existing literature shows that different studies focus on
different countries and country groups, periods and proxy variables, and different
econometric methodologies are used

LITERATURE REVIEW:

The theory of financial liberalization put forth contends that interest rate regulation often
results in low and negative real interest rates, which inhibit the development of the economies
of developing countries. Low interest rates brought on by financial instability make saving
less alluring and deter investment. The quality of the investment will be inferior due to the
low rate of return on initiatives that will be carried out under a repressive regime. They
argued that deregulating interest rates would result in greater rate increases, which would
encourage saving and investment and speed up economic growth. All of these variables,
including the real exchange rate and the unemployment rate, had no statistically significant
link. According to increased stock market capitalization is a result of higher interest rates.

History shows that policymakers strengthen the economic recovery from the financial crisis,
such as a pandemic. During the Covid19, the Central banks worldwide have moved into a
similar area, the negative interest rate and facilitated quantitative easing (QE). Subsequently,
one of the things that happened is that QE pushed asset prices to go higher without increasing
real output. Eventually, the overall CPI rate hit its record high (ECB,2022). OECD (2021)
said that inflation (CPI) is a considerable risk to the real gross domestic product (RGDP), and
the current price rises can be further than the forecast. Due to higher inflation, global growth
is down rated from 5.7% to 4.5 in 2022. IMF (2021), policymakers are concerned that
massive QE, accommodating policy support to respond to pandemic and negative interest
rates could cause recent inflation spikes. Supply shocks and significant uncertainties mainly
associated with the evaluation of economic slack, rising housing prices, and a significant
upswing in the commodity price show the headline inflation may climb significantly higher
than the baseline.

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The following literature review confirms that price policy is not the only purpose of ECB to
attain great moderation in economic growth. QE and central banks' unconventional measures
present challenges and do not impress the RGDP. For this purpose, the literature review
consists of associated explanations, definitions, and a theoretical foundation for the thesis. It
starts with an understanding and defining economic growth in-depth. The economists and
think tanks consider the key factor in measuring the economic growth is RGDP. Define the
APR further, what determines interest rates, in practice matters to the economy. Finally,
defining inflation and its relation to growth and interest rate. Additionally, investigating
theoretically and coupled with inflation, interest rate, growth, and their relation to the
pandemic as the financial crisis.

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