INTRODUCTION

1
 Chapter No 1

INTRODUCTION

Interest Rate
Definition: Interest rate is the percent charged, or paid, for the use of money. It
is charged when the money is being borrowed, and paid when it is being loaned.

Interest is paid by a bank when money is deposited because the bank uses that
money to make loans. The bank then charges the borrower a little more for that
same money so it can make a profit for its service. When the central banks set
interest rates, such as the U.S. Fed Funds rate, it is the amount they charge
other banks to borrow money. This is a critical interest rate, in that it affects the
entire supply of money, and hence the health of the economy.

Examples: High interest rates can cause a recession.

Interest rate. Interest rate is the percentage of the face value of a bond or the
balance in a deposit account that you receive as income on your investment. If
you multiply the interest rate by the face value or balance, you find the annual
amount you receive.

For example, if you buy a bond with a face value of $1,000 with a 6% interest
rate, you'll receive $60 a year. Similarly, the percentage of principal you pay for
the use of borrowed money is the loan's interest rate. If there are no other costs
associated with borrowing the money, the interest rate is the same as the annual
percentage rate (APR).

2
Inflation

Inflation is the pervasive and sustained rise in the aggregate level of prices for
goods and services measured over a given period (Morris and Morris 1999).
Repetitive price increases erode the purchasing power of money and other
financial assets that have fixed values, creating serious economic distortions and
uncertainty. Inflation occurs when actual economic pressures and the anticipation
of future developments cause the demand for goods and services to exceed the
supply available at existing prices or when available output is restricted by
faltering productivity and marketplace constraints.

What Is Inflation?
Inflation is defined as a sustained increase in the general level of prices for
goods and services. It is measured as an annual percentage increase. As
inflation rises, every dollar you own buys a smaller percentage of a good or
service.

The value of a dollar does not stay constant when there is inflation. The value of
a dollar is observed in terms of purchasing power, which is the real, tangible
goods that money can buy. When inflation goes up, there is a decline in the
purchasing power of money. For example, if the inflation rate is 2% annually,
then theoretically a $1 pack of gum will cost $1.02 in a year. After inflation, your
dollar can't buy the same goods it could beforehand.

There are several variations on inflation:

 Deflation is when the general level of prices is falling. This is the opposite
of inflation.

3
  Hyperinflation is unusually rapid inflation. In extreme cases, this can lead
to the breakdown of a nation's monetary system. One of the most notable
examples of hyperinflation occurred in Germany in 1923, when prices rose
2,500% in one month!
 Stagflation is the combination of high unemployment and economic
stagnation with inflation. This happened in industrialized countries during
the 1970s, when a bad economy was combined with OPEC raising oil
prices.

In recent years, most developed countries have attempted to sustain an

inflation rate of 2-3%.

Causes of Inflation

Economists wake up in the morning hoping for a chance to debate the causes
of inflation. There is no one cause that's universally agreed upon, but at least
two theories are generally accepted:

Demand-Pull Inflation - This theory can be summarized as "too much money

chasing too few goods". In other words, if demand is growing faster than
supply, prices will increase. This usually occurs in growing economies.

Cost-Push Inflation - When companies' costs go up, they need to increase

prices to maintain their profit margins. Increased costs can include things
such as wages, taxes, or increased costs of imports.

How Is It Measured?

Measuring inflation is a difficult problem for government statisticians. To do this,

a number of goods that are representative of the economy are put together into
what is referred to as a "market basket." The cost of this basket is then compared

4
over time. This results in a price index, which is the cost of the market basket
today as a percentage of the cost of that identical basket in the starting year.

In North America, there are two main price indexes that measure inflation:

 Consumer Price Index (CPI) - A measure of price changes in consumer

goods and services such as gasoline, food, clothing and automobiles. The
CPI measures price change from the perspective of the purchaser. U.S.
CPI data can be found at the Bureau of Labor Statistics.
 Producer Price Indexes (PPI) - A family of indexes that measure the
average change over time in selling prices by domestic producers of
goods and services. PPIs measure price change from the perspective of
the seller. U.S. PPI data can be found at the Bureau of Labor Statistics.

You can think of price indexes as large surveys. Each month, the U.S. Bureau of
Labor Statistics contacts thousands of retail stores, service establishments,
rental units and doctors' offices to obtain price information on thousands of items
used to track and measure price changes in the CPI. They record the prices of
about 80,000 items each month, which represent a scientifically selected sample
of the prices paid by consumers for the goods and services purchased.

In the long run, the various PPIs and the CPI show a similar rate of inflation. This
is not the case in the short run, as PPIs often increase before the CPI. In general,
investors follow the CPI more than the PPIs.

Problem Statement

In this study we are interested to reduce the higher inflation and interest rate.
Their causes and effects in Pakistan so that we may find the solution to solve the
problem of inflation and interest rate.

5
Objectives of The Study

This thesis introduced a relationship between interest rate and inflation rate. It
effects the economic fluctuations and as well as currency level. So there’s an
inverse relationship between inflation and interest rate. Whenever you hear the
latest inflation update on the news, chances are that interest rates are mentioned
in the same breath.

Objective of this study is too specifying a link between the budget deficit and
taxes and consumption whether this link is positive and negative. We are
interested to give policy recommended according to this result of our study.

Hypothesis
1: H0: There is no significant relationship between inflation and
interest rate.
H1: There is significant relationship between inflation and
interest rate.
2: H0: There is no significant relationship between interest rate
and inflation.
H1: There is significant relationship between interest rate and
inflation.

Limitations

Due to nature of study and availability of time and resources there can be some
various which might be left out from this analysis.

Sources of Data

6
Central bank of Pakistan, Economy of Pakistan, Economy survey, Statistical year
book.

Document Structure

This thesis is structured as follows:

Chapter 2 outlines research and reviews empirical literature from both developed
and developing countries. The chapter then examines alternative explanations
put forward by researchers in an attempt to explain why hypothesis lacks
empirical consistency.

Chapter 3 examines the theoretical framework and its effect on the strength of
the hypothesis. The chapter begins by briefly describing the role of different
economists with their views, outlining its responsibilities, legislative and
governing structure. This is followed a detailed description of inflation-targeting
monetary policy framework, including an outline of the rate of inflation and the
role that monetary policy plays in determining interest rates. The various
channels of the monetary transmission mechanism are then explored. The
chapter concludes by analyzing the dynamics between inflation-targeting,
credibility and the long-run real rate of interest.

Chapter 4 describes the econometric methodology used in the study, the data
and the results are presented.

Chapter 5 provides a summary of the findings, policy implications, limitations and

future research.

7
8
 LITERATURE
REVIEW

Chapter No 2

LITERATURE REVIEW
An interest rate is the price a borrower pays for the use of money he does not
own, and the return a lender receives for deferring the use of funds, by lending it

9
to the borrower. Interest rates are normally expressed as a percentage rate over
the period of one year. Interest rates targets are also a vital tool of monetary
policy and are used to control variables like investment, inflation, and
unemployment. There are many causes of interest rate like; deferred
consumption, Inflationary expectations, Alternative investment, Risks of
investment, Liquidity preference, Taxes.

Inflation is defined as a sustained increase in the general level of prices for

goods and services. It is measured as an annual percentage increase. As
inflation rises, every dollar you own buys a smaller percentage of a good or
service. The value of a dollar does not stay constant when there is inflation. The
value of a dollar is observed in terms of purchasing power, which is the real,
tangible goods that money can buy. When inflation goes up, there is a decline in
the purchasing power of money.

So there is a typically an inverse relationship between inflation and interest rate,

high interest rates equals low inflation, low interest rates = high inflation. For
example; if there is more money in an economy, people tend to spend more, thus
(as a whole) driving up the cost of goods and services. If there is less money in
an economy, there is less to spend and low demand equals lower prices.
If interest rates are low, money is easier and cheaper to borrow, hence more
money in an economy. If rates are high, it is more expensive to borrow, hence
less money in an economy.

There is also a concept know as stagflation, when interest rates and inflation
both increase, such was the case in the Carter Administration. External market
factors or market manipulation may cause stagflation. Economy is like an ocean -
very difficult to see the depth. Inflation and interest rate is razor sharpened on
both side When interest rate rise money flow will be towards secured debt market
and liquidity is contained - funds availability in the market will be rationalized - it
does not guarantee lower inflation - in fact it will have higher inflation because of
cash flow management - Bank lending rate will be higher and it will have

10
cascading effect of higher production cost - higher inflation. Short term capital
inflow will further confuse the strong economy.
If rate is low (int. cut) debt market will sink and there will be more liquidity and
this fuel inflation and outflow of capital to other countries where interest rate is
higher or to sound economy (out of country) will this reduce the currency
valuation. This will also fuel inflation.

Yasuhide yajima (1997) to enhance the effect of monetary policy, the central
bank has been shifting away from its conventional stance of taking action without
elaborating reasons, to a new stance of conveying its policy intentions to financial
markets. In the interest of a more efficient dialogue with the market, the
transparency and accountability of monetary policy must be improved. In line with
this thinking, there have been calls for the bank to introduce inflation targeting.
With inflation targeting, the central bank would announce medium-term inflation
rate targets, and give these targets top priority in monetary policy, while at the
same time being accountable for explaining the current status of its policies.
Because the bank would announce targets and release information pertaining to
implementation measures and policy evaluations, its policies would be accessible
to the public.

A number of countries introduced inflation targeting during the 1990s. New

Zealand was first to do so in 1990, followed by Canada and Israel in 1991,
England in 1992, in most countries; inflation targets have been set to achieve a
consumer price inflation rate of
Around 3%. None of the countries has targeted an inflation rate of zero. This can
be attributed to the fact that most of them have suffered from high inflation rates
in the past, and to the view that an inflation rate near zero is undesirable.
Due to its short history, the general effectiveness of inflation targeting has yet to
be verified quantitatively. However, results from the eight countries show that
inflation rates of around 10% in the 1980s have subsided following the
introduction of inflation targeting. Even allowing for the existence of other factors.

11
Sebastian Edwards (2006) for decades the exchange rate was at the center of
macroeconomic policy debates in the emerging markets. In many countries the
nominal exchange rate was often used as a way of bringing down inflation; in
other countries -- mostly in Latin America – the exchange rate was used as a
way of (implicitly) taxing the export sector. Currency crises were common and
were usually the result of acute (real) exchange rate overvaluation. During the
1990s academics and policy makers debated the merits of alternative exchange
rate regimes for the emerging economies. Based on credibility-based theories
many authors argued that developing and transition countries should have hard
peg regimes – preferably currency boards or polarization. One of the main
arguments for favoring rigid exchange rate regimes was that emerging
economies exhibited a “fear to float.”2 After the currency crashes of the late
1990s and early 2000, however, a growing number of emerging economies
moved away from exchange rate rigidity and adopted a combination of flexible
exchange rates and “inflation targeting.” Because of this move the exchange rate
has become less central in economic policy debate in most emerging markets.
This, however, does not mean that the exchange rate has disappeared from
policy discussions. Indeed, with the adoption of inflation targeting a number of
important exchange rate-related questions – many of them new – have emerged.
In this paper I address three broad policy issues related to inflation targeting (IT)
and exchange rates that have become increasingly important in analyses on
monetary policy in emerging countries.

•First, I deal with the effectiveness of the nominal exchange rate as a shock
absorber in IT regimes. This issue is related to the extent of the “pass-through”
from the exchange to domestic prices. I argue that much of the literature on pass
through has missed the important connection between “pass-through” and
exchange rate effectiveness as a shock absorber.
•Second, I analyze whether the adoption of IT has had an impact on exchange
rate volatility. Many authors have pointed out that since IT requires (some degree
of) exchange rate flexibility, it necessarily results in higher exchange rate

12
volatility. This, however, is not a very interesting statement. A more useful
analysis would separate the effects of IT, on the one hand, and of a more flexible
exchange rate regime, on the other, on exchange rate volatility. This is what I do
in section III of the paper.
 A nd third, I discuss whether in an inflation targeting regime the exchange rate
should affect the monetary policy rule. I point out that, from an analytical
perspective, this is still an unresolved issue. At the policy level, very few IT
central banks openly recognize using the exchange rate as a (separate) term in
their policy rules (i.e. Taylor rules). However, existing empirical evidence
suggests that almost every central bank does take exchange rate behavior into
account when undertaken monetary policy.

Berna Kocaman (2006) Stock prices can go up and down frequently. These
changes supposedly reflect the changing demand for that stock (and its potential
resale value) or changing expectations of a company’s profitability. Therefore,
investors wonder how stock prices are determined. Shares in most large
established corporations are listed on organized exchanges like the Istanbul
Stock Exchange or New York Stock Exchange. Shares in smaller or newer firms
are listed on the NASDAQ-an electronic system that tracks stock prices. Every
time a stock is sold, the exchange records the price at which it changes hands. If,
a few seconds or minutes later, another trade takes place, the price at which that
trade is made becomes the new market price, and so on. Organized exchanges
like the New York Stock Exchange will occasionally suspend trading in a stock if
the price is excessively volatile, if there is a severe mismatch between supply
and demand (many people wanting to sell, no one wanting to buy) or if they
suspect that insiders are deliberately manipulating a stock’s price. But in normal
circumstances, there is no official arbiter of stock prices, (no person or institution
that “decides” a price). The market price of a stock is simply the price at which a
willing buyer and seller agree to trade.

13
One of the most-widely reported figures in the financial press is the price to
earnings (P/E) ratio. Traditionally, the P/E ratio has been assumed to be an
indicator of the quality of an investment; a relatively low P/E ratio implies a good
investment, whereas a relatively high P/E ratio indicates a “poor” investment
prospect. Given the apparent widespread market interest in the P/E ratio,
considerable academic research has investigated the role of the ratio in market
valuation of securities. For example, Basu (1983) provides evidence that P/E
ratios can be used to construct portfolios which outperform the market and
Ohlson (1983; 1989a) employs analytical framework to relate market prices of
equity securities to capitalized earnings. Given the wide acceptance of the P/E
ratio in practice and the academic interest in theoretical relationships between
prices and earnings, it is no great surprise that many recent studies have studied
why P/E ratios differ across firms. Beaver and Morse (1978) and Zarowin (1990)
investigate variables, including growth, risk and differences in accounting
practices that may explain some of the cross-sectional variation in P/E ratios
among United States firms. A related series of studies is concerned with
observable differences in P/E ratios across countries (Aron, 1989; Bildersee et
al., 1990; Lee and Livant, 1991; Poterba and French, 1989; Scheineman, 1989).

Dontoh, Livnat, and Todd (1993) investigated the relationships among P/E ratios,
growth and risk, after deriving exact definitions for growth and risk from a simple
theoretical model. They defined growth in terms of expected earnings beyond
“normal” earnings, where normal earnings are a function of the risk-free rate, the
firm’s dividend policy and random shocks. Similarly, they defined risk in terms of
the uncertainty in forecasting future growth (i.e., abnormal earnings) rather than
the usual systematic risk measure or “beta”. The relationship between P/E ratios
and these measures of abnormal earnings and estimation risk is shown to be
non-linear and their empirical tests incorporate this nonlinearity into the research
design.

14
Dontoh, Levant and Todd (1993) developed and empirically tested a theoretical
model relating growth (abnormal earnings) and estimation risk to one of the most
fundamental financial indicators, the earnings / price ratio. They found that
growth in excess of the risk-free rate, that is, in excess of the long-term expected
return for firm in equilibrium, is theoretically negatively related to the E/P ratio,
i.e., the E/P ratio is decreasing in the growth rate. Similarly, the model suggests
that the E/P ratios should be positively associated with estimation risk; the
greater is the uncertainty about future abnormal earnings the smaller is the price
and the larger is the E/P ratio. Their model indicates that the relationship
between E/P ratios and both growth and estimation risk is not linear, and should
be estimated appropriately. Their results also indicate the importance of growth
(abnormal earnings) and the estimation risk to the explanation of cross-sectional
variation of E/P ratios both across and within various countries. Their model and
associated results also document the importance of variation in short-term
interest rates as an explanatory variable for cross-country variation of E/P ratios.

Bulent Guler and Umit Ozlale (2004) Inflation uncertainty may affect interest
rates for safer assets through two distinct channels. First, an increase in
uncertainty will raise the interest rates by an increase in the inflation risk
premium. Such a relationship is documented in several studies like Refs.. On the
other hand, there is another channel,’ flight to quality’’, that has not been
investigated previously in this context. According to that view, an increase in
inflation uncertainty might lead to a perceived increase in economy-wide risk,
prompting a ‘‘flight to quality’’ by investors, in which their demand for safe assets
like treasury bills rises. This increase in demand for these assets would tend to
lower the associated interest rates. Therefore, a negative relation between
inflation uncertainty and interest rates for safe assets may also exist.

This study takes the above discussion as its starting point and investigates the
validity of these two different channels for the United States economy. Apart from
the studies that have dominated the literature, inflation uncertainty is modeled in

15
a time-varying parameter framework with GARCH specification. Such a
methodology is originally introduced by Evans (1991) and can be used to identify
several types of inflation uncertainties: Uncertainty can either emerge from the
randomness in the structure of inflation process that we name as ‘‘structural
uncertainty’’, or it can be generated by the shocks that hit the economy, which we
name as ‘‘impulse uncertainty’’. The effects of these two distinct types of
uncertainties on safe assets can vary significantly. We find that while structural
uncertainty effects treasury bills positively as expected, impulse uncertainty
generates a ‘‘flight to quality’’ effect and it is negatively associated with safe
interest rates.

Why do increases in the Fed’s target for the federal funds rate raise interest rates
on long-term Treasury securities? One might expect that concretionary monetary
policy would raise short-term rates because of a liquidity effect and reduce long-
term rates by lowering expected inflation. Yet Cook and Hahn (1989) reported
that increases in the Fed’s target for the federal funds rate during the September
1974 – September 1979 period raised interest rates at all horizons. Similarly,
Kuttner (2001) found that unanticipated increases in the federal funds rate target
over the June 1989 – February 2000 period increased interest rates at all
maturities.

One interpretation of Cook and Hahn’s (1989) and Kuttner’s (2001) results is that
contraction monetary policy raises longer-term real interest rates. The nominal
interest rate equals the real interest rate plus the expected inflation rate. If
contraction monetary policy lowers expected inflation or leaves it unchanged,
then evidence that it increases the nominal interest rate implies that it must be
increasing the real interest rate also.
Romer and Romer (2000) provided an alternative explanation for these findings.
They showed that the Fed has substantially more information about future
inflation than is available from commercial forecasts. Their results imply that the

16
optimal strategy for individuals with access to both the Fed’s forecasts and
commercial forecasts would be to rely exclusively on the Fed’s forecasts. They
also demonstrated that Federal Reserve policy actions reveal some of the Fed’s
private information about inflation. An increase in the federal funds rate target
could thus increase interest rates by raising expectations of future inflation.

Gürkaynak, Sack, and Swanson (2005a) presented evidence indicating that

increases in the federal funds rate target have the opposite effect, lowering
expected inflation over the 1990 – 2002 periods. They found that unexpected
increases in the funds rate target lower the one-year forward rate ten years
ahead. They also found that real long-term forward rates derived from inflation-
indexed Treasury securities do not respond to monetary policy surprises, while
the compensation for inflation responds with a significant negative coefficient to
positive innovations in the federal funds rate target. They interpreted these
findings to mean that surprise increases in the federal funds rate target lower
future expected inflation.

Campbell (1995) noted that the effect of funds rate increases on inflation
expectations should depend on the Fed’s credibility in fighting inflation. If the
Fed’s anti-inflationary policies are credible, then they should forestall increases in
longer run expected inflation. If they are not credible, then they may increase
both shorter-term real rates and longer-term expected inflation. Bernanke and
Mishkin (1997) have argued that central bank credibility in financial markets
depends on delivering low inflation. Inflation in the U.S. in the 1970s was high
and volatile while inflation since 1990 has been quiescent. Thus, as Yellen
(2006) discussed, the Federal Reserve's credibility was much weaker in the
1970s than it is now.

One way to test whether monetary policy surprises affected inflation expectations
differently in recent years than in the 1970s is to look at how they impacted daily
traded commodity prices.2 Commodities such as gold and silver are widely

17
regarded as hedges against inflation. The evidence of Gürkaynak, Sack, and
Swanson (2005a) implies that unexpected increases in the federal funds rate
after 1990 lowered longer-term expected inflation and raised short-term real
interest rates. Frankel and Hardouvelis (1985), Hardouvelis and Barnhardt
(1989), Frankel (2008) and others have shown that if monetary policy actions are
expected to increase real interest rates they will lower commodity prices and if
they are expected to lower inflation they will also lower commodity prices. Thus, if
positive federal funds rate innovations are having the effects posited by
Gürkaynak et al., they should unambiguously lower commodity prices.

We find that positive funds rate innovations raised gold and silver prices during
the 1970s and lowered them after 1989. In addition, funds rate hikes over both
sample periods primarily affected short-term interest rates and near-term forward
rates. These results indicate that Romer and Romer’s (2000) information-
revelation explanation applied in the 1970s, when the Fed lacked credibility. They
also imply that funds rate increases in recent years affected short-term real rates.
The findings for commodity prices in recent years are consistent with the
conclusions of Gürkaynak, Sack, and Swanson (2005a). The statistically
insignificant response of far-ahead forward rates is inconsistent with GSS’s
findings, however, and may occur because we lack data to test for a response
over a narrow (thirty-minute) window.

Michel Brzoza-Brzezina For many years money has been a central issue in
monetary policy making. Central banks used to set monetary targets and
academics used to teach monetary policy, as a story about how central bankers
adjust the money supply. Even the name of the main activity of central banks
took its origins from the word .money... Thus, it is no wonder that many economic
papers describing inflationary phenomena still assume that central banks control
the money supply. Its important role in monetary policy, a lot of research has
been done on testing the long-run relationship between money and inflation. The
probably best known study, is based on the quantity theory of money, and called

18
P-star1. The model shows that the quantity equation, being a very simplified
description of the relationship between money and prices, can be used for
monetary targeting and inflation forecasting, provided that some additional
assumptions are fulfilled. However, the world is changing, and targeting
monetary aggregates becomes less and less fashionable. The main reason is
probably the growing instability of money demand functions. In reaction,
monetary authorities move from targeting the money supply towards controlling
nominal interest rates at the money market. As a result, in the recent decade, a
huge amount of papers, describing monetary policy rules based on nominal
interest rates, has been written. As it is, however, well known, assuming there is
no money illusion, it is in fact the real and not the nominal interest rate that can
influence spending decisions of enterprises and households.

Monetary authorities can alter real rates (at least in the short run) as long as
prices and inflationary expectations are sticky2. Thus, it is crucial for a central
banker not only to look at the level of nominal interest rates, but also to monitor
the behavior of real rates. Despite the growing importance of interest rate
oriented policies, our knowledge on this topic is still unsatisfactory. The first
approach to describe the relationship between real interest rates and inflation is
often ascribed to K.Wicksell (1898, 1907). However already 100 years earlier,
two British economists, H.Thornton and T.Joplin, described economic processes
resulting from the central bank’s influence on the real rate of interest
(T.M.Humphrey 1993).

Nevertheless, not much has been done in this field since. Recent papers, among
others by M.Woodford (1999, 2000), revived the (now called) Wicksellian idea of
inflationary processes being determined by the gap between the real and
natural3 rates of interest. In a very recent study K.Neiss and E.Nelson (2001) use
a stochastic general equilibrium model to examine the properties of the interest
rate gap as an inflation indicator. The above mentioned studies are strongly in
favor of using the gap as a measure of the stance of monetary policy that could

19
be used by central bankers in their day-to-day (or rather month-to-month) policy
setting.

Turkey has had a high level of inflation since the mid 1970s. Governments used
Various fiscal and monetary policy tools to control inflation. In addition to these
tools, governments also attempted to control inflation by regulating the prices of
publicly produced goods and services. Governments either use the publicly
produced goods’ prices as a nominal anchor to decrease inflation (e.g., July 1997
and early 2000 ant inflation programs) as a part of their general anti-inflation
programs, or they try to postpone price increases of publicly produced goods and
services until after elections (as was the case prior to the 1991, 1995 and 1999
elections). However, governments ultimately had to correct the lower prices in
the public sector, mainly to avoid losses in the state owned enterprises. On a
parallel with this, Turkish data suggests that, on the average price increases in
the private and public sectors are approximately the same; however, the
frequency of these price increases in the public sector is lower than those in the
private sector.

The purpose of this article is to show that this infrequency of price changes in the
public sector increases the volatility of the general price level, causing
uncertainty in forecasting general price level, and this in turn increases interest
rates. There is extensive literature regarding the effects of inflation uncertainty on
macroeconomic performance. Cukierman and Wachtel (1979) and Holland
(1993, 1995) examined how inflation uncertainty affects the inflation rate while
Hafer (1986) and Holland (1986) searched for the results of inflation uncertainty
on employment.

Prior to this, Froyen and Waud (1987) and Holland (1988) looked at the inflation
Uncertainty-output relationship. In Berument (1999), the impact of inflation
uncertainty on interest rates was investigated for the UK by using the Fisher
Hypothesis framework. A similar approach for determining the result of inflation

20
uncertainty on interest rates in Turkey was pursued in Berument and Güner
(1997) and Berument and Malatyalý (2001). The Fisher hypothesis suggests a
positive relationship between the expected inflation and interest rates. Berument
(1999), Berument and Malatyalý (2001) and Chang (1994) argue that inflation
uncertainty also accelerates interest rates. This study aims to explore the effect
on treasury auction interest rates of the uncertainty stemming from differences in
the public and private sector pricing behavior. In order to model inflation
uncertainty, it is assumed that each component of inflation (public and private
Sector pricing) follows an unbalanced vector autoregressive process and that
their weighted conditional means are equal to the expected inflation. The
conditional variances of the prices of goods produced by the public and private
sectors are estimated via Generalized Autoregressive Conditional
Heteroskedastic (GARCH) processes. The square root of the weighted average
of these conditional variances is used as a measure of inflation uncertainty, and
its effect is investigated within the Fisher hypothesis. Parallel to Berument
(1999), Berument and Malatyalý (2001) and Chang (1994), it is shown that
inflation uncertainty increases the interest rate. Moreover, if the conditional
variance of the public prices was the same as the conditional variance of private
prices, then interest rates would be lowered by 12 percent.

Norges Bank operates a flexible inflation targeting regime, so that weight is given
to both variability in inflation and variability in output and employment. The
outlook for these key variables is influenced by current information about
economic developments. Several simple rules for interest rate setting are found
in the literature. The rules can be used as rough indicators of whether the interest
rate is adapted to the economic situation. Common to these interest rate rules is
that the interest rate is set with a view to keeping inflation around a specific target
over time, at the same time that the interest rate should contribute to stabilizing
output. One example is the Taylor rule, where the interest rate depends on
inflation’s deviation from the inflation target and the output gap. The Taylor rule
will not capture all factors that are given weight in interest rate setting, and the

21
parameters in the rule are not based on the experience of Norwegian monetary
policy.

External analysts and observers will over time seek to form a broader picture of
how the central bank reacts to new information than that which emerges from
simple rules. In order to understand the response pattern in monetary policy,
observers may estimate the relationship between the interest rate and
developments in macroeconomic variables. Such a relationship may be thought
of as the “average pattern” in interest rate setting. In actual interest rate setting
emphasis is placed on many indicators that have a bearing on developments in
inflation and output. An estimated equation will not capture all relevant factors. In
particular, it does not capture separate assessments at the various monetary
policy meetings. An estimated equation for interest rate setting will thus be a
considerable simplification and only provide an indication of how the interest rate
on average has reacted to a selection of variables. Moreover, the estimation
results will depend on the data period and the econometric method. We have
estimated a simple equation that captures Norges Bank’s average response
pattern from 1999 to the third quarter of 2004.

The chart below shows the interest rate path that follows from the average
pattern of Norges Bank, as estimated here, and developments in the sight
deposit rate. The estimated equation includes developments in inflation, wage
growth, Norges Bank’s projections for mainland GDP growth and external money
market rates. The equation also implies that the interest rate in the previous
period is of importance. Given the projections in this report, the estimated
equation indicates that the sight deposit rate will increase by ¾ percentage points
in the first quarter of 2005, primarily because inflation is projected to rise. An
interpretation may be that Norges Bank has normally changed the interest rate
when it was certain that inflation has moved up or down. The chart illustrates,
however, that the interest rate in periods has deviated from the estimated
average pattern. There may often be good reasons for these deviations. The risk

22
that the krone exchange rate will move in an undesirable direction and bring
inflation further from the target may, for example, imply that the average
response pattern should not be followed. This risk may vary over time, for
example depending on themes in the foreign exchange market. An increase in
interest rates in line with the estimated equation in the period ahead may
increase the probability of an appreciation of the krone and thereby persistently
low inflation.

Marcelle Chauvet and Heather L. R. Tierney In recent years, several factors have
revitalized interest in monetary policy in the U.S. The unusual price stability
achieved in the early 2000s, with a declining inflation rate after the 2001
recession raised concerns regarding the risks of potential deflation. This
possibility instigated public debates and several academic contributions over the
costs and benefits of the preemptive decrease in nominal interest by the Fed to
its lowest level in many decades in order to stimulate Economic growth. More
recently, the resurge in core prices have triggered new debates on monetary
policy conduct.

We propose a nonparametric tool to investigate local dynamic impulse response

functions in a VAR system. In general, nonparametric estimation requires
aggregation of coefficients for the purpose of statistical inference. A large body of
research has been devoted to the examination of the relationship between
inflation and nominal interest rates using vector auto regression models. One of
the findings is that sudden rises in interest rates have been followed by an initial
positive response in inflation, which is known and the price puzzle. Sims (1992)
suggests that this might be caused by an insufficient response by the Federal
Reserve to expectations of higher future inflation. Others find evidence of breaks
in the relationship between inflation and nominal interest rates, especially around
1980. Finally, there is a large recent literature examining the reduced variability
of inflation and nominal interest rates since the mid 1980s. Some authors
attribute this to changes in the real side of the economy that have transmitted to

23
inflation, whereas others reckon that the culprit is the more transparent and
effective monetary policy conduct, which has reduced the oscillations in inflation
and interest rates.

Central bankers across North America have adopted targets for short-term
interest rates as their mechanism for implementing market-conditioning monetary
policy. Recent history indicates that there is substantial information conveyed to
markets through changes in targets for the US federal funds rate, as well as the
target band for the overnight financing rate set by the Bank of Canada. Whether
these shifts in the target rate or the target band are in response to market
conditions, or the final result of “watchful waiting” as might have been suggested
by Poole (2001), they are ultimately aimed at sheltering the economy from the
vagaries of the business cycle. Mishkin (1990a, 1990b, 1991) employed Fisher
equations to demonstrate that the slope of the term structure could explain
changes in the inflation rate. During the expansion of the 1990s, many
economists believed that an increase in the slope of the term structure would
restrain inflation: it was possible to maintain a low and stable inflation rate,
thereby generating the associated benefits.

Tkacz (2000) revisited this issue to determine whether there were non-linearity in
the relationship between the slope of the term structure and changes in the
inflation rate. This was justified by appealing to evidence suggesting asymmetric
effects of monetary policy either within the context of a non-linear Phillips curve,
or more generally within a non-linear model of investment and banking behavior.
Using neural network models, Tkacz (2000) demonstrated that a substantial
tightening of the term structure was required to maintain changes in the inflation
rate at low and stable levels for all policy horizons.

Conclusion

24
This study argues that public and private sector pricing behavior affects the
inflation risk premium differently and this increases the interest rate. The
empirical evidence for Turkey shows that the difference in pricing behavior cost
11 % on average for the period from January 1989 to November 2000. There are
two distinct channels through which inflation uncertainty may affect interest rates
for safer assets like treasury bills. First, an increase in inflation risk associated
with higher uncertainty is expected to increase interest rates. Second, an
increase in uncertainty, which could also be viewed as a rise in economy-wide
risk, might generate a ‘‘flight to quality’’ effect and increase the demand for safer
assets, which, in turn decreases their interest rates. In this paper, we explored
the validity of these two channels after decomposing inflation uncertainty into two
parts, namely structural and impulse uncertainty, consistent with the
methodology. We find that while structural uncertainty supports the first channel
and increases the interest rates for treasury bills, impulse uncertainty generates
a ‘‘flight to quality effect’’ and decreases their interest rates.

25
THEORETICAL FRAME

WORK

Chapter No 3

Theoretical Frame Work

Introduction

26
A general explanation of how something works. A theory says what is related to
what and why. A theory is, in part, a collection of related hypotheses. However, a
theory also contains a sense of process and mechanism -- a sense of
understanding of why and how the variables are related the way they are.
Desirable characteristics of a theory include: falsifiability, parsimony, truth,
fertility, generality, surprise, and a sense of process or mechanism.
A theoretical framework is a theoretical perspective. It can be simply a theory, but
it can also be more general -- a basic approach to understanding something.
Typically, a theoretical framework defines the kinds of variables that you will want
to look at.

Theories
Keynesian economic theory proposes that money is transparent to real forces in
the economy, and that visible inflation is the result of pressures in the economy
expressing themselves in prices.

There are three major types of inflation, as part of what Robert J. Gordon calls
the "triangle model":[37]

 Demand-pull inflation: inflation caused by increases in aggregate demand

due to increased private and government spending, etc. Demand inflation
is constructive to a faster rate of economic growth since the excess
demand and favorable market conditions will stimulate investment and
expansion.
 Cost-push inflation: also called "supply shock inflation," caused by drops
in aggregate supply due to increased prices of inputs, for example. Take
for instance a sudden decrease in the supply of oil, which would increase
oil prices. Producers for whom oil is a part of their costs could then pass
this on to consumers in the form of increased prices.
 Built-in inflation: induced by adaptive expectations, often linked to the
"price/wage spiral" because it involves workers trying to keep their wages

27
 up (gross wages have to increase above the CPI rate to net to CPI after-
tax) with prices and then employers passing higher costs on to consumers
as higher prices as part of a "vicious circle." Built-in inflation reflects
events in the past, and so might be seen as hangover inflation.

A major demand-pull theory centers on the supply of money: inflation may be

caused by an increase in the quantity of money in circulation relative to the ability
of the economy to supply (its potential output). This is most obvious when
governments finance spending in a crisis, such as a civil war, by printing money
excessively, often leading to hyperinflation, a condition where prices can double
in a month or less. Another cause can be a rapid decline in the demand for
money, as happened in Europe during the Black Death.

The money supply is also thought to play a major role in determining moderate
levels of inflation, although there are differences of opinion on how important it is.
For example, Monetarist economists believe that the link is very strong;
Keynesian economics, by contrast, typically emphasize the role of aggregate
demand in the economy rather than the money supply in determining inflation.
That is, for Keynesians the money supply is only one determinant of aggregate
demand. Some economists disagree with the notion that central banks control
the money supply, arguing that central banks have little control because the
money supply adapts to the demand for bank credit issued by commercial banks.
This is the theory of endogenous money.

The inflationary genie is out of its bottle. Or so we are told by orthodox

economists and their dependent politicians in Australia. The new Australian
Prime Minister, Kevin Rudd, claims that “inflation is the ultimate enemy of
working families”, and his Treasurer, Wayne Swan, is certain that “inflation is a
‘cancer’ eating away at living standards’. At the December 2007 election we were
promised a new approach to economic and social problems, but while the
rhetoric has changed the message is just the same – inflation is evil and has to
be surgically removed from society. Nothing has changed. In the past, we were

28
told by former Treasurers, Peter Costello in the Liberal Party and Paul Keating in
the Labor Party, that it was essential to “slay the dragon of inflation”. Politicians,
of course, are captives of the technical mysteries of neoclassical economists.
Therefore, while we can change governments and their rhetoric, we can’t change
their policies on inflation.

We are all to aware of the weapon, or surgical instrument, of choice wielded by

the Reserve Bank of Australia (RBA), official dragon slayer or economic surgeon.
It takes the form of persistent increases in interest rates. The latest interest rate
increase (5th February 2008), of 0.25 percentage points, is the eleventh
consecutive increase since May 2002, and the third in six months, taking the
cash rate to 7 percent, currently one of the highest in the Western world. But this
is not expected to be the end to this upward trajectory. Newspaper headlines tell
us that: “RBA warns worse to come; rates to keep climbing until inflation curbed”.
The surgical instrument has become a meat axe, and the RBA is all out of
anesthetic.

The pain of inflation excision is palpable. While there is no evidence after six
years of surgery that the “cancer” has been cured, there is growing evidence that
the patient is suffering badly. “Australian working families”, as we are now
referred to by politicians, are hemorrhaging. Increasingly, Australian families are
finding it impossible to maintain mortgages that are absorbing up to a third of
household budgets. Increasingly, family homes throughout Australia are being
forced onto the market, and their former occupants are seeking rental
accommodation. Increasingly, Australian families are being forced to abandon
their dreams of owning their own homes.

All this pain is necessary – or so we are told by orthodox experts – in order to

stop us spending, thereby bringing inflation under control. In other words, in order
to kill the “cancer” that is “eating away at our living standards”, we must be forced
to reduce our living standards! At least those of us whose family surplus is

29
already minimal and vulnerable must do so. Pain, the affluent market economists
and economic consultants tell us, is good for the soul. Provided it is someone
else’s soul.

In my quantitative studies of the modern world, I’ve discovered a strong positive

correlation between long run fluctuations in prices and living standards
(measured by real GDP per capita). This data provided the basis for my
discovery of the “growth-inflation curve” – for the very long run (1370–1994), long
run (1870–1994), and short run (since World WarII) – which demonstrates that
inflation is a stable, non-accelerating function of economic growth – see my Long
run Dynamic and “Strategic demand & the growth-inflation curve” (1997). In the
period from the 1950s to the 1980s in OECD countries, high and sustained rates
of economic growth (up to 5% in terms of real GDP per capita) were achieved
with rates of inflation of between 5 and 7 percent per annum. And we all
prospered. Hence, in viable societies economic growth and inflation fluctuate
together, with prices remaining under strategic control.

What about the well-known examples of hyperinflation, such as in Germany in

the 1920s and in Zimbabwe today? The answer is simple. All societies
experiencing hyper-inflation – or inflation accelerating out of control – were/are
unsuccessful strategic societies. I’m able to say, without fear of contradiction,
that no viable strategic society has ever experienced hyper-inflation. In
successful strategic societies, inflation is a stable and non-accelerating function
of economic growth. Further, I ague that in the long run the implication is clear:
no inflation, no economic growth.

Inflation targeting is a theory-free concept. Instead it appears to arise from a

widespread human fear of societal change – a fear that unless someone is seen
to be in charges of the levers and pulleys of the economy it will surely run out of
control. Orthodox economists, our self-appointed economic guardians, are
forever fantasizing about their fictional world of balance and harmony called the

30
concept of equilibrium. Even so-called neoclassical “growth theory” is not about
real world dynamics – about disequilibrium – but about convergence to
equilibrium. This is a concept that economics early imported from classical
thermodynamics, and has tenaciously held onto despite the shift in thought in
thermodynamics to analysis of a “far-from-equilibrium” kind.

There is, however, a general dynamic theory that can explain the real-world
relationship between inflation and living standards that is reflected in the real-
world growth-inflation curve. It is the dynamic-strategy theory that I’ve been
developing a large number of books – beginning with The Dynamic Society
(1996) – and articles– the most recent in Complexity (2008) the journal of the
Santa Fe Institute. Only aspects of this theory can be briefly outlined here. For a
full account see my Long run Dynamics (1998).

In the dynamic-strategy theory a distinction is made between strategic and no

strategic inflation. Strategic inflation is central to the dynamic mechanism of a
growing society, while no strategic inflation is an outcome of poor economic
policy and external impacts like the 1970s OPEC oil crisis. Strategic demand
comprises the effective dynamic demand exercised by decision a maker for a
wide range of physical, intellectual, and institutional resources required in the
strategic pursuit as the society’s dominant dynamic strategy (by which the desire
for survival and prosperity is achieved) unfolds. Strategic inflation, therefore, is
the widespread increase in prices resulting from the pressure of strategic
demand on resources, commodities, and ideas.

Inflation targeting, where this constrains strategic inflation as it usually does, acts
as a brake on the unfolding dynamic strategy because it distorts the strategic
incentive system. By eliminating strategic inflation in the long run we will
inevitably eliminate economic growth. And the means by which strategic inflation
is eliminated – ever higher interest rates – creates a great deal of unnecessary
and unacceptable economic pain and frustration among young families, which

31
are the future of society. It is essential to realize that this pain is not caused by
strategic inflation, but rather by conservative and incorrect perceptions of the
costs of inflation. Inflation is only the “enemy of working families” because the
RBA has made it so, owing to its totally inappropriate policy responses. Of
course, inflation does have its social costs, but these are overwhelmed by the
benefits of rapid economic growth that it facilitates; and they are more easily
alleviated than officially induced mortgage crises by taking measures to ensure
that money incomes of disadvantaged social groups keep pace with inflation. If
we wish to maximize long run economic growth and minimize mortgage pain
experienced by Australian families, it is essential to abandon the untenable policy
of inflation targeting. The only “cancer” eating into living standards is the failure of
expert and politician alike to comprehend the dynamics of modern society.

A household in Korea having two choices for housing service, either purchase or
chonsei, would consider the following factors. First, there are inherent differences
between homeowners and chonsei tenants. For example, the homeowners are
free to move whenever they want, while the chonsei tenants do not enjoy such a
freedom. This is a factor that boosts the sales price relative to chonsei price. In
contrast, however, the homeowners should bear the cost to maintain the quality
of houses that chonsei tenants do not have to care about. This is a factor that
discounts the sales price relative to chonsei price. A priori, therefore, it is not
clear whether the sales price should be inherently higher than the chonsei price.
Second, the homeowners should bear the risk of price fluctuations, while the
chonsei tenants are relatively well protected from such risks. As far as investors
are risk averse, this is a factor that discounts the sales price relative to chonsei
price. Third, the homeowners should pay taxes that chonsei tenants are free
from.7 This is another factor that discounts the sales price relative to chonsei
price. In short, these factors cannot explain why sales prices are substantially
higher than chonsei prices for the basically same housing services.

32
Therefore, the primary reason for the huge discrepancy of the sales price relative
to chonsei price seems to lie in the expectation on capital gain. That is, the
chonsei tenants are expected to recoup only the deposit in monetary unit upon
maturity, but the owners will be able to enjoy capital gains if the house prices rise
as they did in Korea. As any other prices in monetary economy, the rise of house
price is composed of two parts, the rise in the relative price of house over general
prices and the rise of general prices (or inflation) itself. However, the rise of
relative price can hardly be sustained in the long run, and thus this paper focuses
on the general price inflation as the underlying factor that persistently increases
house price.8 For the same reason, the general price inflation can be seen as a
primary factor for the sales price that remains substantially higher than chonsei
price all the time.
Focusing on the aforementioned factor of expected capital gain, the arbitrage
condition between the sales and chonsei prices. This arbitrage condition can be
recursively solved forward, and the solution will be a complicated function of the
expectations about future chonsei prices and interest rates. Assuming a steady
state with no speculative bubbles (in which the interest rate is fixed at and the
chonsei price increases at a constant inflation rate of), however, produces a
simple and intuitive result: That is, the ratio of the sales to chonsei price is equal
to the ratio of nominal to real interest rate. Of course, this result is based on
many restrictive assumptions. Nevertheless, if the sustained real interest rate is
around 4 percent and chonsei price inflation rate is around 3 percent (a medium-
term target inflation rate of the monetary authority in Korea), this ratio becomes
1.75, which is similar to the ratio of sales to chonsei price at the end of 2003.

Most of the econometric models developed in Sri Lanka during the last few
decades were either the results of designing development plans by the
government agency responsible for economic planning or the doctoral
dissertations of individual researchers.So far, there have been very few modeling
exercises published by government institutions or policy-making bodies in Sri
Lanka.

33
Leontief developed a methodology known as the Input-Output Framework, which
is very useful for the detailed quantitative and qualitative analysis of the structure
of an economy, involving its inter-sector linkages and associated multipliers. The
Keynesian framework helps to analyze the Macroeconomic performance of the
economy, through appropriate Macro-Econometric Modeling (Colombage, S.S.,
1992). These two approaches are suitable and hence widely used for quantitative
economic modeling and for generating policy prescriptions. Following Klein
(1965, 1978 & 1986), this paper argues that by combining both these mainstream
methodologies, we would obtain a more suitable theoretical framework for
analyzing a developing economy like Sri Lanka. The Input-Output component of
this model captures the details of the production structures of the various sectors
of the economy working as a highly disaggregated production function and
providing the much-needed supply content to the model. The Econometric Model
serves the purpose of modeling the aggregative expenditure components on the
demand side as also the GDP using these components. With this type of a
model, it would be possible to determine the sector-wise investments required to
free the individual sectors from their respective bottlenecks (from the Input-
Output Sub-model), and also, to arrive at the necessary policy adjustments to
ensure that the required policy stimulus comes forth (from the Macro-
Econometric Sub-model), such that there is a proper co-ordination between the
sets of policies at the two levels.

The article sums up the economic thinking behind the system for targeting
inflation in Hungary and the main economic-policy experiences with this. It
presents briefly a framework model that the author sees as best reflecting
present central-bank thinking about the functioning of the economy. It
summarizes what normative conclusions can be drawn with the model about
optimal monetary policy, and how these theoretical issues are reflected in the
monetary systems for targeting inflation. The article then turns to international
experience with the effectiveness and success of the regime. Finally, the author

34
looks back over five years at the conditions that accompanied the targeting of
inflation, at subsequent experiences with the economic-policy issues of that
period, and at operation of the system so far.

A brief historical review is followed by a forecast assessment. Based on

theoretically justified assessment of conditional forecasts, the following
conclusions can be drawn. In most cases, the turning points in inflation were
projected correctly, i. e. the monetary-policy signals were adequate. The
statistical analysis of key forecast errors revealed that projection errors were
unbiased. There were, however, projection errors as well, in wage adjustment,
household consumption growth, and external activity of the corporate sector.
Comprehensive analysis of the structure of the forecasting errors indicates that
ex post forecasts have not utilized all information to an optimal extent. There was
overreaction to the latest-quarter CPI figure, while the effect of nominal wages,
exchange rates and oil prices might be weaker in the short run and stronger in
the long run, compared with the National Bank forecasting methods.

During the past five years – in line with the logic of inflation targeting and
following international best practice – the National Bank of Hungary has been
moving towards a greater degree of transparency. The evolution of the
international best practice can be explained by the fact that in the past decade,
views on the desirability of central-bank transparency have changed to a great
extent. In the past, several central banks explicitly aimed to operate discreetly,
but a general tendency towards increased transparency can be seen since the
beginning of the 1990s. Calls for increased transparency may come from two
directions. On the one hand, a democratic political setup requires public
accountability of decision-makers at independent central banks, while on the
other, economic thinking in the last decade has robustly inferred that central-
bank transparency can preclude the emergence of inflation bias, increase the
effectiveness of monetary policy and under some conditions, and have a welfare-
enhancing effect. The study examines the validity of the latter assertions with two
simple models often applied in transparency literature. It illustrates that the right

35
degree of transparency can be subject to debate in theoretical and in practical
terms. Finally it shows how transparency practice has evolved at the National
Bank of Hungary since inflation targeting was introduced.

36
 DATA
AND

METHODOLOGY

Chapter No 4

Data and Methodology

37
Data

A sample period of 25 years has been selected for this study for the period of
1983-2007 with annual frequency. Data on all the variables have been collected
from World Development Indicators. Two variables have been selected for this
study. Inflation rate (INF), and interest rate. The description of variables has been
given below:

Inflation rate (INF)

This variable is measured by the consumer price index, which shows the annual
percentage change in the value of a fixed basket of goods and services.

An interest rate (i)

Is the price a borrower pays for the use of money he does not own, and the
return a lender receives for deferring the use of funds, by lending it to the
borrower. Interest rates are normally expressed as a percentage rate over the
period of one year.

Variable

Inflation Rate ═X
Interest Rate ═Y

Methodology

Econometric Model
IRt = βo + β1INt + εt

38
A Stationary process

A stationary time series has a constant mean, a constant variance

and the covariance is independent of time. Stationarity is essential
for standard econometric theory. Without it we cannot obtain
consistent estimators.
First of all I will check whether all above series are stationary or
not? To test the stationary property of all above series, I will
employ the augmented Dickey- Fuller (ADF) test. In statistics and
econometrics, an augmented Dickey-Fuller test (ADF) is a test for a
unit root in a time series sample. The augmented Dickey-Fuller
(ADF) statistic, used in the test, is a negative number. The more
negative it is, the stronger the rejections of the hypothesis that
there is a unit root at some level of confidence.

Testing Procedure:

The testing procedure for the ADF test is,

∆IRt = β0 + λ2IRt – 1 + β2t + α1∆ IRt – 1 + α2 ∆ IRt – 2 + ….. + αp ∆

IRt – p + εt

Where, ΔIRt = IRt − IRt − 1

∆INt = β0 + λ3INt – 1 + β3t + α1∆ INt – 1 + α2 ∆ INt – 2 + …+ αp ∆
INt – p + εt
Where, ΔINt = INt − INt − 1

Where βo is a constant, α is the coefficient on a time trend and p the

lag order of the autoregressive process. Imposing the constraints α
= 0 and β0 = 0 corresponds to modeling a random walk and using

39
the constraint β0 = 0 corresponds to modeling a random walk with a
drift.

By including lags of the order p the ADF formulation allows for

higher-order autoregressive processes. This means that the lag
length p has to be determined when applying the test. One possible
approach is to test down from high orders and examine the t-values
on coefficients.

The unit root test is then carried out under the null hypothesis γ = 0
against the alternative hypothesis of γ < 0. Once a value for the test
statistic

Is computed it can be compared to the relevant critical value for the

Dickey-Fuller Test. If the test statistic is greater (in absolute value)
than the critical value, then the null hypothesis of γ = 0 is rejected
and no unit root is present

Now the hypothesis that will be checked by ADF test

For checking the stationary property in time series of Interest rate

(INt),

Hypothesis 1
H0:INt is non-stationary, λ1 = 0.
Versus
HA: INt is stationary, λ1 < 0.

Hypothesis 2 for checking the series of inflation rate (IRt)

H0: IRt is non-stationary, λ2 = 0.

40
Versus
HA: IRt is stationary, λ2 < 0.

Decision rule:

If t* > ADF critical value, ==> not reject null hypothesis, i.e., unit
root exists.

If t* < ADF critical value, ==> reject null hypothesis, i.e., unit
root does not exist.

Simple Regression Analysis

I will run simple regression analysis between poverty and inflation
and between poverty and unemployment individually. And I will use
scatter diagram for seeing the relationship between poverty and
inflation and poverty and unemployment respectively.
Following is the Simple regression equation for Poverty and
Inflation
PRt = α + β1IRt + εt
Following is the Simple regression equation for Poverty and
unemployment rate
PRt = α + β2URt + εt

Test Of Goodness Of Fit And Correlation:

We will test the overall explanatory power of the
entire regression; this is accomplished by calculating the coefficient
of determination which is usually denoted by R2. The coefficient of
determination (R2) is defined as the proportion of the total variation
or dispersion in the dependent variable (about its mean) that is
explained by the variation in the independent or explanatory
variable(s) in the regression. In my study the R2 will measure how

41
much of the variations in the inflation in Pakistan at long run is
explained by the variation in unemployment respectively, in
Pakistan at long run.
Where
Explained variation in inflation (IRt)
R2 =
Total variation in inflation (IRt)

∑ (IRt - IR) 2
R2 =
∑ (IRt – IR) 2

In the simple regression analysis the square root of the coefficient

of determination (R2) is the absolute value of the coefficient of
correlation, which is denoted by r. That is,
r = √ R2

This is simply a measure of degree of association or co variation

that exists between variables inflation and unemployment.

Adjusted R2 :

Adjusted R2 is a modification of R2 that adjusts for the number of

explanatory terms in a model. Unlike R2, the adjusted R2 increases
only if the new term improves the model more than would be
expected by chance. The adjusted R2 can be negative, and will
always be less than or equal to R2.

42
 It is denoted by R2.

R2 = 1 – (1 – R2) (n – 1\ n – k)

Where n is the no. of observations or sample data points and k is

the no. of parameters or coefficients estimated.

Co-integration regressions for Inflation and Interest rate can

be expressed as follows:
IRit = βo + βi INit + εt
Where , і= 1,2,3,4,5,6……
Hypothesis
H0: There is no significant relationship present between inflation
and interest rate in Pakistan in long run, β = 0.
Versus
HA: There is a significant relationship present between inflation and
interest rate in Pakistan in long run, β ≠ 0.
Now I will use F – Test for testing the above hypothesis.

Analysis of Variance
The overall explanatory power of the entire regression can be
tested with the analysis of variance. This uses the value of the F
statistics, or F ratio. Specifically, the F statistic is used to test the
hypothesis that the variation in the independent variables explains
a significant proportion of the variation in the dependent variable.
Thus, I will use the F statistic to test the null hypothesis that all the
regression coefficients are equal to zero against the alternative
hypothesis that they are not all equal to zero.
The value of the F statistics is given by
Explained variation ∕ (k – 1)
F=
Total variation ∕ (n – k)

43
Where, n is the number of observation and k is the number of
regression coefficients. It is because the F statistics is the ratio of
two variances that this test is often referred to as the analysis of
variance. I will calculate the F statistics in terms of the coefficient of
determination as follows:
R2 ∕ (k – 1)
F=
(1 – R2) ∕ (n – k)
Here R2 represent the coefficient of determination between poverty
rate and inflation rate in Pakistan in long run.
Then we will compare the calculated value of the F statistics with a
critical value from the table of the F distribution. If the calculated
value of the F statistics exceeds the critical value of the F
distribution I will reject the null hypothesis that there is no significant
relationship between inflation and unemployment rate in Pakistan in
long run, and I will accept the alternative hypothesis at 5 % level of
significance that not all the coefficients equal to zero, and vice
versa.

44
DATA ANALYSIS

Chapter No 5

Data Analysis

45
In this chapter we check all the data that is stationary and non-stationary. We use

the unit root test of the “Augmented Dickey Fuller” test on the level but all the data

that is non-stationary we check all the data on the 1st difference where all the

variables become stationary. Second test impose on the variables of “Phillips-perron

test” where all the variables are non-stationary on the level. But all the variables

become stationary on the 1st difference, which shows that all the variables are

stationary on the 1st difference.

Then we will check the co-integration between these variables inflation, and interest

rate. If the trace statistics values less the critical values and level of significance

which is 0.05. This co-integration shows that there is no long run relationship

between inflation and interest rate. If there is no long run relationship between

variables then we use the Granger Causality Test in which if there is relationship

between variables then we reject H0 the and accept the H1.

Table

Years Inflation Interest

Rate Rate
1983 7.28 21.099
1984 7.3 23.686
1985 5.31 25.319

46
 1986 3.51 27.080
1987 4.7 30.128
1988 8.8 32.679
1989 7.9 40.783
1990 9.1 48.125
1991 12.7 54.111
1992 10.6 61.899
1993 9.8 80.520
1994 11.3 99.943
1995 13 100.775
1996 10.8 125.802
1997 11.8 146.324
1998 7.8 183.167
1999 5.7 199.871
2000 3.6 236.585
2001 4.4 312.721
2002 3.5 318.749
2003 3.1 257.434
2004 4.6 317.723
2005 9.3 274.717
2006 7.9 304.794
2007 7.8 295.842

A Stationary analysis of data:

5.1 Augmented Fuller Test
The results are following:
5.1a:
These are results of AFD test At first Difference

Augmented Dickey-Fuller Test (ADF):

Table 1: Augmented Dickey-Fuller unit root test dependent variable INFLATION:

Null Hypothesis: D(INFLATION) has a unit root

Exogenous: Constant
Lag Length: 0 (Automatic based on SIC, MAXLAG=5)

47
 t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -4.494048 0.0019

Test critical values: 1% level -3.752946
5% level -2.998064
10% level -2.638752

Interpretation:
In the above series naming as the unit root test of Inflation,
the dickey fuller and Mackinnon test shows that the t-statistic value is greater
than critical value therefore we can say that the data is stationery at first
difference. My probability value is less than at 10% level of significance so that
my dependent variable is stationary that’s why we reject null hypothesis and
alternative hypothesis is accepted. My dependent variable inflation is effected the
independent variable interest rate.

Table 2: Augmented Dickey-Fuller unit root test independent variable INTEREST

RATE:

Null Hypothesis: D(INTERST_RATE) has a unit root

Exogenous: Constant
Lag Length: 0 (Automatic based on SIC, MAXLAG=5)

t-Statistic Prob.*

Augmented Dickey-Fuller test statistic -6.118207 0.0000

Test critical values: 1% level -3.752946
5% level -2.998064
10% level -2.638752

*MacKinnon (1996) one-sided p-values.

Interpretation:
Here we have a series of unit root test for unemployment
including the results of Dickey fuller (6.118207 > 0.10) which shows that the
calculated value is greater than the critical value therefore we will reject the null

48
hypothesis H0. My probability value is less than at 10% level of significance so
that my independent variable is stationary that’s why we reject null hypothesis.
My independent variable interest rate is effected inflation.

Phillips-Perron Test

Table 3: Phillips-Perron unit root test dependent variable inflation:

Null Hypothesis: D(INFLATION) has a unit root

Exogenous: Constant
Bandwidth: 2 (Newey-West using Bartlett kernel)

Adj. t-Stat Prob.*

Phillips-Perron test statistic -4.486138 0.0019

Test critical values: 1% level -3.752946
5% level -2.998064
10% level -2.638752

*MacKinnon (1996) one-sided p-values.

Residual variance (no correction) 4.754523

HAC corrected variance (Bartlett kernel) 4.425723

Phillips-Perron Test Equation

Dependent Variable: D(INFLATION,2)
Method: Least Squares
Date: 01/28/09 Time: 11:56
Sample (adjusted): 3 25
Included observations: 25 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

D(INFLATION(-1)) -0.980566 0.218192 -4.494048 0.0002

C 0.021215 0.475858 0.044583 0.9649

R-squared 0.490248 Mean dependent var -0.005217

Adjusted R-squared 0.465974 S.D. dependent var 3.122672
S.E. of regression 2.281958 Akaike info criterion 4.570886
Sum squared resid 109.3540 Schwarz criterion 4.669625
Log likelihood -50.56519 F-statistic 20.19647
Durbin-Watson stat 1.958845 Prob(F-statistic) 0.000199

49
Interpretation
My probability Value of Phillips-perron unit root test is less than 0.1
so that my dependent variable inflation is stationary. In the above table my
probability value of Phillips- perron test is less than the 10% level of significance
so that I reject null hypothesis.

Table 4: Phillips-Perron unit root test independent variable Interest Rate:

Null Hypothesis: D(INTERST_RATE) has a unit root

Exogenous: Constant
Bandwidth: 1 (Newey-West using Bartlett kernel)

Adj. t-Stat Prob.*

Phillips-Perron test statistic -6.110056 0.0000

Test critical values: 1% level -3.752946
5% level -2.998064
10% level -2.638752

*MacKinnon (1996) one-sided p-values.

Residual variance (no correction) 711.0987

HAC corrected variance (Bartlett kernel) 719.0674

Phillips-Perron Test Equation

Dependent Variable: D(INTERST_RATE,2)
Method: Least Squares
Date: 01/28/09 Time: 12:00
Sample (adjusted): 3 25
Included observations: 25 after adjustments

Variable Coefficient Std. Error t-Statistic Prob.

D(INTERST_RATE(-1)) -1.291217 0.211045 -6.118207 0.0000

C 15.42514 6.374830 2.419695 0.0247

R-squared 0.640611 Mean dependent var -0.501739

Adjusted R-squared 0.623497 S.D. dependent var 45.48152

50
S.E. of regression 27.90739 Akaike info criterion 9.578601
Sum squared resid 16355.27 Schwarz criterion 9.677340
Log likelihood -108.1539 F-statistic 37.43246
Durbin-Watson stat 1.950625 Prob(F-statistic) 0.000005

Interpretation

My probability Value of Phillips-perron unit root test is less than

0.1 so that my independent variable interest rate is stationary. In the above table
my probability value of Phillips- perron test is less than the 10% level of
significance so that I reject null hypothesis.

Co integration:
Table 5: Co integration of the dependent variable Inflation and independent
variable Interest Rate:

Date: 01/28/09 Time: 11:30

Sample (adjusted): 3 25
Included observations: 25 after adjustments
Trend assumption: Linear deterministic trend
Series: INFLATION INTERST_RATE
Lags interval (in first differences): 1 to 1

Unrestricted Cointegration Rank Test (Trace)

Hypothesized Trace 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None 0.194479 4.987092 15.49471 0.8102

At most 1 0.000564 0.012975 3.841466 0.9091

Trace test indicates no cointegration at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values

Unrestricted Cointegration Rank Test (Maximum Eigenvalue)

Hypothesized Max-Eigen 0.05

No. of CE(s) Eigenvalue Statistic Critical Value Prob.**

None 0.194479 4.974117 14.26460 0.7451

51
 At most 1 0.000564 0.012975 3.841466 0.9091

Max-eigenvalue test indicates no cointegration at the 0.05 level

* denotes rejection of the hypothesis at the 0.05 level
**MacKinnon-Haug-Michelis (1999) p-values

Unrestricted Cointegrating Coefficients (normalized by b'*S11*b=I):

INTERST_RAT
INFLATION E
-0.375939 -0.004323
0.000918 -0.009501

Unrestricted Adjustment Coefficients (alpha):

D(INFLATION) 0.928340 0.012646

D(INTERST_R
ATE) -5.304447 0.551557

1 Cointegrating Equation(s): Log likelihood -155.0764

Normalized cointegrating coefficients (standard error in parentheses)

INTERST_RAT
INFLATION E
1.000000 0.011499
(0.01181)

Adjustment coefficients (standard error in parentheses)

D(INFLATION) -0.348999
(0.16930)
D(INTERST_R
ATE) 1.994149
(2.20891)

Interpretation
The above calculation shows that there is no co integration between the
variables of Inflation and Interest Rate. Because all the traces statistics values
less than that of the critical values and the level of significance which is 0.05.

52
This co integration shows that there is no long run relationship between inflation
and interest rate. The results shows the short run relationship between inflation
and interest rate. So because of short run relationship we find the results with the
help of Granger Causality Tests.

Granger Causality Test

Table 6: Granger Causality Test of the dependent variable Inflation and

independent variable Interest Rate:

Pairwise Granger Causality Tests

Date: 01/20/09 Time: 11:37
Sample: 1 25
Lags: 2

Null Hypothesis: Obs F-Statistic Probability

INTERST_RATE does not Granger Cause

INFLATION 23 0.49363 0.61843
INFLATION does not Granger Cause INTERST_RATE 0.75609 0.48384

Interpretation:
In the above table my F-Statistics value is 0.49363 and my probability
value is 0.61843. My probability value is less than 0.1 so my statement is wrong
because Interest rate is Granger Cause Inflation and Interest rate does effect on
Inflation at 10% level of significance. On the other hand my probability value is
less than 0.1 so my statement is wrong because Inflation is Granger Cause
Interest rate and Inflation does effect on Interest rate at 10% level of significance.

53
CONCLUSION

54
 Chapter No 6

CONCLUSION

Summary of Findings

This thesis presents an empirical investigation into the strength and validity of the
hypothesis using developed and developing countries data during the inflation-
targeting monetary policy regime. A significant amount of research has been
conducted in developed countries to prove and establish this hypothesis, yielding
conflicting results. However little has been done to explore this relationship in
developing countries which, in contrast to the developed countries studied, tend
to have higher and more volatile levels of inflation. The sparse empirical research
conducted using data from developing countries is also inconsistent. Three
prominent interpretations have emerged in the literature in an attempt to
reconcile these inconsistencies. These effects suggests that interest rates should
adjust by less than one-for-one to expected inflation, whereas the risk aversion
effect proposes a greater than one-for-one movement. Finally, the inverted
Fisher effect postulates that it is interest rates that remain constant over time and
it is the real interest rate that moves inversely to inflation.

Despite these alternative interpretations, the hypothesis, in its strictest form, still
attracts a significant amount of empirical research. This is largely attributed to the
Fisher equation’s ability to analyze whether the real rate of interest has remained
constant over a given period of time. Due to the infancy of most inflation-targeting
monetary regimes, very few previous studies have empirically investigated the
Fisher effect using data from an inflation-targeting monetary policy framework.

55
This thesis is therefore an attempt to fill this gap and uncovers a variety of
interesting relationships specific to an inflation-targeting regime.

The thesis adopted an inflation-targeting monetary policy framework. One of the

main reasons that the previous “eclectic” monetary policy approach to a
monetary framework that targeted inflation directly was to achieve greater
credibility of monetary policy in the “eyes of the public”. The inflation-targeting
framework has enjoyed widespread credibility and has made promising steps
towards successfully containing inflation.
Against this backdrop the crucial question addressed is the extent to which
monetary authorities have been able to affect both the long- and short-term real
rates of interest through policy action in an environment where inflation
expectations are becoming increasingly firmly anchored. This equation is
therefore used as a behavioral equation to analyze the relationship between
expected inflation and both short- and long-term nominal interest rates.

The analysis distinguishes between a short-run effect and a long-run effect. The
short-run effect is unlikely to hold empirically, given the effects of the
transmission mechanism. This is confirmed by the empirical results, which show
no statistically significant long-run relationship between expected inflation and
short-term nominal interest rates. This is consistent with the transmission
mechanism’s influence on the short-term real rate of interest.

The long-run effect analysis is able to identify whether monetary policy has been
able to reduce the long-run real rate of interest. This information is important to
monetary authorities because a reduction in the long-term real rate of interest
enables the economy to achieve long-run increases in economic output. Utilizing
Johansen’s maximum likelihood cointegration framework, the results suggest a
weak long-run cointegrating relationship between expected inflation and long-
term nominal interest rates. This would indicate that the long-term real rate of
interest has not remained constant since the inception of inflation-targeting and

56
that monetary policy has actually influenced the long-term real rate of interest.
This also implies that changes in inflation expectations do move in the same
direction as the long-term nominal interest rate; however the movement is less
than unity.

CONCLUSIONS AND POLICY IMPLICATION

Short- Run Effect

Economic agents will only place their long-run faith in monetary policy if the
short-run dynamics of the monetary framework work efficiently and in a timely
manner. The analysis of short-term interest rates presents an encouraging
testament to the effectiveness of the SARB’s inflation-targeting framework, and
more especially the monetary transmission mechanism in developing countries. It
also implies that short-term interest rates are not driven by inflation expectation
and are therefore a good indication of the stance of monetary policy in developed
or developing countries.

Long- Run Effect

The thesis concludes that long-term interest rates are co integrated with
expected inflation. The long-run adjustment is, however, less than unity. This can
primarily be attributed to the credibility of the inflation-targeting framework and
the success it has achieved in locking inflation expectations into the target range,
thereby ensuring that the expected inflation premium required by economic
agents to compensate them for the inflationary erosion of nominal money
balances remain relatively low and stable. Economic agents do not require
nominal interest rate movements to fully adjust to changes in expected inflation
because inflation is not perceived to remain at abnormally high or low levels. If,
for example, an acceleration of the currency causes inflation expectations to

57
increase beyond the mid-point of the target range, economic agents would feel
confident that this impact would only be transitory due to the effectiveness of
monetary policy.

Applying a similar argument, the weak long-run relationship may be indicative of

the increasingly influential role that the long-term real rate of interest is having on
nominal interest rates. This scenario is even more compelling given the length
and success of inflation-targeting regime. The results may therefore advocate
that the SARB is beginning to evolve into the second evolutionary stage of an
inflation-targeting regime. This stage is characterized by nominal interest rates
that primarily reflect movements in the long-term real rate of interest rather than
the relatively constant expected rate of inflation.

LIMITATIONS AND FUTURE RESEARCH

The study suffered from two limitations. Firstly, although the results are generally
robust, the Johansen procedure was found to be sensitive to lag length chosen.
Various authors including Gonzalo (1994:220), Hawtrey (1997:344) and Yuhn
(1996:42) have all also reported similar sensitivity. Secondly, a major challenge
in all empirical investigations of the Fisher effect is that inflation expectations are
not directly observable. Although there are various approaches available within
the developed or developing countries context, not all are available or have an
appropriate length to be used in this study.

Since the adoption of inflation-targeting there has been an increased importance

placed on developing accurate expected inflation forecasts. This has spurred an
increase in the number of inflation expectations time series available for use in
future empirical econometric studies, thereby presenting exciting research
opportunities, not only for future studies but also for explorative analysis into the
relationship between expected inflation and interest rate. Due to the crucial role
played by expectations of future inflation and interest rate in all policy decisions,

58
further insight into the dynamics of inflationary expectations will provide valuable
information for monetary authorities.

59
REFERENCES

60
References

Anderson, N., Sleath, J. 2001. .New Estimates of the UK Real and Nominal Yield
Curves., Bank of England WP 126.

Andres, J., Mestre, R., Valles, J. 1997. .A Structural Model for the Analysis of the
Impact of Monetary Policy an Output and Inflation, in Monetary Policy and the
Inflation Process, BIS Conference Papers Vol.4.

AKSOY, T.A. and KUTAN, A.M., 2002. A public information arrival and the
Fisher effect in emerging markets Istanbul stock and gold exchanges.
Working Paper 02-1101. Edwardsville: Department of Economics and
Finance, Southern Illinois University.

ARON, J. and MUELLBAUER, J., 2000. Inflation and output forecast for
South Africa: Monetary transmission implications. Working Paper Series
2000:23. Oxford: Centre for African Economics, Oxford University.

ABARBANEL, JEFFERY S., & BUSHEE, BRIAN J., 1997, “Fundamental Analysis,
Future Earnings and Stock Prices.” Journal of Accounting Research, Vol. 35, No. 1:
1-24.

Bernanke, Ben S., and Frederic S. Mishkin. 1997. Inflation Targeting: A New
Framework for Monetary Policy. Journal of Economic Perspectives 11:97-116.

Blanchard, O.J., Quah, D. 1989. .The Dynamic Effects of Aggregate Demand and
Supply, Disturbances, American Economic Review 79, pp. 655-673.
Berument, Hakan, 1999, Impact of Inflation Uncertainty on Interest Rates in the UK,
Scottish Journal of Political Economy, 46(2), 207-218.

61
 Berument, Hakan and Güner, Nuray, 1997, Inflation, Inflation Risk and Interest
Rates: A Case Study for Turkey, METU Studies in Development, 24(3), 319-327.
Ball, Laurence. 1999. "Policy Rules for Open Economies," In J. Taylor (ed.):
Monetary Policy Rules, Chicago: University of Chicago Press

BARTOV, E., 1992, “Patterns in Unexpected Earnings as an Explanation for Post-

Announcement Drifts.” The Accounting Review, Vol. 67, No. 3: 610-622.

Campbell, John Y. 1995. Some Lessons from the Yield Curve. Journal of Economic
Perspectives 9:129-152.

Cook, Timothy, and Thomas Hahn. 1989. Federal Reserve Information and the
Behavior of Interest Rates. Journal of Monetary Economics 24:331-351.
Amato, J. 2001. .Wicksell, New Keynesian Models and the Natural Rate of Interest.,
mimeo, IS.

Chan, Lois K.C., 1994, Consumption, Inflation Risk, and Real Interest Rates: An
Empirical Analysis, Journal of Business, 67(1), 69-96.

Corbo, Vittorio. 1998. “Reaching One-Digit Inflation: The Chilean Experience,”

Journal of Applied Economics. 1(1): 123-63.

F.S. Mishkin, The real interest rate: an empirical investigation, Carnegie–Rochester

Conf. Ser. Public Policy 15 (1981) 151–200.

Froyen, Richard T. and Roger N. Waud, (1987), an Examination of Aggregate Price

Uncertainty in Four Countries and Some Implications for the Real Output, International
Economic Review, 28(2), 353-73.

62
63