Impact of interest rate on economic growth in pakistan
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Rate of Interest and its Impact on Investment to the Extent of Pakistan
Metrics details. Saving and investment are two of the most important tools for economic growth. The interest rate has always been considered an important determinant of saving and investment. However, according to Islamic teachings, riba or earning interest on saving or investment is forbidden, and thus, many Muslims try to avoid earning income from the interest rate. We applied the random effect and system generalized method of moments GMM model separately to data of 17 non-Islamic and 17 Islamic countries from to The results suggest that people in Islamic countries are not concerned about the interest rate on saving, but in non-Islamic countries, the interest rate, per capita income, and inflation have significant positive impacts, and national expenditure has a significant negative impact on saving.
However, in Islamic countries, remittances received and national expenditure have negative significant impacts, and per capita income has a positive significant impact on saving. In the case of investment, interest rate and inflation show a negative effect on investment while trade affects investment positively in both Islamic and non-Islamic countries. Furthermore, domestic credit provided by banks has a negative significant effect on investment in non-Islamic countries, while in Islamic countries, remittances show a positive significant impact on investment.
The governments and policy makers of Islamic countries should not imitate the economic policies of non-Islamic countries because religious factors play an important role in the interest rate—saving relationship. Instead, they should increase per capita income by improving employment conditions and by reducing remittances received and national expenditure. Policies on saving should not allow earning interest. Furthermore, in order to increase investment, efforts should be made to lower the interest rate and inflation, and to enhance remittances received and trade.
These policies will increase saving and investment in Islamic countries, ultimately resulting in improved economic growth. The interest rate is considered an important factor affecting saving and investment. The interest rate is defined as the cost of borrowing or gain on lending. Typically, a rise in the interest rate encourages people to save more as the former leads to increased income. However, an increase in the interest rate also raises the cost of capital, resulting in a reduction in investment within the economy.
According to Islamic teachings, riba is prohibited. Riba is a practice through which one earns excess returns, where no equivalent counter-value or reward is justified. Riba is an Arabic word, meaning increase or growth; the interest on saving would result in an increase in the final amount payable over and above the original value. Observe your duty to Allah, and give up what remaineth due to you from usury, if you are in truth believers. Many empirical studies report that people seek monetary rewards regardless of the type of bank they patronize Islamic or otherwise for example study of Metwally conclude that similar returns were offered to the depositors by Islamic and conventional banks; however, this statement is not always true.
Consider the example of the Kuwait Finance House, the first bank to operate in accordance with the Islamic Shariah Islamic Law established in According to Haron and Noraffifiah the bank has not provided depositors interest on their saving in However, it has enjoyed widespread patronage, and there have been no reports of mass deposit withdrawals.
In another example, the Islamic banks of Sudan have never paid their current account holders any kind of income, but a large proportion of their funding is derived from such accounts. The Prophet PBUH advised Muslims to work hard to earn their keep and discouraged income generated without any effort, such as through earning interest or riba. As people in Islamic countries dislike riba or income from saving because of the religious teachings of Islam, it is a general perception that savings in Islamic countries are not affected by changes in the interest rate.
Thus, the aim of this study is to highlight the differences between the effects of the interest rate on saving and investment in Islamic and non-Islamic economies.
Because riba or earning income from interest is forbidden according to Islamic teachings, we expect that the interest rate will have different impacts on Islamic and non-Islamic countries. If our expectation is found to be true, we propose that the policymakers of Islamic countries use different criteria while making saving-related policies. This study is conducted using country-level panel data after categorizing the countries as Islamic or non-Islamic. Although many previous studies have covered different aspects of the interest rate with regard to saving and investment, to the best of our knowledge, this is the first study to determine not only the effects of Muslim religious teachings on saving and investment in Muslim countries but also to conduct a comparison between Muslim and non-Muslim countries in this respect.
We use the real interest rate to assess its impact on saving and investment in Islamic and non-Islamic countries. The remainder of this paper is organized as follows. The next section provides a review of the literature.
Then, we present the methods and its results. The last section concludes. According to classical economists, saving is a function of the interest rate. When the latter is high, people tend decrease their present consumption and save more. However, if we focus on utility maximization, current consumption can change owing to the substitution effect and income effect.
In the event of a higher interest rate, the former would lead to a decrease in current consumption, while the latter would have the opposite effect. High interest rates translate into high borrowing cost for lenders; thus, people try to save more to fulfill their future needs, and theoretically, the interest rate is expected to have a positive relationship with saving.
Classical economists were the first who determine the importance of saving. Anyanwu and Oaikhenn categorize the determinants of saving into two factors. Quantitative factors: They include income level, interest rate, inflation rate, inflation rate expectations, and ease of saving available to a person. Non-quantitative factors: These are psychological factors that affect saving.
According to Jalaluddin, saving is not just the part of income that remains after consumption; certain ethical and social responsibilities are linked with saving. A Muslim saves to fulfill his duties toward himself, his family, society, and Almighty Allah. To fulfill these duties, he requires money. Keynes notes that in the long run, changes in the interest rate can modify social habits, including the propensity to save.
Economists e. Their relationship is defined as under. The interest rate increases the cost of borrowing money, and hence, it reduces investments. However, an increase in income raises investment. Although various studies have discussed the impacts of the interest rate on saving and investment in non-Islamic countries, only a handful refer to Islamic countries. Even so, these studies focus on a single country, or compare Islamic and conventional banks in terms of profitability and saving using country-level panel data.
We aim to bridge this gap. According to Khamlichi and Laaradh , Islamic banks, Islamic funds, and indices have not been studied as rigorously owing to their relatively short history of existence.
Accordingly, we attempt to compare our results with the available theoretical and empirical literature in this area of research. There is no consensus regarding the impact of the interest rate on bank deposits and saving in Islamic countries.
Kasri and Kassim conclude that Mudarabah Footnote 1 deposits, a proxy of the saving or investment level in Islamic banks, are positively correlated with the real rate of return on Islamic deposits and negatively correlated with the real interest rate on conventional deposits.
According to Kassim et al. This stability translates into saving, which in turn has a positive impact on monetary policy and the overall financial stability of the economy. Gerrard and Cunningham note that Muslims residing in non-Muslim countries like Singapore continue to practice their Islamic beliefs.
Thus, they hold their money in Islamic banks, which do not pay interest on saving or investment. However, Metawa and Almossawi conclude differently from Gerrard and Cunningham They study the case of Bahrain, where most people practice Islam, and find that while depositors select banks mainly on religious grounds, they also refer to the rate of return.
Thus, they note that the rate of return is not the only or primary variable influencing deposit volume in Islamic banks. Khan et al. Many empirical studies on investment and interest rate conclude that interest rate has a significant negative impact on investment.
Using macroeconomic data, Tokuoko shows a negative relationship between the real interest rate and corporate investment. In their study on the impact of the real interest rate on investment and growth, Pattanaik et al. However, they advise against any policy move that would reduce the interest rate by increasing tolerance against inflation.
Christy and Clendinon note that the saving rate and interest rate are two important determinants of investment. Hyder and Ahmed study the reasons for the collapse of private investment in Pakistan and suggest ways to restore the same.
They conclude that an increase in the interest rate will lead to a decline in investment. Larsen , Aysan et al.
Conversely, Salahuddin et al. They investigate the trends in the investments of 21 developing Muslim countries from to Using the fixed effect model, they conclude that debt servicing has a negative impact on investment while all other variables, namely, lagged investment, growth rate of real GDP per capita, domestic saving, institutional development, and trade openness, have a positive impact. Although private sector credit and aid from foreign countries show positive significant impacts, the results are not robust.
They further conclude that the lending rate, inflation, growth in population, and human capital have no impact on investment in developing Muslim countries. Muhammad et al. Using data from to , they conclude that the interest rate has a negative relationship with investment while income has a positive impact on it. Nasir and Khalid study saving and investment trends for Pakistan using time series data for to They conclude that budget deficit, government investment, and interest rate are insignificant determinants of saving.
Moreover, return on government investment does not have any impact on saving. However, current government expenditure, high income, growth in GDP, and increase in remittances maximize saving. They further conclude that public loan and foreign saving have positive but insignificant impacts, while domestic saving and interest rate have positive significant impacts on investment. Athukorala refer to Indian data and conclude that an increase in the interest rate encourages saving and investment, helping the Indian economy to grow.
Expectations and uncertainties are also considered to be important determinants of investment. For instance, any increase in the prices of material or energy will reduce investment. Onwumere et al. After liberalization, however, the interest rate has had a negative non-significant effect on saving, and a negative but significant effect on investment. The basic purpose of this study is to investigate the impact of the interest rate on saving and investment in Islamic countries and to compare these results with the corresponding impacts in non-Islamic countries.
The purpose of this exercise is to determine whether people in Islamic countries behave differently toward earning income from interest. We use the random effect method and system generalized method of moments GMM model for saving and investment.
Pakistan. Abstract. Background: Saving and investment are two of the most important tools for economic growth. The interest rate has always been considered. () observe that a lower interest rate can increase economic growth () study the effect of the interest rate on investment in Pakistan.
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Riphah International University. Barro,
Metrics details. Saving and investment are two of the most important tools for economic growth.
Effect of interest rate on economic performance: evidence from Islamic and non-Islamic economies
This paper investigates the impact of inflation, nominal exchange rate, FDI and capital stock on economic growth of Pakistan by using time series data for the period of All variables found stationary at level. The results of OLS show that inflation and exchange rate has negative and significant affect economic growth of Pakistan. One percent increase in inflation will decrease GDP by 0. Exchange rate coefficient is
