Stock Prices Interest Rate And Inflation Rate Economics Essay

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Over the route of the past decade and so, Pakistan's economy had taken such extreme turns that it had mystified most of the economists and researchers to watch carefully for the prediction and decisions. One such changed was above record performance of the equity market, represented by the KSE-100 index along the course of 2003 to 2007. For instance in 2003 the KSE-100 index boost up from 3000 to around 5000 index points level in 2004. Such a ground breaking change had naturally made a lot of stakeholders to find the fundamental rationale behind the change. This study was an attempt to find out which of the basic determinants that affected the behavior of KSE 100 index and in what direction. The result and conclusion gave better picture about which one of the considered macro economic variables defined the behavior of KSE 100 index and became a good forecaster for researcher and economist for market evaluation.

The study was an examination of the correlation between the four variables (stock prices, Interest rate, inflation rate & output growth rate) in different economic circumstances. The study inter linked the two fields (Finance and Economics) in a way that it validated, if there was any relationship existed in between the financial market indicator (KSE 100 Index) and economic variables (Interest rate, inflation rate & output growth rate). There was a mutual consent among the economists and financial experts that the equity market's price were driven by macroeconomic variables and hence called "fundamentals" in the economic terminology. It was also settled that the connection was both way; reciprocal relation exist between the stock prices and macro economic variables. The inflation rate and output growth rate were the pure economic variable where as the Interest rate was the monetary policy tool used to control the supply of money in the economy. Government used to set the interest rate through monetary policy tool intended to stabilize the inflation rate and to increase the sustainable out put growth rate. The reason of examining the two fields together was that the financial feat was closely related to that of the economic development, because the monetary policy worked through these financial intermediaries therefore it could be concluded that the competent financial markets could be the qualification for the economic strength in a nation. When ever economy came across any crises or boom, KSE 100 Index reacted or in others words, KSE 100 Index could also be viewed as a tool to view economy's trail. It was assumed that the above said variables were correlated with each other, showed a pattern when the economic condition changes.

It was resolutely believed that when the economy was performing well, that was the Interest rate & inflation rate were moderately low level & out put growth rate was high, stock prices should also advanced up to show the relation with the growing economy. As the above proclamation elucidates that the analysis evaluated the nature of relationship on how stock prices reacted when either of the variables showed any flux. There had been a great pact of study into the fact described above in the developed countries such as the Germany, Japan, US, UK etc, where researchers had come up with very informative and insightful results.

The results helped the students, researchers, economists as well as the individual investor to very much extent in the explanation of stock exchange behavior and equity prices, and in turned helped to make better predictions about the current and future routine and decision regarding investments. It was rational that such studies should be conducted in Pakistan's market so that students, researcher, economist and individual investors can be benefited from the extrapolative power of economic variables for KSE 100 Index and other stock exchange index. The study covered the time period started from 1991-92 to the end of 2008-09 covering eighteen years because of the availability of KSE 100 index (Stock Prices) from 1990-91 onwards. The most prominent regimes were of Muslim league N & Q Government, Pakistan Peoples Party & Marshall Law imposed by Pervez Musharaf.

1.2 Problem Statement

The key quandary addressed in this research was mainly focused on "To estimate the relationship among the stock prices (KSE 100 Index) and macro economic variables (Interest rate, Inflation & GDP growth rate) of Pakistan" in order to facilitate the job of the investors, financial analyst, researchers, economist as well as the up coming student to strengthen the understanding about the stock price variations and it's link with the macro economic variables. The results concluded the relationship among the stock price and macro economic variable so that the target group had a strong prediction power and confidence was develop when decision was to be made. In trying to investigate the above mention problem many other question were also unfolded as

Did interest rate in the economy affected KSE 100 index?

Did GDP Growth rate in the economy affected KSE 100 index?

Did inflation rate affected GDP growth rate (production)?

Did inflation rate in the economy affected interest rate?

Did inflation rate affected KSE 100 index?

Did interest rate affected real activity in the economy?

1.3 Hypothesis

The purpose of the study was to assess the relations between the key economic variables such as, Inflation rate (CPI Based), Interest rate (Call money rate), Out put growth rate (GDP growth rate) with that of stock prices (KSE 100 Index) in context of Pakistan's economy, where stock exchanges were less mature as compared to other countries with well matured financial markets such US, Japan and the UK. Therefore it was assumed that there was a positive relation between KSE index and GDP growth rate (production) and a negative relation among the KSE index and interest rate as well with that of Inflation rate. The multiple hypotheses were constructed in order to test the relationship of KSE 100 index with each of the variable separately.

1.4 Out line of the study

Stock prices were driven through many factors called "fundamentals", among the top most were the macro economic variables; most notably among were Interest rates, inflation rate and out put growth rate. Looking into the functionality of Pakistan's economy, interest rate was the most affective driver having direct and indirect affects to all the parts of economy through supply of money. It also drives inflation rate and out put growth rate in the economy as well as allied with the determination of the stock price at any point in time. When ever the interest rate fluctuated it could be observed that inflation rate and out put growth rate also showed a movement. Government's one of the main objectives of setting the policy was to boost up the stock prices through the adjustment of macro economic variables to guarantee the sound performance of the economy. So when ever the macro economic variables fluctuated, it could be noticeable that the stock market index also improved to show the after affect of change in the interest rates, there fore it was assumed that when ever the interest rate was lower with moderately acceptable level of inflation rate and real out put growth rate (GDP) was high then the stock prices also showed an upward trend. It was very important to know which macroeconomic variable affected the stock prices and with which magnitude.

1.5 Definitions

KSE 100 Index:

A KSE 100 index in Pakistan was the stock market index act as a benchmark for the stock market to evaluate the prices (of the stock) with and to keep a watch on how Karachi stock exchange was performing over the period of time. The companies with the highest market capitalization were considered being a part of it from each of the sector. The index was first formed in 1991 with base index points of 1000. In particular, KSE 100 was designed to provide investors with intelligence of how equity market performed. KSE100 was analogous to other sign that trailed sectors of the economic growth and activity as in the case the gross national product, consumer price index, etc. The KSE Index consisted of about 100 companies listed, on the basis of the sector's demonstration and highest market capitalization, which was over more than 80% of the total capitalization of the listed companies in the stock exchange according to market. Out of the all the Sectors, 34 were selected, one from each sector ignoring the Mutual Fund Sector and the remaining out of 100 listed companies were on the basis of capitalization in reducing order where as dividend, bonus and rights were also adjusted (Karachi Stock Exchange, 2009)

It was also used as a standard of how economy was working because it seemed to reacted sensitively to the happening of any economic, financial & political event (that also described the economic performance) for case in point, KSE 100 index quickly fallen when the assassination of former prime minister Benazir Bhutto (Belated) happened in 2007 and due to financial crises of 2008 fell to 9187 points from 15500 points.

Figure 1.1: KSE 100 Index (1990-91 to 2008-09) Source Business recorder

Although it was universal that Stock prices were negatively affected by the interest rate in any point in time because when ever the government increased the interest rate, it didn't have an instantaneous affect on the stock market. The increased in the interest rate have direct affected that it became more costly for commercial banks to take money from the state bank of Pakistan. The first indirect affect of increased interest rate was that commercial banks also increased the rates charged to the customers for lending money. Individuals were affected through increased credit card's and mortgage's interest rates. This had the affect of the decreased quantity of money individual could spend. After all, individual still had to pay the utilities, and when those utilities became more costly and households were left with less earnings and hence spend less and therefore, companies were also affected by the interest rate by the actions of individuals. But businesses were how ever affected by the interest rate with a direct way as well. Businesses borrowed capital from banks to run and expand the activities. When the banks borrowing became costly, companies might not take as much and have to pay a higher rate of interest on the loan borrowed. Less spending slow down the growth of a company as a result decreased in profitability occurred. Change in the interest rate affected the spending pattern of both the individual and business, equity market was also affected in a way that how investors valuing a company by considering all the cash flows that company could have generated and discounted back to the present to arrive at a stock's price. This price fluctuated as a result of the different prospect of individual perception about the different companies at different point in time. Because of the differences, investors buy or sell stocks at diverse prices. The declining equity market was not a desirable outcome for the investors. Investors wanted to spot the invested amount to be increased in value. Investing in stock market was scrutiny as too uncertain compared to other investment's options. When the Government raised the rate and offered government securities such as Treasury bills and bonds that were mostly taken as safest investments and usually experienced a parallel increased as in the interest rates. The "risk-free" rate of return raised up make these investments more popular.

The interest rate, commonly discussed by the media had variety of impacts on the economy. The general affected was less the amount of money in circulation, which worked to keep inflation down. It also made the borrowed money more costly, which have an affect on the way the consumers and businesses used to spend the money, this increased expense for the companies, lower the earnings by impact the ability of debt to pay. Finally, it made the equity market a slightly unattractive place to invest. How ever there were many other ways of how the KSE 100 index could have been affected. The percentage change in the KSE 100 index over the past 15 Years from 1994-95 to 2008-09 was shown graphically (Financial Market review 2009).

Figure1.2: Percentage Change in KSE 100 Index (1990-91 to 2008-09) Source Business recorder

Interest Rate:

Interest rate was taken as the discount rate offer by the state of Pakistan to all the commercial banks in Pakistan and also referred as policy rate, so that the banks could further lend it to the customers to earn the markups. Interest rate was also one of the tools of monetary policy to control the money supply in the economy through commercial banks. When the Interest rate was high the cost of capital was high which also reduced the investment and less of the business activity took place. It was also a main cause of inflation as the low Interest rate which increased the disposal income of the individual because it became more easy for the individual to get the money at low rate and the pattern of spending thus increased gave rise to buying power behind the consumer demand and it eventually increased the prices which gave rise to inflation. On the other hand when interest rate was low the entrepreneurs found it easy to expand the business because of ease of money supply in the economy and give rise to GDP growth until and unless the interest rate was not likely to hike by the government because of the fact to settle down the inflation affected caused by it.

Over the last decade, interest rate of Pakistan was not that much stagnant because of the government policy was not the same as different government took over the control and difference in the mandate tends to change the interest rate over the time of the regime to control the dependent economic activities on it. In the mid of 1990's interest rate was at hike (10.33%) as to control the inflation rate(13.0%) which was also double digit and the GDP was quite fair (4.1%), the affect usually not immediate as it took a year or two for the interest rate to affect and to settle down the other economic variable. It was experience in the late 1990's and the start of the 2000 when the inflation (3.6%) was settled down to almost one digit which was a good sign but the also showing its affect on GDP (3.9%) which was not at a good signal for the economic point of view. Moving on to the mid of 2000 when the interest rate (1.86 %) was at record low rate tends to increase the inflation and GDP(6.4%) as more of the entrepreneurs wanted to earn the good profit margin in the times of high inflation. Graphically the Interest rate was shown from 1994-95 to 2008-09.

Figure1.3: Money at Call & Rates (1990-91 to 2008-09) Source: SBP


Inflation was the gradual increase in the level of good's and service's prices over a specific period of time and defined in percentage. It was also a good indicator of how economy was performing. The rate of the inflation was one of the most important macroeconomic indicators and a key variable for state bank of Pakistan to consider for scrutinized while set up its policy specially in the case of setting Interest rate (Government of Pakistan, 2009).

Gauging the inflation at a sustainable level was very important for economic growth. Inflation had dual affect not only on consumer side to safe income groups but also make the cost of business manageable for production side. The main motive of the government was to boost up the economic growth and to keep the inflation rate at controllable level. When inflation rate was moderately high it was a clear indication that the money supply in the economy was much (individual having more money to spend on) due to which increased in the demand of products and services lead to the high prices. It was therefore accepted in any economy that inflation should be moderately low in order to have a good economic growth.

Inflation internationally was among the top most priority in the last year 2008-09 as the rise in the global inflation was also witnessed all over but eventually calm down. A series of global shocks started from the beginning of the financial calamity at the international level lead to fall in the consumer confidence and declining of the aggregate demand caused the commodity's price to drop steeply all over the globe. This decline in the inflation rate changed the overall depiction of the global economy and the policy maker as well bureaucrats thought to restore the growth strength by easing the key Interest rate (money at call & rates) in order to enhance the demand. Inflation in the developed countries was no more an issue but the danger of recession was still far greater. Pakistan was one of the many economies where there was still a chance of facing the double digit inflation rate and even reached to almost 21 percent in the year 2009. Being a developing country, Pakistan need to have a low and stable inflation rate persisted to sustained period in order to track on a sustainable growth trend. With such increase in the domestic price level during the past two years, the affects on consumer especially the lower income group were ruthless and the macro economic variable was also way far from the most wanted economic objectives.

Pakistan entered into many stabilization programs the most apparently among was with IMF in November 2008 to revive the entire macro economic indicator including inflation that were at precarious level. Food was the primary source of inflation but non food component of the CPI was also very high in the year 2008-09. The three types of index from which inflation in an economy could be reported were consumer price index, whole sale price index and sensitive price index each of which representing different categories as per requirement. CPI was a measure of percentage rise that examined the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI was calculated by taking price changes for each item in the fixed basket of goods and averaging them; the goods were weighted according to importance. Changes in CPI were used to assess price changed associated with the cost of living and was the best source to check the influence of the rise in price over the population because it directly affected the cost of living of different income groups. The Whole sale price index covered the prices of the primary and the whole sale price market where as sensitive price index covered the price rise of the necessary commodities on a small interval basis.

The best reflector of inflation was CPI which was mostly preferred by the policy maker to locate the rate for monetary policy. The problem of inflation for Pakistan was not new. Historically Pakistan's experienced in growth and inflation could be expressed in five phases. Starting with the late fifties there was low inflation with very poor growth and in the sixties there was low inflation with good growth. In the period of seventies entailed high inflation with poor growth rate; the eighties seemed to have moderate inflation with good growth; and in the nineties observed high inflation with average growth rate. Over the last decade that was from 2000-01 to 2008-09, inflation was a low up to 3.1 percent in 2002-03 to a high record level to 20.8 percent during the last year, which was also the record high level in the last decades studied. The overall annual inflation was up to 20.8 percent where as GDP growth to remain poor at 2.0 percent for the year 2008-09 (Government of Pakistan, 2009). Graphically

Figure1.4: Inflation CPI based (1990-91 to 2008-09) Source SPB

Gross Domestic Product:

GDP (Gross Domestic Product) the measure of economic performance/out put and it was a valuation of goods and services produced in term of market, it was the market value of all final goods and services made within the borders of a country in a year. The GDP was different from GNP in way that the value of all the goods and services produced with in the premises of the economy regardless of by whom it was produced. It could be valued on the basis of either cost of production, value added cost at each level of production or the expenditure incurred (Labor) to produce those goods and services. During the last two decades GDP of Pakistan varied from (4.1%) in 1994-95 to (7.7 %) in 2004-05 and (2.1%) in 2008-09. Pakistan's economy witnessed the ending of the four distinct and very severe shocks of the last two years. The first was the negative shock to the economy sources from a severe macroeconomic crisis resulted from the policy modified imbalance of the past several years that had assumed unsustainable portion by 07-08. This was prolonged by the second shock involving a large worsening in Pakistan's net external terms of trade as a result of the spike in the commodity prices that had occurred in the 07-08 as a result of which economy faced the significant supply shock mainly in the case of provision of energy. The third shock was the affected of the turmoil in global financial markets because of the external demand of its export and limited funds to finance it fiscal and current account deficit. The indirect affected of the global financial crises also felt on the market and investor confidence in Pakistan as the banking system and financial market became under pressure. Finally the domestic security challenge increased the cost in terms of fight against terrorism and affected on the investment inflow and market confidence. The cumulative affect of these challenges faced by Pakistan had significantly affected the overall output growth, real GDP growth in the year was only 2 % as compared to 4.1 % in the previous year. The commodity producing sector with only rise of 0.2 % the lowest from 1990-91 due to declined in the investment by the private sectors, in response to the challenges faced by the Pakistan's economy, government took measures like the withdrawal of the general subsidies, direct income support to poor house holds and home grown stabilization program with support of IMF. In case of Pakistan the dominant affect if the global financial crises and being transmitted through the external trade and capital flowed channels, where prospect for the worker remittances was one of the biggest concern. In relative to multiple shocks faced by Pakistan over the last two years, the economy showed up a fair degree of flexibility as compared to the other countries affected by the global financial crises. It was remarkable that Pakistan was among the handful of countries with the positive rate of out put growth and among few with the lowest decline in the real GDP growth rate. The most terrible ever international and financial crisis has had serious for the developed and the developing countries. The result had spread through a widely interlinked international and financial markets and resulted in a contraction of credit and general dyeing up of liquidity in the economy. The crisis was not limited to financial markets but the economy at both international and national levels, its association; the dynamic formation was also in risk. The financial meltdown inevitably rebounded on the process of outlay in the production cycle of products and services (Government of Pakistan, 2009).