Impact of FDI and

Inflation on 2642GDP in
M.Bilal Khan

Pakistan
Bilal Wajid
2520

Kiran Salim
Research Paper

Economic analysis
 Impact of FDI and Inflation on GDP in Pakistan

Contents:
1. Abstract Page no. 3
2. Introduction Page no. 4
3. Theoretical background Page no. 5
4. Empirical study Page no. 5
5. Modeling framework Page no. 8
6. Estimation and result Page no. 8
7. Policy recommendation Page no. 9
8. Conclusion Page no. 9
9. References Page no. 10

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 Impact of FDI and Inflation on GDP in Pakistan

Abstract

The objective of the paper is to investigate impact of FDI and inflation on the GDP in
Pakistan by using annual data for the period of 2000-2008. The regression analysis
technique is used to determine the impact. The results suggest the positive impact of FDI
and inflation on GDP. Which shows as the FDI and rate of inflation will increase in
Pakistan the GDP will also increase. Expansionary fiscal policy should be implemented
so that the GDP will increase in Pakistan.

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 Impact of FDI and Inflation on GDP in Pakistan

INTRODUCTION:

GDP is a basic measure of a country's economic performance. The impact of FDI and inflation
on GDP is an important to determine because FDI and inflation are the most important factors
that affect the GDP of a country. Most of the economic growth literature emphasizes the
positive impact of FDI on GDP because it accelerates the growth of an economy by filling up the
saving-investment gap, increasing productivity etc. FDI, besides filling the saving-investment
gap, may bring advanced technologies and new entrepreneurial skills, which enhance production
and export composition of host economies. Foreign firms operating in host countries are also
expected to diffuse ideas and technology to domestic enterprises that, in turn, will improve
domestic management capabilities and the export performance of host countries. It is, therefore,
believed that inward FDI accelerates the stagnant growth process of Pakistan. As we have
witnessed that before the war against terrorism there was a good FDI in Pakistan which was
influencing our GDP positively but soon after the war against terrorism the FDI declined in
Pakistan due to adverse law-and-order situation within Pakistan. Most developing countries such
as Pakistan now considered FDI as the major external source of funding to meet obligations of
resources gap and economic growth, however it is difficult to measure economic effects with
precision. Nevertheless, various empirical studies showed a significant role of inward FDI in
economic growth of the developing countries, through its contribution in human resources,
capital formation, enhancing of organizational and managerial skills, and transfer of technology,
promoting exports and imports and the network effect of marketing. The other positive spillover
effect was that the presence of foreign firm helps expand infrastructure facilities, which makes it
easier and profitable for local firms to crowd-in. The negative impacts occur with competition
over scarce resources and limited skilled manpower, due to strategic motives by the affiliates of
Multinational Corporations (MNCs) or the high technological gap between local and foreign
firms.

High or unpredictable inflation rates are regarded as harmful to an overall economy. They add
inefficiencies in the market, and make it difficult for companies to budget or plan long-term.
Inflation can act as a drag on productivity as companies are forced to shift resources away from

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 Impact of FDI and Inflation on GDP in Pakistan
products and services in order to focus on profit and losses from currency inflation. In Pakistan
inflation rates have continuously been rising which has adversely affected the GDP because of
the uncertainty for the companies to prepare there budgets in the long-term and inefficiencies in
the market.

THEORETICAL BACKGROUND:
There exists a vast literature regarding the impact of FDI and inflation on growth in the world
economy. If real GDP grows too quickly, however, it can cause price inflation as firms are
forced to bid against one another for increasingly scarce workers. In contrast during trough
periods of the business cycle the economy is experiencing declines in real GDP, and
unemployment rates are high.
A long-run co integrating relationship is found between FDI and GDP after allowing for
heterogeneous country effects. The co integrating vectors reveal bidirectional causality between
GDP and FDI for more open economies. For relatively closed economies, long-run causality
appears unidirectional and runs from GDP to FDI, implying that growth and FDI are not
mutually reinforcing under restrictive trade and investment regimes.

EMPIRICAL RELATIONSHIP:
There are contradictions in the studies whether inflation has positive impacts on growth on
negative impacts. Several studies have been conducted to find out the real impact of inflation on
growth. Some of these argue that inflation effects growth positively whereas some of these
studies claims that inflation has adverse effects on growth. Fischer (1993) examined the role of
macroeconomic factors in growth. Fischer also argued that some countries have experienced
rapid growth at high inflation rates. During the period 1961-88, at least fourteen countries in the
World Bank database experienced an annual inflation rate greater than 50 percent in at least one
year. Growth in some of these countries exceeded 5 percent during a year or more of the 50
percent or more inflation. Fischer investigated the impact of inflation rate; ratio of budget surplus
to GDP; change in terms of trade; black market exchange premium on growth rate of real GDP.
Fischer used regression analysis to investigate the impact of these variables on GDP. The results

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 Impact of FDI and Inflation on GDP in Pakistan
indicated that inflation reduces growth by reducing investment and productivity growth. He
further notes that, low inflation and small fiscal deficits are not necessary for high growth even
over long periods; likewise, high inflation is not consistent with sustained economic growth.

Shamim Ahmed (2005) has empirically explored the relationship between inflation and economic
growth in the context of Bangladesh. The variables included are GDP as criterion and inflation as
independent variable. The empirical evidence demonstrated that there was a statistically
significant long-run negative relationship between inflation and economic growth for the country
as indicated by a statistically significant long-run negative relationship between CPI and real
GDP. Shamim suggests that these results have important policy implications for both domestic
policy makers and the development partners of Bangladesh. First, taking into consideration that
the inflation rate is not indexed in the wages and salaries, inflation will lead to a decrease in the
purchasing power and an increase in the cost of living. Second, given that the Bangladesh
frequently has to balance the credit requirements by the private and public sector against both
inflationary and balance of payments pressures, it is not always possible for the monetary
authority to increase (or adjust) the nominal interest rate above the expected (or actual) inflation
rate through contractionary monetary policy. In this regard, the monetary authority can think of
an alternative way by working on the expectations channel to reduce inflation.

Muawya Ahmed Hussein (2009) assessed the impacts of foreign direct investment on economic
growth in the gulf cooperation council (GCC) countries. The variables included are GDP as
dependent and FDI as a predictor. The regression analysis was conducted to find out the impact
of FDI on GDP which reflected a positive relationship between these two variables. The results
showed that FDI contribution to GCC countries GDP is positive. Hussein also argued that there
is a need of more influx of FDI in GCC countries because they are lacking in attracting foreign
investors which is not a good sign for the economy of GCC countries. Hussein further suggested
that GCC countries should facilitate licensing and documentation, eliminate hidden non-tariff
barriers and develop and liberalize financial markets and financial intermediaries. Hussein also
recommends that there is a need to adopt and integrate a well-planned investment promotion

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 Impact of FDI and Inflation on GDP in Pakistan
strategy to attract an increased share of foreign investment, especially investments that will lead
to exports. Finally after creating an attractive environment for the FDI, it is also important to
have clear policies that aim at channeling this FDI towards sectors that increase welfare and
foster growth such as manufacturing, information technology, health, media, tourism and
financial services. Creating clusters is one possible form of driving FDI to desired directions.

Ozturk, et al. (2007) has examined the relationship between the FDI and economic growth in two
countries: Pakistan and Turkey. The variables studied include FDI and economic growth. They
found the impact of FDI on economic growth. The techniques used for this purpose are the
Engle-Granger co integration and Granger causality test. Their empirical findings suggest that it
is GDP that causes FDI in the case of Pakistan, while there is strong evidence of a bi-directional
causality between the two variables for Turkey. On one hand, many would argue that, given
appropriate policies and a basic level of development, FDI can play a key role in the process of
creating a better economic environment. They also founded that based on the number of crucial
factors like: the trade regime, the human capital base in the host country, financial market
regulations, banking system and the degree of openness in the economy FDI has a positive
impact on overall economic growth.

Adeolu B. Ayanwale (2007) has empirically explored the relationship between the FDI and
economic growth in Africa and Nigeria. The technique they have used to find the relationship
between FDI and GDP is regression analysis. FDI in Nigeria contributes positively to economic
growth. Although the overall effect of FDI on economic growth may not be significant, the
components of FDI do have a positive impact. The FDI in the communication sector has the
highest potential to grow the economy and is in multiples of that of the oil sector. The
manufacturing sector FDI negatively affects the economy, reflecting the poor business
environment in the country. The researcher suggested that there is need for guided training and
integration of the human resources of the country to enable them to contribute positively to
economic growth wherever they find themselves employed either with foreign or with
indigenous firms and whichever sector they are in. The need for training high quality personnel

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 Impact of FDI and Inflation on GDP in Pakistan
in the country cannot be overemphasized. He further suggested that greater policy sensitivity
towards the openness of the economy is needed so that the traded commodities will be beneficial
to the economy as a whole.

MODELING FRAMEWORK:

This section presents a model that attempts to capture the impact of inflation and foreign
direct investment on growth of the economy. A behavioral function of real GDP growth,
representing economic growth, is specified as follows:

GDP = f (FDI , INF)

OLS i.e. ordinary least square method is used as research methodology. The Ordinary Least
Squares method of estimation is extended to two explanatory variables. The study illustrates the
effects of inflation and FDI on growth of the economy. Therefore the model is:

GDP = α + β1 FDI + β2 INF + µ

Where;
α: Constant
GDP: gross domestic product
FDI: Foreign direct investment
INF: Inflation
µ: Error
β1: Coefficient of foreign direct investment
β2: Coefficient of Inflation

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 Impact of FDI and Inflation on GDP in Pakistan

ESTIMATION AND RESULT:

The model consists of three variables foreign direct investment (FDI), inflation (INF) and gross
domestic product (GDP). All variables data were obtained from “Economic Survey of Pakistan
2008.”

Table 1

Adjusted R2 0.950
P value P value of constant 0.00
P value of Inflation is 0.060
P value of FDI is 0.006

T- Value T- Value of constant = 21.6463854256

T- Value of Inflation = 2.308217335748
T- Value of FDI = 4.098553099875
F-Statistics 57.1300462009
P value 0.000

GDP = 3392246.242211 + 3.628 INF+81350.70231862 FDI+ µ

According to the results FDI and inflation have 95% effect on GDP of Pakistan. Both the
independent variables have positive impact on GDP.

1
Table 2: GDP of Pakistan (Rs. in million)

Year GDP (Rs. in Million)

1999-2000 3562018

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 Impact of FDI and Inflation on GDP in Pakistan
2000-2001 3632091

2001-2002 3745118

2002-2003 3922104

2003-2004 4215608

2004-2005 4593230

2005-2006 4860476

2006-2007 5191709

2007-2008 5404486

2
Table 3 : FDI in Pakistan (Rs. in million)

Year FDI in Pakistan (Rs. in Million)

1999-2000 24280.55

2000-2001 18816.97

2001-2002 29730.09

2002-2003 46682.60

2003-2004 54638.20

2004-2005 90460.98

2005-2006 210755.1

2006-2007 311659.8

2007-2008 322302.1

1
Pakistan Economical Surveys Statistical Data
2
Pakistan Economical Surveys Statistical Data

3
Table 4 : Inflation Rates in Pakistan

Year Inflation Rates In Pakistan

1999-2000 3.60%

2000-2001 4.40%

2001-2002 3.50%

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 Impact of FDI and Inflation on GDP in Pakistan

2002-2003 3.10%

2003-2004 4.60%

2004-2005 9.30%

2005-2006 7.90%

2006-2007 7.80%

2007-2008 12.00%

CONCLUSION AND POLICY RECOMMENDATION:

Foreign direct investment (FDI) plays an important role in the economic growth of Pakistan so
government should try to adopt those policies which will increase the FDI in Pakistan. Also
government should create a friendly environment where foreign investors experience
comfortable in investing in Pakistan. When the inflows of FDI will increase in Pakistan economy
will grow.
Also the moderate inflation rate is also necessary for the economic growth of Pakistan. So
government should increase their expenses and should expand the economy. Both of this will
result in the prosperity of the country.
The policy we recommend is Expansionary Fiscal policy. Government should encourage the
flow of FDI in many sectors and should increase the expenditures for the growth of the economy.
3
Pakistan Economical Surveys Statistical Data

REFRENCES:

Adeolu B. Ayanwale 2007. “FDI and Economic Growth: Evidence from Nigeria”. Department
of Agricultural Economics Obafemi Awolowo University Ole-Ife, Nigeria, AERC Research
Paper 165, African Economic Research Consortium, Nairobi, April 2007
December, 1993

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 Impact of FDI and Inflation on GDP in Pakistan
Muawya Ahmed Hussein 2009. “Impacts of Foreign Direct Investment on Economic Growth in
the Gulf Cooperation Council (GCC) Countries”. International Review of Business Research
Papers Vol. 5 No. 3 April 2009 Pp. 362-376.

Shamim Ahmed and Md. Golam Mortaza 2005. “Inflation and Economic Growth in Bangladesh:
1981-2005,” Working Paper Series: WP 0604, Policy Analysis Research Department,
Bangladesh Bank Head Office, Dhaka, Bangladesh.

Stanley Fischer 1993. “The Role of Macroeconomic Factors In Growth”. NATIONAL BUREAU
OF ECONOMIC RESEARCH, 1050 Massachusetts Avenue Cambridge, MA 02138

Ozturk, Ilhan and Kalyoncu, Huseyin 2007. “Foreign Direct Investment and Growth:An
Empiricial Investigation Based on Cross-Country Comparison”. Cag University MPRA Paper No.
9636, posted 19. July 2008 / 18:19

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