International Journal of Accounting and Financial Reporting

ISSN 2162-3082
2014, Vol. 4, No. 2

Impact of Trade Openness, FDI, Exchange Rate and

Inflation on Economic Growth: A Case Study of
Pakistan
Sadia Bibi
Lecturer, COMSATS Institute of Information Technology, Vehari Campus

Syed Tauqeer Ahmad (Corresponding author)

Assistant Professor, COMSATS Institute of Information Technology,Vehari Campus
Email: tauqeerahmad@ciitvehari.edu.pk

Hina Rashid
COMSATS Institute of Information Technology, Vehari Campus

Accepted: September 17, 2014

DOI:10.5296/ ijafr.v4i2.6482 URL: http://dx.doi.org/10.5296/ ijafr.v4i2.6482

Abstract
This study focuses on empirical analysis to find out the role of trade openness, inflation,
imports, exports, real exchange rate and foreign direct investment in enhancing economic
growth in Pakistan. The analysis based on time series data for the period 1980 to 2011. This
paper uses ADF; PP and DF-GLS tests to find out stationarity of the variables and
Co-integration and DOLS (Dynamic Ordinary Least Square) techniques have been used for
the estimation. Co integration results indicated the long run relationship among the variables.
However, negative impact of trade openness can be overcome by producing import
substitutes and creating conditions for trade surplus. Furthermore, foreign direct investment
and trade are considered vital elements that improve the influence of economic growth.
Keywords: Foreign Direct Investment, Exchange Rate, Trade Openness, Inflation, Economic
Growth, DOLS, Pakistan.

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1. Introduction
According to UNCTAD and WTO estimates, world merchandise exports grew by 2.1% in
2013 (current prices). The strongest exports growth was observed in developing Eastern Asia
(6.5%). At the same time, exports contracted the most in Northern Africa (-10.6%). Imports
grew particularly in developing countries of Western Africa (8.6%) and Eastern Asia (6.2%),
while they decreased the most in developed Oceania (-5.8%), followed by developed Asia
(-5.5%). Variant growth in different regions as is evidenced by Fig. 1, prompts the writers to
investigate the glaring reasons for the unequal growth rates of merchandise and services
export growth rates. LDCs, Developing Asia coupled with Developing Economies seem to be
spearheading the trade growth. One reason which is widely debated and linked to growth in
trade is trade openness.
Fig. 1
Annual average growth rates of merchandise and services exports, 2008 - 2013 (%)

Sources: UNCTAD and WTO

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Fig. 2
Total World Trade in Goods and Services
(US Dollars at current prices and current exchange rates in millions)

Source: UNCTAD, WTO

The bourgeoning amount of literature in economics had nearly established a solid link
between trade openness and economic growth when Halit Yankkiya[2003] re-examined the
relationship and studied issue by segregating the impact of trade openness on developed and
developing economies. Contrary to popular belief, the empirical work of Halit Yankkiya
found negative relationship between trade openness and growth in case of developing
countries and positive relationship between trade openness and growth in case of developed
countries. The paper asserts that not only there is negative relationship between trade
openness and growth rather the developing countries can be benefitted by trade restrictions as
far growth is concerned.
The empirical findings of afore-mentioned study can be re-examined in the context of
Pakistani economy. Economy of Pakistan is passing through the period of economic
stabilization. It is facing very low economic growth rate as compared to the potential. The
major problems of Pakistan’s Economy that affect its growth rate are high inflation rate,

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adverse changes in exchange rate, trade deficit, energy crises and security conditions. These
problems affect macroeconomic factors like trade openness, imports, exports, inflation,
foreign direct investment and exchange rate which are considered as the key elements of the
economy.
Various empirical studies illustrates that trade openness is growth promoter. The relationship
of trade openness with economic growth is studied by various economists. Some of which
concluded that trade openness is growth enhancing factor [Marelli and Signorelli (2011),
Kahnamoui (2013), Ahmed and Anoruo (2000)]. Some other studies showed that it is not
growth promoter [Vernon (1996), Findlay (1984)]. The findings on trade liberalization,
however, are contentious and the research and empirical findings not yet conclusive
(Rodriquez and Rodrik, 2001).
We analysed this problem in the perspective of Pakistan’s Economy to overcome this type of
confusion. Studies of [Roy and Berg (2006), Iqbal et al (2010)] mentioned foreign direct
investment as a growth propelling factor for the economy. Most of developing economies
experience the issue of saving- investment gap. Foreign direct investment fulfils this gap by
enhancing productivity, enhancing modern technology, creating employment opportunities
and also increasing competition [Kobrin (2005)]. Foreign direct investment surged in
Pakistan from 0.64 per cent of gross domestic product in 2004 to 3.9 per cent of gross
domestic product in 2007 more than any year throughout the selected time span of 1980 to
2011. After that, it dropped constantly and in 2011, its value was 0.62 per cent of GDP. Since
the start of 2008, security conditions have proved to be insecure and unpredictable. Such
conditions gave rise to capital flight, decrease in foreign direct investment, high inflation rate
and devaluation of currency. Previous studies emphasized the presence of non-linear
connection of inflation with growth rate and highlighted the low level of inflation as growth
promoter, within this, surged inflation level has strong opposite relation with growth (Sarel,
1996; Bruno and Easterly, 1996; Ghosh and Phillips, 1998; Khan and Senhadji, 2001;
Sweidan, 2004; Mubarik, 2005; Hussain, 2005). Exchange rate is growth promoter as surge
in exchange rate increase the exports and therefore demand for goods improve [Mehmood et
al (2011)].
2. Objectives of the Study:
Objectives of the study are:
1. To evaluate the impact of Trade Openness on economic growth of Pakistan.
2. To inspect influences of exchange rate on economic growth.
3. To find out strategy for achieving balance of payment.
4. To examine the relationship of inflation with economic growth.
5. To observe the behaviour of foreign direct investment towards economic growth.
6. To investigate long run relationship among the variables.
7. To evaluate growth promoter policies within these variables.

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3. Empirical Literature Review:

Following table shows the empirical literature review;
Table. 1 Empirical Literature Review

Year Authors Empirical Dependent Independent Sample Findings

Approach Variables variables Period

2005 Mubarik OLS,2SLS Real gross inflation, 1973 to The empirical

, domestic investment, 2000 results
product consumer recommended
Causality
price index that 9 per cent
test
and threshold inflation
population was appropriate
growth rate for economic
boost in Pakistan.

2009 Zahoor ADF, PP Real Exchange 1982 to Outcomes

Hussain and Auto Gross rate 2010 indicated long run
Javed and regressive domestic volatility, relation among all
Muhammad distributiv product reserve the factors except
Farooq e lag money, exports and
manufacturi exchange rate
ng products, randomness. This
imports, study concluded
exports, that internal
reserve economic
money and performance
consumer changed with
price index alteration in
exchange rate
volatility in long
run in case of
Pakistan.

2011 IqbalMahm FDI, exchange 1975 to Results indicated

ood, Major ADF,OLS GDP, rate 2005 that exchange rate
Ehsanullah technique growth volatility had a positive
and Habib and rate and relationship with
Ahmed GARCH trade GDP, growth rate
model openness as well as with
trade openness

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and inversely
linked with FDI
in case of
Pakistan.

2012 AsmaArif ADF, Co Output Trade 1972 to The outcomes

and Hasnat integration growth openness 2010 indicated
Ahmad , ECM and causality and long
Granger run relationship
Causality between trade
openness and
GDP growth in
Pakistan.

2011 Bishnu ADF and GDP FDI, 1986 to Results showed

Kumar PP growth Trade 2008 causality and
Adhikary Johansen-J rate openness, equilibrium in
uselius Capital long run among
test, formation the variables,
Impulse Economic shocks
response to the
and independent
variance variables
decomposi provided a
tion positive influence
on GDP growth.
And
VECM results
VECM
depicted the
negative impact
of trade openness
on economic
growth in case of
Bangladesh.

2011 Usman OLS RGDP Import, 1970 to The empirical

owolabi export 2005 results suggested
Akeem Economic that Imports,
Openness, Exports and
Foreign Exchange Rate
Exchange had inverse

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Rate and relationship with

Per Capita Gross Domestic
Income Product in case of
Nigeria. There
was causality
among the
variables.

2006 Atrayee SEM, PP, RGDP Growth 1970 to Evaluated results

Ghosh Roy KPSS Growth rates of the 2001 showed that
and Hendrik tests. Rate entire United States had
F. Van den capital found boost in its
Berg stock minus economic growth
FDI, because of
foreign direct
collected
investment.
FDI, labour
Labour force was
force, and
positively related
exports
with growth in
case of United
States.

2010 Muhammad ADF, co FDI, 1988:1 The study showed

Shahzad integration Economic Imports and to that the
Iqbal, Faiz test, Growth Exports 2005:4 bidirectional
Muhammad VECM rate causality existed
Shaikh, test, VAR between
Amir and
Economic
Hussain causality
growth, export
Shar test
and FDI and
single relationship
of import to
export and import
to FDI. FDI and
trade had proved
to be growth
promoter in
Pakistan.

2011 Enrico OLS, two Economic trade, gross 1980 to Empirical results
Marelli and stage least Growth domestic 2007 showed that the

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Marcello square product per influence of all

Signorelli (2SLS) capita, trade exogenous
technique openness, variables on
foreign economic growth
direct were positive and
investment significant in all
and gross conditions in
capital cases of China
formation and India.
lagged

2012 Sarbapriya OLS, nominal public 1990-1 Results indicated

Ray KPSS, GDP sector 991 to that private
co investment, 2010-2 investment,
integration trade 011 human resource
test openness, development and
Granger private trade openness
Causality sector were in favour of
and ECM investment, growth while
financial capital financial
integration integration was
and human inversely related
resource with growth. All
developmen variables were
t cointegrated, in
case of India

2013 Farrokh OLS per capita Gross 1970-1 Trade openness

Kahnamoui Technique growth of domestic 999 had positive
gross product at impact in the
domestic initial level, existence of
product human export credit.
capital, Through this
physical study, it was
capital, concluded that
trade export credit had
restriction, direct and
and export substantial
credit per impression on
person economic growth
in a positive way
for recipient. So,
trade openness

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was more
favourable for
economic growth
in OECD
countries.

2009 Ramesh KPSS, PP, Economic External 1950-2 Results indicated

Chandra ADF and growth debt, labour 006 that Co
Paudel and DF and force, trade integration was
Nelson Johansen liberalizatio present among
Perera Cointegrat n external debt and
ion financial growth,
trade
liberalization and
labour force.
Labour force was
the main variable
of growth during
that time period in
case of Sri Lanka.

2011 Zaheer ADF, Gross Exchange 1980-2 This useful study

Khan Kakar Johanson domestic rate, foreign 010 indicated that in
and Bashir co-integrat product direct comparison with
Ahmad ion test, investment other two
Khilji Granger and trade variables trade
Causality openness openness showed
test great effect on
economic growth
in case of
Pakistan. Foreign
direct investment
inflows and gross
domestic
investment
showed causality
for each other in
case of Malaysia.

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4. Theoretical Framework:
Mercantilist Theory was formulated in 16th to 18th century by Antorio Serra, DavidHum,
Von Hornick, Josiah Child and many more in Western Europe mainly in France and England.
Mercantilist theory stated that national wealth should be increased through trade. Adam
Smith proposed the absolute advantage theory in 1976. He favoured the opinion of free trade
as more beneficial instrument for countries. The theory advocated that specialization of
resources for producing a specific good could give more output, from which other nations can
be benefited by free trade. A classical trade theory, presented by David Ricardo, was based on
comparative advantage and relative prices. The objective of Ricardo was to describe the
benefits of trade among states and the significance of trade liberalization policy. Labour was
the only variable which was considered as an immovable factor according to the Ricardian
Model. The major element that was discussed in Ricardo’s Model was the advantage of
producing a good with specialized factor rather than consuming it for any other good for
which it was not specified. This theory describes the scarcity of resources that leads to the
trade-off among the manufacturing of commodities. Trade- off is related to the opportunity
cost. The unit of one commodity which is given up for the manufacturing of one unit of
another commodity is the opportunity cost (Begg et al. 2003:254). Swedish Economists,
Hecksher and Ohlin developed a theory named as Hecksher-Ohlin Model. This theory was
concerned with the allocation of resources for their best use and their prices among countries
are the key elements of trade. Hecksher Ohlin preserved that resource allocation regulated a
country’s comparative advantage. The model supposed two goods, two variables and two
countries which demonstrated perfect competition. Harrod in 1939 and Domer in 1946
presented a model to enlighten the economic growth. This model predicted that growth was
dependent function of capital as well as labour. As investment increases then capital surges
which tends towards economic growth.

Y s

Y K … (3.7)

Solow presented neoclassical growth theory which extended the Harrod Domer Model by
increasing another variable that was technology. This theory described that three variables
enhances the output named as, enlarged and educated labour force, more investment in capital
formation and advanced technology. This model was represented in Cobb-Douglas
production function form.
 1
Y  AK L 01
t t t t … (3.8)

5. Data and Methodology:

The choice of variables depends on the choice made by other investigators (Ghosh and
Phillips 1998, Khan and Senhadji 2001, Mubarik 2005).

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This paper used the data of real gross domestic product, real imports, real exports, foreign
direct investment inflows, inflation and real effective exchange rate from World Bank. We
selected the time span from 1980 to 2011. We used Real GDP as dependent variable and
Trade Openness, FDI, Real Exports, Real Imports, Inflation and Real Effective Exchange
Rate as dependent variables.

Y=f (Xi) +  … (4.1)

Where Y=GDPR
Xi=TON, FDIN, INN, EERR, IMR, EXR

GDPR    TON   FDIN   INN   EERR   IMR   EXR  

t  1 t 2 t 3 t 4 t 5 t 6 t t (4.2)

Where Y= GDPR=Real Gross Domestic Product

 =Error term

α=Constant
TON=Trade openness
FDIN=Foreign Direct Investment
INN=Inflation
EERR= Real Effective Exchange Rate
IMR=Imports Real
EXR=Exports Real
 =Error Term

t=Time
5.1. Description of Variables
Endogenous Variable
5.1.1 Real Gross Domestic Product:
Real gross domestic product is referred to as a macroeconomic variable which is used as a
measure of the value of the economic output fixed for price fluctuation. While nominal gross
domestic product shows market prices of all finished commodities and services which are
produced inside the border of the state.

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GDPN
GDPR  ...(4.3)
INN
It is expressed in percentage.
Pakistan’s economy experienced the increasing trend in real gross domestic product from
1980 to 2011.Its economic growth had been intensely rising since 1986 .As compared to a
low economic growth rate of 2.8 per cent in 1986, annual growth rate amplified to 6 per cent
during 1988 and augmented to over 9 per cent in 1995 as well as1996. The growth rate
declined initially in 1989 and 1990 due to the failure of the Communism system of Russia
and Eastern Europe. Average growth of GDP rate in1986-1990 was 4.4per cent, which was
improved intensely in 1991-1995 up to 8.18 per cent. Nevertheless, because of strong effects
of Asian economic calamity in 1997-1998, gross domestic product was dipped to 5.8 per cent
in 1998 while in 1999 dipped at 4.8 per cent. The Pakistan economy was effectively
recovered after the catastrophe and settled at 7.48 per cent of growth rate during 2001-2005.
Getting control on numerous problems and trials, economy faced 8.4 per cent growth rate that
is considered highest. Our country has been focusing on industrial development since 1986. I
proposed the hypothesis that economic growth is positively related with FDI, Imports,
Exports and real effective Exchange Rate and negatively with trade openness and inflation
rate. Within this, there is long run relationship among the variables.
5.1.2 Independent Variables
5.1.2.1 Trade Openness:
Trade openness can be defined as the level of trade which a country permits to do with the
other country. It includes all kinds of open trade linkages. It is beneficial in terms of getting
foreign investment and investing in other countries. We formulated the trade openness data
from the summation of real import and real export and divided it by real gross domestic
product.

TON 
IMR  EXR  ...(4.4)
GDPR

Previous research of Levin and Renelt (1992) showed the confusing results which predicted
that there was no big difference among export and import supportive strategies. They used
data from 1960 to1989 of 119 countries. They on the basis of their results discussed that
increment in resource accumulation instead of distribution of resources favoured the trade
openness. Adhikary (2011) found the inverse connection among trade openness and growth of
economy in Bangladesh from 1986 to 2008. This was due to the devaluation of currency and
adverse balance of payment. Pakistan faced fluctuations in Trade Openness during
1980-2011.The highest trade openness was seen in 1980 of 39% and afterwards in 2006, it
became 37 per cent. Trade openness can be appeared as positive or negative depending on the
values of determinants of trade openness.

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5.1.2.2 Foreign Direct Investment:

Foreign Direct Investment can be described as an investment made by one state to another
state in any business or entity. Open economies having good economic conditions attract high
amounts. There are two main types of foreign direct investment. First is horizontal foreign
investment which is stated as an investment made by one country into second country to
produce the same product for its population? Second is the vertical foreign direct investment
which states as an investment made by a country into another country to manufacture the
differentiated product which may be downgraded or innovative? Mostly it preferred
innovation in the product that was harmful for the domestic country’s industry. Foreign direct
investment and trade are the vital variables in boosting the economic growth (Iqbal et al
2010). Foreign Direct Investments raise the technological spill over, competition and
reinforce the production capabilities of the host economy (Pugul 2007). In 2008, Pakistan
experienced stagnation in growth terms. Pakistan faced reduction in foreign direct investment
due to its contribution against terrorism and generated uncertainty. Since 1986 there was
implementation of reforms, FDI has been considered as an important factor to developing the
Pakistan economy. The diversification of Pakistan economy from planned to market
dependent economy showed sudden effects. Pakistan Statistical Yearbook 2005 shows that
7279 FDI schemes got investment certificates while total recorded capital value was
US$66244.4 million since 1988- 2005. Foreign investment increased to 1296 dollars during
1995-1996 from10.7 dollars during 1976-1977. However, it dropped to $950 million during
1996-1997. The inflow of external investment during1991-1992 propagated at the multiple
rate of growth 15.2%. During 1995-1996 Inflows of foreign direct investment augmented
by 93.3% normally because of the investment in electric power sector. The asset has now
climbed $ 3521 million during 2005-06. This illustrates that FDI faced a 332% surge from
2001-02 to 2006-2007. Afterwards this trend declined and Pakistan received FDI with
dropping rates till now.
5.1.2.3 Imports:
Pakistani imports are more than its exports which deteriorates its balance of payment.
Pakistan’s imports are mostly final products, steel, machinery, petrochemicals, tea, edible oils
and equipment related to transportation. Pakistan imports products from China, Saudi Arabia,
Kuwait and Malaysia. It is big importer of China’s products. Growth rate of imports is
observed to be increasing year to year but some fluctuations are also found. In 1991-1995
Pakistan observed maximum growth rate (24.3%). The period of 2004 to 2006 shows
another big increase in real imports. The yearly average rate of growth of imports is
calculated 16.1 per cent during 1986-2005 every year. There are fluctuations observed on
continuous basis in imports till 2011.
5.1.2.4 Exports:
Pakistan’s exports are less than its imports which worsens its position of trade. Its core
exports are related to agriculture like rice, sports commodities, leather products and textiles.
United States, China, Germany and United Arab Emirates are its primary exporters from
which United States is its big exporter. Its exports are increasing day by day. From 1980

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export growth was increasing.1990 to 2007, yearly average exports growth rate is observed
21.22 per cent per annum. In 2005, export worth was observed 40.8 times greater than 1986,
from $0.79 billion calculated in 1986 to an increased amount of $32.23 billion in 2005. The
earnings from exports surge gradually from 35.7 per cent in 1986-1990 up to 46% during
2001-2005 and still following some more upward trend.
5.1.2.5 Real Effective Exchange Rate:
Pakistani Rupee was fixed against pound sterling till 1982 during the reign of Zia-ul-Haq and
it devalued by 38.5 per cent during 1982 to 83.Businesses faced massive proliferation in
import costs. At that time State Bank of Pakistan removed this effect by dropping interest
rates and purchasing dollars for the preservation of the country’s export competition ability.
During the Bhutto’s regime, rupee was appreciated and after that external aid devalued the
rupee. Exchange rate observed highest values in1980-1981. Afterwards it started declining till
2001 from 237PKR in 1981 to 97PKR in 2001.From 1982 onwards, rupee devalued due to
the introduction of managed floating system of exchange rate. In 2002 it increased and settled
at 103PKR. From 2002-2004 Pakistan experienced a dropping trend with a dropped value
97PKR in 2004. After observing an increase in 2004-2006 from 97PKR to 102.85PKR where
it showed stability, it started declining till 2008 with a value of 97.74PKR. From 2008-2011 it
experienced an increasing trend. The value in 2011 is recorded as 106PKR.
5.1.2.6 Inflation:
An increase in money supply or escalation in overall price level is called inflation. When
price level increases, it creates a reduction in buying power. There are different types of
inflation. A reduction in overall price level is referred to as deflation. Disinflation is a
reduction in the level of inflation. Hyperinflation is an uncontrolled inflationary coil. An
increase in price level, sluggish financial growth and high joblessness are collectively called
Stagflation. Reflation can be defined as an effort to nurture the overall price level to respond
deflationary forces. There are different measures of inflation from which consumer price
index and GDP deflator are commonly used. Double digit inflation in percentage, is very
harmful for the economy. Pakistan faced highest double digit inflation in 2008. Fisher (1993)
described that inflation was a cause of reduction in growth which resulted from decline in
investment and output growth. Nell (2000) evaluated that single digit inflation was
favourable, on the other hand double digit inflation led towards sluggish growth. Malik and
Chowdhry (2001) used cointegration for the investigation of the relationship between
inflation and economic growth for Pakistan, India, Bangladesh and Sri Lanka. They observed
that inflation had a positive relationship with growth of economy. Changes in growth had
greater influence on inflation rather than inflation on the economic growth. In Pakistan,
inflation experienced huge fluctuations like, in one year it was showing increasing trend and
in next year it showed decreasing trend. The period of 1997 to 2003 observed a continuous
decrease in inflation rate. In 2008 it experienced highest level of inflation which is 20 per
cent. Afterwards it started declining and in 2011 it was observed at 11.9 per cent which
showed double digit inflation and was risky for the economy.

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5.2 Econometric Techniques

5.2.1 Unit Root Test:
The empirical section primarily examines the stationary conditions of the data applying the
augmented Dickey –Fuller (1979) test and the Phillips-Parron (1988) test. Dickey and Fuller
stretched the procedure of their test proposing an augmented version that contained more
lagged term of endogenous variable to eradicate the autocorrelation. The three considerable
forms of the ADF test are described as follows:
q
Tt  Tt 1   i Tt 1   t
j 1
… (4.5)

q
Tt     Tt 1   i Tt 1   t
j 1
… (4.6)

q
Tt     Tt 1   2t   i Tt 1   t
j 1
… (4.7)

The difference among these equations relates to the existence of

  and  2t .

5.2.2 Cointegration Test

Cointegration test is applied to find out the long run relationship between the used variables.
This technique is used when two variables are non-stationary but their linear combination
demonstrates lower order of integration. When non stationary variables do not show
cointegration then it would show spurious regression. In the other case if the two variables
cancel their stochastic trends then it would show cointegration which demonstrates long run
relationship between the variables.

M t  1   2 N t  ut ...(4.8)

  
u t  M t   1   2 N t ...(4.9)

5.2.3 Dynamic OLS

A modest method for creating an asymptotically effective estimator that eradicates the
reaction in the cointegrating structure has been supported by Saikkonen (1992) and Stock and
Watson (1993). Named Dynamic OLS (DOLS), the technique contains enhancing
thecointegrating regression which uses lags with leads of t ΔX thus the subsequent error term
of cointegrating equation is orthogonal to the whole past of stochastic regressor
improvements:

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
yt  X   D  1 
t
' '
1t  X
j  q
'
t j   v1t ...(4.10)

According to the assumption by adding q lags and r leads of differenced regressors dripping
up all of the relationship between t u1 and t u 2 , least square approximations of θ = (β ' ,γ ' )'
Applying the above expression shows the similar asymptotic dispersal as those acquired from
FMOLS (Fully-modified least square) and CCR (Canonical Cointegrating Regression).
Table.2 Unit Root Test

Variables ADF Test Results PP Test Results DF-GLS Test Conclusion

Level 1st Level 1st Level 1st

Difference Difference Difference

GDPR -2.96 -2.96 -2.96 -2.96 -1.95 -1.95 I(1)

Tabulated 1.25 -3.26 2.73 -3.26 -0.21 -2.53
Values

IMR -2.96 -2.96 -2.96 -2.96 -1.95 -1.95 I(1)

Tabulated -0.72 -5.52 -0.73 -5.54 0.59 -4.52
Value

EXR -2.96 -2.96 -2.96 -2.96 -1.95 -1.95 I(1)

Tabulated 0.37 -5.03 0.37 -5.04 0.98 -5.12
Value

TON -2.96 -2.96 -2.96 -2.96 -1.95 -1.95 I(0)

Tabulated -3.40 -5.93 -3.45 -6.01 -2.41 -4.67
Value

FDIN -2.96 -2.96 -2.96 -2.96 -1.95 -1.95 I(0)

Tabulated -2.66 -3.95 -2.04 -3.07 -2.57 -3.44
Value

INN -2.96 -2.96 -2.96 -2.96 -1.95 -1.95 I(0)

Tabulated -2.58 -6.87 -2.67 -6.89 -2.44 -6.97
Value

ERR -2.96 -2.96 -2.96 -2.96 -1.95 -1.95 I(1)

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Tabulated -1.80 -3.06 -1.80 -5.49 -1.64 -1.89

Value

Author’s own calculation using E Views7

Note: a) At 5% level of significance based on Mackinnon (1996) and Eliot
Rottenberg-Stock (1996).
b) Null Hypothesis of all above unit root test is that series has a unit root.
c) SBC and AIC criteria are used for optimal lag selection

The outcomes of the tests are illustrated in the tabular form. According to the null hypothesis;
series has a unit root as it is non-stationary. In conclusion I (0) shows that variable is
stationary at level and I (1) illustrates that variable is stationary at first difference. A
comparison is held in the table by comparing the calculated values with the tabulated values.
Trade openness, FDI and inflation are at level I (0) and imports, exports, real exchange rate
and real GDP are at first difference I (1).
Table. 3 Johansen and juselius (1990)Max. Likelihood Test for Cointegration

Null Trace Critical Prob. Max. Critical Prob.

Values** Values**
Hypothesis Statistics Value at Eigen Values at
based on 5% Values 5%
likelihood
Ratio

R=0 264.5598 125.6154 0.0000 121.0493 46.23142 0.0000

R≤1 143.5105 95.75366 0.0000 49.55574 40.07757 0.0032

R≤2 93.95474 69.81889 0.0002 47.88584 33.87687 0.0006

R≤3 46.06890 47.85613 0.0729 21.67710 27.58434 0.2374

R≤4 24.39180 29.79707 0.1844 13.63639 21.13162 0.3956

R≤5 10.75541 15.49471 0.2270 8.069268 14.26460 0.3717

R≤6 2.686140 3.841466 0.1012 2.686140 3.841466 0.1012

Author’s own calculation using E Views7

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Note: a) Trace Test indicates 3 co integrating equations at the 0.05 level

b) Max. Eigen Value indicates 3 co integrating equations at the 0.05 level
* denotes rejection of the hypothesis at the 0.05 level
**Mackinnon-Haug-Michelis (1999) P- values
The rule of thumb for testing co integration describes that greater value of trace statistics
(based on likelihood ratio) and Max. Eigen values than their critical value leads towards
rejection of null hypothesis. This also includes that Prob. Value should also be less than 0.05.
Application of Johansen cointigration test tells the cointigration between the variables in the
long run. It is clear from the Likelihood Ratio that there are three cointigration equations. It
can also be said that there are three linear combinations among the variables. Hence, results
indicate that all the variables have long run relationship.

Table.4 Dynamic OLS

Variables Coefficient Standard Error t-Statistics Prob.

lnIMP 0.418589 0.113595 3.684915 0.0142

lnEXP 0.572200 0.092719 6.171358 0.0016

lnTOP -1.091020 0.067418 -16.18298 0.0000

lnFDI 0.014783 0.094586 1.184431 0.2895

lnINF -0.010126 0.004848 -2.088788 0.0910

lnER 0.179287 0.094586 1.895498 0.1165

R2 0.999949 DW 1.839382

Adjusted R2 0.999716

Author’s own calculation using Eviews7

This study has generated a series of all variables with log and then applied Dynamic OLS
technique. Results show that the value of adjusted R2 is 0.999716 which is less than R2 value,
given in the table. Durbin Watson test shows a value of 1.839382 which shows that there is
no positive autocorrelation among the variables, so null hypothesis is accepted in this case.
Results indicate that variables show the expected signs. Real imports and real exports are
positively related with real gross domestic product. 1 per cent increase in real imports and
real exports will increase 41.8 per cent and 57.2 per cent respectively in real gross domestic

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product. Trade openness and inflation are negatively related to real gross domestic product. 1
per cent increase in trade openness and inflation will result in 109.1 per cent and 1 per cent
respectively decrease in real gross domestic product. These four variables show the
anticipated signs and are significant as their t values are greater than 1.96. Results of real
exchange rate and foreign direct investment are not significant. But have positive impact on
real gross domestic product. 1 per cent increase in real exchange rate and foreign direct
investment will enhance the real gross domestic product by 17.9 per cent and 1.4 per cent
respective.
6. Conclusion
The purpose of this study is to examine the relationship of growth rate with trade openness,
inflation, exchange rate, imports, exports and foreign direct investment during the time period
of 1980-2011. I proposed the hypothesis that foreign direct investment, imports and exports
have positive impact on economic growth. Inflation and trade openness has negative
relationship with the growth of economy and exchange rate affects economic growth in a
positive way. Secondly there and long run relationship among these macroeconomic variables.
Stochastic and deterministic trends are present in the data. So, by applying unit root test (ADF,
PP, and DF-GLS) trade openness, foreign direct investment and inflation are stationary at
level I (0) and imports, exports, real gross domestic product and exchange rate are stationary
at first difference I(1). Cointegration results indicate that there is long run relationship among
the variables, as described in null hypothesis. Dynamic OLS results indicate that trade
openness is negatively related to the economic growth rate in Pakistan because of the
depreciation in exchange rate, huge volume of imports and resulting trade deficit. Inflation is
negatively related to economic growth. According to the results, imports and exports are
growth promoter due to the positive connection with real gross domestic product as proposed
earlier. Similarly, foreign direct investment is also a strong growth indicator. According to the
study results foreign direct investment have positive impact but not significant. Trade
openness proved to be highly negative because of the trade deficit and changes in exchange
rate. Exchange rate has positive but not significant relationship with economic growth as its
local economic performance is so much sensitive to the variation in exchange rate in the
long-run period. So, all the results are according to the formulated hypothesis. This might
determine that foreign direct investment financed in Pakistan was fascinated by the economic
growth and policy of foreign trade. Furthermore, foreign direct investment and trade are
considered vital elements that improve the influence of economic growth. If suitable policies
are formulated then economic growth can be enhanced by trade openness at a large scale.
Single digit inflation is essential condition for a growing economy like Pakistan. Exchange
rate cannot be ignored as it has a significant impact on the economy. This is not the end of
research. This thesis can be used as a base for further research works.
Policy Recommendations:
 Export promotion policy should be analysed and import substitution policy should
also be examined, so that country can take benefit from trade. The fiscal authorities
should boost exports and encourage domestic products.

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 Industrial sector should expand their production so that their products would be
reasonable in the global market.
 Research should be promoted to enhance the overall productivity of final goods.
 Excise duties and tariffs should be dropped so as to boost home industries to trade
their goods and services.
 Only the essential capital goods should be imported keeping in view that all the
imported material is not mandatory.
 Generation of electric power should be focused at low cost and should be provided to
enhance the output of manufactured goods as well as exports. Safety conditions
should be made considerably perfect and reliable to enhance the foreign direct
investment. This investment should be used for developmental projects instead of
consumption purposes.
 Inflation rate should be kept below double digit as double digit inflation is dangerous
for the economy.
 The results stated earlier recommend that policy makers should take into account both
the presence and the amount of exchange rate instability and take into account the
likely influence of the exchange rate changes on each macroeconomic factor in
application of trade policies, therefore that greater volumes of trade as well as foreign
direct investment might be fascinated.
So, main focus should be on the electric power supply, controlled money supply,
manufactured goods and safety conditions to make the economy grow on real terms.

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