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Interest Rate Determination in Developing Countries: A Conceptual Framework


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  • Sebastian Edwards
  • Mohsin S. Khan


As a number of developing countries move towards more liberalized financial systems, the question of how interest rates respond to foreign influences and domestic policies is one that policymakers in these countries have started to face. Most existing studies of interest rates typically treat only the extreme cases of either a fully open economy, where some form of interest rate arbitrage holds, or a completely closed economy, in which interest rates are determined solely by domestic monetary factors. Developing countries, however, generally fall somewhere between these two extremes, so that the standard models of interest rate determination would not seem to be relevant to their case.The purpose of this paper is to outline a theoretical framework that can serve as a starting point for analyzing interest rate determination in those developing countries that are in the process of removing controls on the financial sector and restrictions on capital flows. The approach suggested here combines elements of the closed-economy and open-economy models, and thus is able to incorporate the influences of foreign interest rates, expected changes in exchange rates, and monetary developments on domestic interest rates. An interesting feature of the resulting model is that the approximate degree of financial openness, defined as the extent to which domestic interest rates are linked to foreign interest rates, can in fact be as certained from the data of the particular country. To illustrate the empirical validity of the proposed model it was applied to two countries -- Colombia and Singapore. These two countries are quite different in terms of levels of financial development and degrees of openness, and thus provide a useful first test of the general nature of the model. The model is able to represent both these cases quite adequately. The estimates indicate that in Colombia both foreign and domestic factors are important, while domestic interest rates in Singapore are fully determined by foreign interest rates and variations in the exchange rate. This is precisely what would have been expected, given the characteristics of the respective financial systems in the two countries.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1531.

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Date of creation: Jan 1985
Date of revision:
Publication status: published as Edwards, Sebastian and Mohsin S. Khan. "Interest Rate Determination in Developing Countries" A Conceptual Framework," International Monetary Fund Staff Papers, Vol. 32, No. 3, September 1985, pp. 377-403.
Handle: RePEc:nbr:nberwo:1531

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  1. Darby, Michael R, 1975. "The Financial and Tax Effects of Monetary Policy on Interest Rates," Economic Inquiry, Western Economic Association International, Western Economic Association International, vol. 13(2), pages 266-76, June.
  2. Townsend, Robert M, 1983. "Financial Structure and Economic Activity," American Economic Review, American Economic Association, American Economic Association, vol. 73(5), pages 895-911, December.
  3. John H. Makin, 1982. "Effects of Inflation Control Programs on Expected Real Interest Rates (Effets exercés par les programmes de lutte contre l'inflation sur les taux d'intérêt réels prévus) (Efectos de los," IMF Staff Papers, Palgrave Macmillan, Palgrave Macmillan, vol. 29(2), pages 204-232, June.
  4. Mario I. Blejer, 1982. "Interest Rate Differentials and Exchange Risk: Recent Argentine Experience (Différentiels de taux d'intérêt et risque de change: le cas de l'Argentine) (Diferenciales en los tipos de inter�," IMF Staff Papers, Palgrave Macmillan, Palgrave Macmillan, vol. 29(2), pages 270-279, June.
  5. José Saúl Lizondo, 1983. "Interest Differential and Covered Arbitrage," NBER Chapters, National Bureau of Economic Research, Inc, in: Financial Policies and the World Capital Market: The Problem of Latin American Countries, pages 221-244 National Bureau of Economic Research, Inc.
  6. Blanco, Herminio & Garber, Peter M, 1986. "Recurrent Devaluation and Speculative Attacks on the Mexican Peso," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 94(1), pages 148-66, February.
  7. Fama, Eugene F, 1975. "Short-Term Interest Rates as Predictors of Inflation," American Economic Review, American Economic Association, American Economic Association, vol. 65(3), pages 269-82, June.
  8. Mathieson, Donald J., 1982. "Inflation, interest rates, and the balance of payments during a financial reform: The case of Argentina," World Development, Elsevier, Elsevier, vol. 10(9), pages 813-827, September.
  9. Robert Mundell, 1963. "Inflation and Real Interest," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 71, pages 280.
  10. Cumby, Robert E & Obstfeld, Maurice, 1981. "A Note on Exchange-Rate Expectations and Nominal Interest Differentials: A Test of the Fisher Hypothesis," Journal of Finance, American Finance Association, American Finance Association, vol. 36(3), pages 697-703, June.
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Cited by:
  1. Paul Boothe & Debra Glassman, 1988. "Alternative Tests of International Asset Substitutability," UCLA Economics Working Papers, UCLA Department of Economics 463, UCLA Department of Economics.
  2. Carlos Fernando Lagrota R. Lopes, 2004. "Monetary Policy And External Vulnerability In Brazil," Anais do XXXII Encontro Nacional de Economia [Proceedings of the 32th Brazilian Economics Meeting], ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of G 071, ANPEC - Associação Nacional dos Centros de Pósgraduação em Economia [Brazilian Association of Graduate Programs in Economics].
  3. repec:eee:deveco:v:99:y:2012:i:2:p:358-369 is not listed on IDEAS
  4. Menzie Chinn & William Maloney, 1995. "Financial and capital account liberalization in the Pacific Basin: Korea and Taiwan during the 1980's," International Finance, EconWPA 9508005, EconWPA.
  5. Sebastian Edwards, 2012. "The Federal Reserve, Emerging Markets, and Capital Controls: A High Frequency Empirical Investigation," NBER Working Papers, National Bureau of Economic Research, Inc 18557, National Bureau of Economic Research, Inc.
  6. Luis Eduardo Arango & Yanneth R.Betancourth, . "A Signal of Imperfect Portfolio Capital Adjustments from the Relationship Between Yields of Domestic and Foreign Colombian Debt," Borradores de Economia, Banco de la Republica de Colombia 216, Banco de la Republica de Colombia.
  7. Sebastian Edwards, 1998. "Capital Inflows into Latin America: A Stop-Go Story?," NBER Working Papers, National Bureau of Economic Research, Inc 6441, National Bureau of Economic Research, Inc.
  8. Thomas D. Willett & Young Seok Ahn & Manfred W. Keil, . "Capital Mobility for Developing Countries May Not Be So High," Claremont Colleges Working Papers, Claremont Colleges 2000-26, Claremont Colleges.
  9. Sebastian Edwards, 1999. "International capital flows and emerging markets: amending the rules of the game?," Conference Series ; [Proceedings], Federal Reserve Bank of Boston, Federal Reserve Bank of Boston, vol. 43(Jun), pages 137-171.


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