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Interest Rate Determination in Developing Countries: A Conceptual Framework

  • 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
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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
Note: ITI IFM
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  1. Fama, Eugene F, 1975. "Short-Term Interest Rates as Predictors of Inflation," American Economic Review, American Economic Association, vol. 65(3), pages 269-82, June.
  2. 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, vol. 36(3), pages 697-703, June.
  3. Robert Mundell, 1963. "Inflation and Real Interest," Journal of Political Economy, University of Chicago Press, vol. 71, pages 280.
  4. Mathieson, Donald J., 1982. "Inflation, interest rates, and the balance of payments during a financial reform: The case of Argentina," World Development, Elsevier, vol. 10(9), pages 813-827, September.
  5. Blanco, Herminio & Garber, Peter M, 1986. "Recurrent Devaluation and Speculative Attacks on the Mexican Peso," Journal of Political Economy, University of Chicago Press, vol. 94(1), pages 148-66, February.
  6. Townsend, Robert M, 1983. "Financial Structure and Economic Activity," American Economic Review, American Economic Association, vol. 73(5), pages 895-911, December.
  7. Darby, Michael R, 1975. "The Financial and Tax Effects of Monetary Policy on Interest Rates," Economic Inquiry, Western Economic Association International, vol. 13(2), pages 266-76, June.
  8. 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 programas," IMF Staff Papers, Palgrave Macmillan, vol. 29(2), pages 204-232, June.
  9. José Saúl Lizondo, 1983. "Interest Differential and Covered Arbitrage," NBER Chapters, in: Financial Policies and the World Capital Market: The Problem of Latin American Countries, pages 221-244 National Bureau of Economic Research, Inc.
  10. 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 interés y rie," IMF Staff Papers, Palgrave Macmillan, vol. 29(2), pages 270-279, June.
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