Macroeconomic Analysis of Interest Rate and Economic Growth in developing countries

Macroeconomic Analysis of Interest Rate and Economic Growth in developing countries

According to Haron (2004), volatility and interest rate are used to assess financial liberalization on economic growth. Economic theory indicates that the base rate defines the interest rate set by the bank to determine the central bank interest rate. Interest rates play an important role in the determination of economic performance and returns of the investment. The central bank via the commercial bank rate and monetary policy play a critical role in the performance of any industry.

Long-term economic growth has been one of the key concerns of the economic profession. The history of long-term economic growth can be traced from the Keynesian classical theory of economics developed by  Ricardo, 1817. Solow (1957) and Swan (1956) made many contributions to the discussion on the factors that contribute to the economic growth of the country. The Keynesian theory provides the explanation of economic growth which includes technology as a shifting factor and labour as a factor of production. Developing nations focus on achieving optimal economic growth via a favorable balance of trade and return on investment. The determinant of health economic growth inflation rates, exchange rates, and interest rates.

The macroeconomic variables’ effect on the economic growth of developing countries specifically interest rates are of immense concern and interest to the financial analyst as well as potential and current investors. According to Nyagena (1991), the abrupt and large increase in interest rate can have a significant impact variable which exerts enormous pressure on business performance as well as economic growth. The interest rates have a significant impact on economy operations in terms of production and consumption level via the transition mechanism of the foreign exchange rate, inflation, and other monetary variables.  The macroeconomic theory argues that interest rate help in the transmission of monetary policy actions into the economy.  According to Smith (1970), when interest rates are ignored, the monetary aggregate loses its explanatory powers to a significant level, hence, the interest rate has played a crucial role in the economic growth arena. Following the interest rate liberalization, the interest rate responds to changes in the supply and demand of loanable money in the financial markets. According to Leite and Sandrajan (1999), rapid liberalization in the nation whose financial institutions and enterprises lack sufficient experience to prove counterproductive results of the sound financial industry.

Several empirical studies have been conducted on the impact of interest rate on specific sectors of the economy. Scholars have accessed the relationship between the interest and performance of the private sector as well as how interest rates influence saving and investment. The majority of the previous research work has focused on how interest rate changes influence the performance of the economy however have much have not been done on how the interest rate affects the performance of commercial banks.

This study will provide valuable insight into the relationship between the interest rate and financial performance.  Given the microeconomic environment volatility in developing countries, it is important to conduct an empirical study on the complex correlation between the interest rate and the economic growth of the financial institutions.   The main objective of this study, therefore, is to assess the effect of interest rate on the economic growth of developing countries.

Data

The researcher applied used quarterly averaged interbank lending interest rates in this study. Secondary data was used to carry out this study. The research obtained the quarterly averaged interbank lending interest rates from the central bank of Kenya.  The annual gross domestic product values were retrieved from the Kenya National Bureau of statistics. Ngechu (2004), define the study population as a specified or well-defined set of individuals, households, things, services, events, or elements that the researcher aims to investigate. Hence the population should comply with certain specifics and the study population should be homogenous to the topic being studied.  Interbank interest rates and GDP fit the researcher specific in this study.

The effect of interest rate on economic growth was analyzed using the regression analysis. In this empirical study, the researcher employed a dynamic econometric model to investigate the relationship between the interest rate and economic growth in Kenya.

To establish the relationship between the interest rate and economic growth the researcher formulated the regression equation below.  Shojai’s (1999) model, was applied in this research to establish the impact of the commercial bank interest rate to GDP growth in the county and Ordinary Least Square (OLS) was applied to ensure that assumption thereof are fulfilled.  These assumptions include its non-stochastic characteristic, the linearity of the model, distribution with equal variance and mean value of zero.  The researcher did not apply the natural log interest rates, inflation rates, and GDP as they have small absolute value. The valuables are expressed mathematically is as follow:

Y = β0 + β1X1 + €

Where,

Y = Economic Growth measured as a change in Gross Domestic Product (Dependent variable)

X1 = Lending Rate (LR), inter-bank lending rate

€ = Stochastic Error Term.

X1 represents the independent variable.

β0 = represent the regression constant or intercept

β1= regression coefficient for the independent variable. The regression coefficient shows the correlation between the independent variable and the dependent variable.

€= random term that represents any errors that may occur as a result of measurement errors or random behavior.

Result and discussion

The researcher conducted a multiple regression analysis to test the influence of the predictor variables. statistical package for social sciences (SPSS V 20) was applied in the coding and computation of the multiple regression measurements.

Based on the above findings the researcher found that adjusted R squared was .04. This shows that there is a 4% variation on the economic growth of economic growth as a result of a change in interest rate.  A negative correlation between the variables of study is also observed as shown by the R correlation coefficient in the table above.

Analysis of Variance

1. Dependent Variable: GDP b. Predictors: (Constant), Interest Rate

Based on the ANOVA statistics the variable, a significance level of 4.2% was observed which indicates that the data is appropriate for decision making about the variables since the significance (p-value) is less than 5 percent.  The model demonstrates significance as the F value is more than the F critical (value 2.262). The results of the study, therefore, demonstrate that the interest rate by the commercial banks affects the economic growth of the country.

Regression Model Coefficients

Assuming that:

Y = β0 + β1X1 + €

Based on the research finding the researcher established that the regression equation was;

Y = 1.013+ -0.112 X 1 + 010278

The regression model above indicates that assuming the interbank lending interest rate remains constant the economy of the nation would grow by 1.013%. a unit increase in interest rate would result in a decline of economic growth by 0.112. the result of this study is in line with the findings of Giovanni (2012), who argued that developing economies are affected by the interbank lending rates.

Conclusions

In conclusion, the findings of the study demonstrate that the economic growth of a country is affected negatively by an increase in interest rates. The regression analysis revealed a negative relationship between the interest rate and economic growth in Kenya.