BEHAVIOUR OF REAL INTEREST RATES : LITERATURE REVIEW AND SELECTED COUNTRY EXPERIENCES

Abstract

The aim of this thesis is to ascertain the determinants of real interest rates based on both a literature review and an empirical analysis. The literature review indicates that the main determinants of real interest rates are money supply growth, monetary policy shocks, expected inflation, lagged inflation, nominal interest rate and supply shocks. Both the constancy of real interest rates over time and the international equality of real interest rates are commonly rejected. The Fisher effect does not apply to all countries, and a strong effect occurs only in periods when inflation and interest rates have a common stochastic trend. There may be a long run relationship between real exchange rates and real interest rates but there is no evidence to support this.

This thesis also explores empirically the determinants of the real interest rates for Singapore, Japan and Germany. One major finding from the empirical estimates is that the ex ante real interest rates in the three countries do not appear to be constant over the 1980-1994 period. Based on the correlation analysis, it was found that the Fisher effect and hence a weak association between real and nominal interest rates holds in all the three countries. The evidence also suggests that ex ante real interest rate provides a good proxy for the actual real interest rate.

It is found from multiple regressions that two principal variables with an impact on the real interest rate arc the nominal interest rate and a one period lagged inflation rate. Saving ratio adds significant explanatory power to the ex ante real interest rate only in Singapore. Lagged money supply growth has no significant impact on the real interest rate. This is consistent with the proposition based on rational-expectations that monetary policy is ineffective and that predictable changes of money supply do not have any effect on the expected real interest rates. The empirical estimates based on ordinary least squares and instrumental-variable estimations strongly reject a perfect linkage in real interest rates across countries.