Short-term interest rates, inflation and demand for real money balances 1988-2000

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Until 1987, the financial system in Ghana was highly repressed. Among other, interest rates ceilings, credit rationing and liquidity requirements were pursued under the controlled or repressed regime. With high inflation rates over and above the prevailing rates of interest as set by the monetary authorities, real interest rates turned out to be negative. Hence, Very typical of a developing economy, the demand for real money balances remained determined mainly by income and the rate of inflation. In the wake of the financial reforms that commenced in the latter part of 1987, interest rates were liberalized and became market—-determined. This led to a rapid upsurge in the stock of money market instruments associated with short-term interest rates. 1-lowever, the high rates of inflation experienced during the repressed era also continued to plague the economy even well over a decade after the reforms. A robust co—integration test of real money demand in Ghana that incorporated short— term interest rate in addition to the conventional variables of income and inflation post financial reforms, proved to be significant. Regressions were run both for the long run and also for the short run. All the estimates were obtained using the Eviews Version 3.1 software package. The long-run regression results were consistent but not significant. However, the short-run (dynamic) results based on the first difference method were neither consistent nor significant. When a partial adjustment model (PAM) was used, again the results turned out to be Consistent but still highly insignificant. However, for parsimonious estimates, the interest rate variable became statistically significant at the 5% level. All the other included independent variables were also consistent and highly significant. The implication is that indirect monetary control (via the transmission mechanism) cannot be completely ruled out as ineffective in Ghana for the sample period. it is suggested that appropriate measures must be taken to reduce drastically the dominant influence’ of government in the money market in order to render indirect monetary control more effective and thereby generate the desired output growth. One such recommended measure is for the monetary authorities i.e. the Bank of Ghana to encourage the existing financial institutions to develop and deal in short-term securities that also offer competitive rates of returns.
A thesis submitted to the Department of Economics and Industrial Management, Kwame Nkrumah University of Science and Technology in partial fulfilment of the requirements for the award of Master of Arts degree in Economics, 2003