Determinants of Interest Rates: The Case of Sri Lanka

Abstract

Many studies have looked in to the determinants of interest rate in developed countries. The objective of this paper is to examine the determinants of interest rates in Sri Lanka. The model employed in this study is based on the framework developed in Edwards and Khan (1985) and a few modifications suggested in Cavoli (2007), Cavoli and Rajan (2006), Berument, Ceylan and Olgun (2007) and Zilberfarb (1989). The model nests the interest rate parity theory, liquidity preference theory and the Fisher hypothesis augmented with inflation uncertainty. We employ Autoregressive Distributed Lag (ARDL) approach to capture long-run relationships among the variables involved. Quarterly data from 2001:1 to 2012:2 has been used. There are a few important findings. First, there is no evidence for inflation uncertainty in Sri Lanka during the sample period concerned. Second, the ARDL bound testing approach suggests that there is no long-run impact of the national income, money supply, inflation, foreign interest rates and net foreign assets on the domestic interest rate. Third, apart from the interest rate parity conditions, neither the liquidity preference theory nor Fisher effect is useful in explaining short-run interest rate changes in Sri Lanka during the period in question.