Interest rate and Economic growth


Question

Discuss how the relationship between the interest rate and economic growth has attracted considerable attention and debate in recent years.

Answer

Some of the studies based on the relationship between the interest rate liberalization and economic growth like the thrust of the debate have been whether interest rate liberalization, as originally prescribed by the McKinnon (1973) and Shaw (1973) hypotheses, can unambiguously lead to economic growth. A number of empirical studies have been conducted on the link between interest rate and economic growth in many developing countries, and the majority of these studies have concentrated mainly on Asia and Latin America, affording sub-Saharan African (SSA) countries very little coverage even where such studies have been undertaken, findings on the role played by high interest rates and their effect on financial deepening, savings and economic growth are, at best, inconclusive (see Odhiambo, 2009c).

First, the majority of the previous studies on this subject have attempted to examine the relationship between interest rate reforms and economic growth directly. Yet it is now becoming clear that the relationship between interest rate reforms and economic growth is an indirect one. Interest rate liberalization impacts on economic growth, through its influence on financial deepening (Odhiambo, 2009c). Secondly, the majority of the previous studies on this subject has mainly used a bivariate causality test to examine the causal relationship between financial development and economic growth and may, therefore, suffer from the omission-of-variable bias. Thirdly, some of the previous studies have relied on the cross-sectional data to examine the relationship between interest rate reforms and economic growth.

The current study, therefore, attempts to fill this gape by examining the impact of interest rate on the economic growth in Canada by using time sires data.

Interest rate is among the closely watched variable in the economy, their movements are reported almost daily by news media because they are directly affect our everyday lives and have important consequence for the health of the economy and it is important macroeconomic variables for economic growth, they affect personal decisions such as whether to consume or to save, whether to buy a house and whether to purchase bonds or put funds into a saving account.

Economic growth is a delicate occurrence. In conventional economic literature, factors of production such as capital, labor and land are the main determinants of economic growth. The new growth theories add further variables including technological advancement, human capital (the skills and knowledge of workers) and social capital as sources of economic growth. Interest rate and investment are among the central variables influencing economic growth rate. Most investments are of governmental origin and decisions about their realization are primarily affected by real interest rate. Usually a reduction in the real interest rate increases economic growth through capital accumulation. Furthermore, if interest rate is fixed in an economy by banking authorities, effects of economic growth on interest rate will not be recognizable.so under this study I will examine the impact of interest rate as one of the central variable that affect economic growth in Canada.

Motivation

The main purpose of the study is to investigate the impact of interest rate on the economic growth and under economic growth we look things like investment, employment rate, inflation rate, export rate and other economic variables where by the study aim to look on impact resulted due to interest rate and those economic variables mentioned above.

Economic growth may affect the interest rate level directly or indirectly. A higher GDP growth more than the expected amount is considered to be inflationary, causing the central bank to raise the interest rate in order to slow down the growth. In the current literature, there are some studies dealing with the causality relations among economic growth, investment and interest rates.so the paper aims to analyze the impact of interest rate on Canada economy so as to see how the country is affected by the increase or decrease of interest rate.

Interest rate, saving and investment are among the central variables influencing the economic growth rate. Usually a reduction in the real interest rate increases economic growth. Most investments, especially in developing countries, are of governmental origin and decisions about their realization are primarily affected by the real interest rate.

An increase in interest rates means that consumers have to pay more to finance their Consumption. Then higher required payments discourage the consumers from buying durable goods, which reduces consumption. The same goes for investments, which can be seen as consumption by firms. Higher interest rates for financing of equipment and machinery discourage firms to do investments. In other words, when interest rates increase, investments go down, since it gets more expensive to borrow money and more tempting to save money. Thus, consumption decreases and it leads to decreased demand (Suntum, 2008). hence it trouble the country economy.

Immediately after the introductory chapter, the rest of the work is organized as follows; chapter two reviews the relevant literature on foreign direct investment and economic growth nexus. Chapter three gives and outline of the model and further describe the estimation procedure that will be carried out. Analysis of results will be done in chapter four while conclusion and recommendation will be made in chapter five.

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