024 Article A001 en

Interest Rate Determination
in Developing Countries
A Conceptual Framework
SEBASTIAN EDWARDS and MOHSIN S. KHAN*
URING THE PAST DECADE or so economists have emphasized

D the critical role that interest rate policies play in the devel-
opment process. The growing literature on financial "reforms"
and financial "liberalization" in developing countries has dealt
with a variety of issues, such as the relation between financial
intermediation and economic growth, the sensitivity of the vol-
ume of savings to changes in real interest rates, and the relation
between investment and interest rates. Generally speaking, the
empirical evidence indicates that there is indeed a positive associ-
ation between the degree of development of the financial sector,
including in particular freer interest rates, and economic per-
formance in developing countries.1 This finding has undoubtedly
prompted the authorities in a number of such countries to pursue
policies to remove controls on interest rates and to allow market
forces to play a relatively greater role in the determination of
interest rates.
Now that the process of financial liberalization is well under
way, however, economists and policymakers are faced with a dif-
ferent set of issues relating to interest rates in developing coun-
tries. The focus has begun to shift away from investigating the
* Professor Edwards was a consultant with the Research Department when

this paper was written. He is currently with the University of California, Los
Angeles, and with the National Bureau of Economic Research. He is a graduate
of the Universidad Cat61ica de Chile and of the University of Chicago.
Mr. Khan, Advisor in the Research Department, is a graduate of Columbia
University and of the London School of Economics and Political Science.
1
See, for example, McKinnon (1973), Fry (1982), Lanyi and Saracoglu (1983),
Mathieson (1983), andTownsend (1983); for a contrary view, see van Wijnbergen
(1983).
377
©International Monetary Fund. Not for Redistribution

378 SEBASTIAN EDWARDS and MOHSIN S. KHAN
effects of freeing interest rates to examining how interest rates are

in fact determined once the domestic financial market has been
liberalized. The interest in this particular issue has been height-
ened by two factors. The first is the recent experiences of the
countries of the Southern Cone of Latin America—Argentina,
Chile, and Uruguay—where domestic interest rates rose to extra-
ordinarily high levels following the implementation of financial
reform policies.2 The second is the evidence that has accumulated
suggesting that the high and volatile world interest rates in recent
years were at least partially transmitted into developing countries.
Both these factors have been a cause of concern to policymakers
and have generated some fundamental questions about the behav-
ior of interest rates in developing countries—in particular, about
what should be expected when controls on interest rates are elim-
inated. At present, however, there are few studies dealing with
this general issue, and even fewer specifically examining the re-
spective influences of foreign factors and domestic monetary con-
ditions as they affect interest rates in developing countries.3
It is obvious that the process of determination of interest rates
will be significantly different under alternative degrees of open-
ness of the capital account of the balance of payments. For exam-
ple, in the case of a fully open capital account some form of
interest arbitrage will hold, with domestic interest rates de-
pending on world interest rates, expected devaluation, and per-
haps some risk factors. In contrast, in countries with a completely
closed economy (closed capital and current accounts) open econ-
omy factors will obviously play no role, and the nominal interest
rate will be determined by conditions prevailing in the domestic
money market and by expected inflation. Most developing coun-
tries, however, do not fall in either of these two extreme cate-
gories, so that interest rates will in general depend on domestic
money market conditions, as well as on the expected rate of
devaluation and world interest rates.4 From a policy perspective it
2
This subject has been addressed by, among others, Diaz-Alejandro (1981),
Edwards (1985b), Hanson and de Melo (1985), Harberger (1982), Sjaastad
(1983), and Zahler (1983).
3
The only studies we are aware of that include both open economy and domes-
tic monetary factors in the analysis of interest rates are Mathieson (1982,1983),
on Argentina and Chile respectively; Blejer and Gil Diaz (1985) and Hanson and
de Melo (1985) on Uruguay; and Edwards (1985a) on Colombia.
4
Even if the capital account of the balance of payments is closed but there is
some trade with me rest of the world, open economy factors can still indirectly
affect domestic interest rates. For example, a terms of trade shock can produce
changes in real income and prices that will affect the domestic demand for credit
and, thus, equilibrium interest rates.

INTEREST RATES IN DEVELOPING COUNTRIES 379
is important to determine the way in which these different factors

actually affect interest rates. For example, how expected deval-
uations or changes in domestic monetary conditions or both affect
interest rates in developing countries is crucial for assessing the
significance of one of the possible mechanisms through which
stabilization policies will affect aggregate demand. Stabilization
programs typically involve both exchange rate adjustments and
tighter credit and monetary policies. If these policies generate an
increase in the domestic (real) interest rate, there will be an
additional channel (usually not considered in formal studies about
stabilization programs in developing countries) through which ag-
gregate demand will be affected.5
In this paper a framework is proposed for empirically analyzing
the determination of nominal interest rates in developing coun-
tries. Even though the model is quite general and of relevance for
any small country, the discussion is carried out with those devel-
oping countries in mind that have liberalized their domestic fi-
nancial sectors in the sense that controls on interest rates have
been removed. The model, which is described in Section I, com-
bines features of models for both closed and open economies, and
it is shown that the relative importance of the domestic monetary
conditions and the open economy factors will depend essentially
on the openness of the capital account. An interesting property of
the model is that the approximate degree of openness of the
financial sector in a particular country can be estimated from the
data. In Section II of the paper the usefulness of this framework
for analyzing interest rate behavior is illustrated using data for
Colombia and Singapore. The results obtained indicate that, as
expected, in Singapore only open economy factors appear to
matter; in Colombia, however, both domestic monetary dis-
equilibria and open economy conditions have influenced nominal
interest rates during the past 15 years. Section III describes some
areas in which the analysis could be extended—including, for
example, studying the behavior of real interest rates, the deter-
mination of interest rates under changing degrees of openness, the
modeling of the effects of expected exchange rate changes, and,
5
Until now most studies that have analyzed the effect of stabilization policies
on output, prices, and the balance of payments in developing countries have not
included the interest rate as a possible transmission mechanism. The main reason
for this omission is that the experience with liberalized capital markets is still
relatively recent. A theoretical discussion, however, of the effects of a stabiliza-
tion program working through increases in real interest rates is contained in
Dornbusch (1982b).

finally, introducing the possibility of currency substitution. The

concluding section summarizes the main points and results of the
analysis.
I. Theoretical Models of Interest Rate Determination
In this section three basic models for analyzing interest rate

behavior in developing economies are briefly presented. The first
is a simple model that assumes that the country in question is
completely closed to the rest of the world. Under these circum-
stances it is assumed that the nominal interest rate depends on the
real interest rate and on expected inflation. The second model
considers the other extreme, in which the capital account is com-
pletely open. In this case domestic interest rates are closely linked
to world interest rates through interest arbitrage. Finally, a more
general model that allows both foreign and domestic factors to
affect the behavior of the nominal interest rate, and thus contains
the other two models as special cases, is presented and discussed.
Interest Rates in a Closed Economy

Following the standard Fisher approach, we can specify the
nominal interest rate as equal to6
where
i = the nominal rate of interest
rr = the real (ex ante) rate of interest
Tte = the expected rate of inflation.
The real interest rate in turn can be specified as
where p is a constant and represents the long-run equilibrium real

interest rate. The variable EMS represents the excess supply of
money, X is a parameter (X > 0), and co, is a random error term.
According to equation (2), the real rate of interest deviates from
6
We are ignoring here, for example, the effects of taxation on the relation
between expected inflation and the nominal interest rate. On this topic see
Darby (1975), and Tanzi (1976).

its long-run value p if there is monetary disequilibrium; and excess

demand (supply) for (of) real money balances will yield a tempo-
rarily higher (lower) real interest rate. This relation has been
called the "liquidity effect" in the literature (Mundell (1963)). In
the long run, however, the money market would be in equi-
librium, and the variable EMS would play no role in the behavior
of rrt 7 Introducing this liquidity effect into the model, contrary to
most recent empirical studies of interest rate behavior, allows the
real rate of interest to be variable in the short run. 8 As such, even
though the Fisher equation (1) is assumed to hold continuously,
the possibility of slow adjustment of the real interest rate (given
by X) implicitly allows for the possibility of delayed response of the
nominal interest rate to monetary changes.
The solution for the nominal interest rate in a closed economy,
therefore, is
To estimate equation (3), however, some assumptions have to

be made regarding the unobserved variables, ire and EMS. The
expected rate of inflation can be specified in a variety of ways.
One is to use the traditional adaptive expectations model, in
which the expected rate of inflation is assumed to be a (geo-
metrically) distributed lag function of past rates of inflation. An
empirical generalization of this approach is to assume an auto-
regressive process for the rate of inflation and to use the predicted
values as representing the expected rate of inflation.9 Other possi-
ble methods include the use of survey data (for example, the
Livingston series on inflationary expectations) or of models that
allow for the influence of additional economic variables (other
than only past rates of inflation) in the formation of expecta-
tions.10 Of course, it can also be assumed that actual and expected
rates of inflation are the same—an assumption that would imply
7
Note that EMSt could also affect TT*. Furthermore, it is assumed here that
changes in < have no direct effects on rrt. On these types of effects, see Mundell
(1963).
Recent empirical studies on interest rate behavior in the United States in-
clude, among others, Fama (1975), Tanzi (1980), Makin (1982), and Melvin
(1983).
9
In this formulation the weights of the lag distribution are not assumed to
follow any specific pattern.
10
These would be the empirical representations of the rational expectations
model in which economic agents are assumed to take into account all available
information in forming their (conditional) expectations.

a strict form of rational expectations (that is, perfect foresight).

There is no compelling theoretical reason for preferring one
method over any other, and the choice is ultimately an empirical
one.
The excess supply of money is defined as
where m is the actual stock, and md the desired equilibrium stock,

of real money balances.11 In an economy that has completed the
financial reform process, we would expect substitution to take
place between both money and goods, as well as between money
and financial assets, so that the demand for money would be a
function of two opportunity-cost variables (the expected rate of
inflation and the rate of interest) along with a scale variable (real
income).12 The equilibrium demand for money can therefore be
written as
It should be noted that long-run demand for money is assumed

to be a function of the equilibrium nominal interest rate, defined
as the equilibrium real interest rate (p) plus the expected rate of
inflation (77*), rather than of the current nominal interest rate.
The model can be closed by assuming that the stock of real
money balances adjusts according to
where A is a first-difference operator, Alog mt = log mt - log m,_i,

and p is the coefficient of adjustment, 0 ^ (3 ^ 1. If the nominal
stock of money is exogenous, then equation (6) really describes an
adjustment mechanism for domestic prices. In essence, equation
(6) introduces a process by which the nominal interest rate returns
eventually to its equilibrium level.
11
Note that equation (4) is only one of the alternative ways to specify excess
money supply, or monetary disequilibrium. For example, it can be postulated
that only money surprises will influence the real interest rate (Makin (1982)). In
such a case EMS would have to be replaced by some proxy of unanticipated
monetary changes in equation (2).
12
Of course, one could also introduce an "own" rate of return into the money
demand formulation. This would certainly be advisable when dealing with broad
definitions of money that include deposits paying positive rates of interest (see
Mathieson (1982, 1983)). Because we work with narrow money (currency plus
demand deposits) throughout, in our case this omission is obviously not serious,
since demand deposits typically are non-interest-bearing.

The workings of the model given by equations (3), (4), and (6)
can be conveniently described within the framework of Figure 1.
In the figure the initial equilibrium is point A, where the long-run
demand for real money balances is equal to the supply (EMS = 0),
the nominal interest rate is at its equilibrium level (p + ire), and
the actual stock of real money balances is equal to m0. Suppose
now that there is an increase in the supply of money from msQ to
m(. This would create an excess supply of real money balances
(EMS >0), and the nominal interest rate would fall below its
equilibrium value (say, to ^). The movement from A to B in
essence represents the short-run liquidity effect we referred to
earlier. B, however, is only a temporary equilibrium position
because in the next period the (unchanged) long-run demand for
money is less than the actual stock in the previous period,
m?+l<mt(=ms2}\ therefore, by equation (6) the actual stock of
real money balances would begin to decline. In Figure 1 the m 5
schedule would shift to the left until the actual money supply is
once again equal to equilibrium money demand, and conse-
quently the nominal interest rate would be given by p + rf.
Figure 1. Interest Rate Determination in a Closed Economy

Equation (6) can be simplified to
combining equations (4) and (6a), we obtain
Using equations (1), (5), and (7), we can derive the reduced-form
equation for the nominal interest rate:
where the composite parameters are
Once TTe is replaced by some appropriate measured variable,

equation (9) can be directly estimated. In the estimation it would
be expected that yl > 0 and that y2 < 0; the sign of 73 would be
negative or positive depending on whether X(l - P)(a2 + a3) is
greater or less than unity.
Interest Rates in a Fully Open Economy

If the economy is completely open to the rest of the world, and
there are no impediments to capital flows, domestic and foreign
interest rates will be closely linked. In particular, in a world with
no transaction costs and risk-neutral agents the following un-
covered interest arbitrage relation will hold:
where i* is the world interest rate for a financial asset of the

same characteristics (maturity and so on) as the domestic instru-
ment, and et is the expected rate of change of the exchange rate
(defined as the domestic price of foreign currency). If agents are
assumed to be risk averse, however, et should be replaced by the
forward premium; alternatively, a (time- varying) risk-premium
term should be added to equation (9).13
13
Introducing the forward premium into the specification in place of the ex-
pected change in the exchange rate implies, of course, that the forward premium
is a good approximation of the change in the future spot exchange rate.

The analysis of interest rate behavior in open economies usually

has amounted to investigating the extent to which equation (9), or
some variant of it, holds. One way of doing this is by adding
transaction costs and defining a band within which the interest-
parity differential can vary, without violating the arbitrage condi-
tion. Another way of testing equation (9) is through analysis of the
time-series properties of the interest-parity differential. If these
time series are not serially correlated—that is, if they are white
noise—it is usually concluded that the domestic interest rate de-
pends only on open economy factors.14 Frenkel and Levich (1975,
1977), for example, have analyzed the extent to which the covered
arbitrage condition, which replaces et by the forward premium in
equation (9), held for industrialized countries during the period
after adoption of floating rates in 1973. They showed that, once
transaction costs are allowed into the analysis, this arbitrage con-
dition has worked well for these countries. Using a similar meth-
odology, Lizondo (1983), however, found evidence of large and
persistent deviations in Mexico during 1979-80. Cumby and Obst-
feld (1981) adopted the second of the two approaches and
analyzed the time-series properties of the uncovered interest arbi-
trage differential using weekly data for six industrialized coun-
tries; they found that in five of the six cases these series exhibited
strong serial correlation. They interpret these results as providing
evidence that there exists a (time-varying) foreign exchange pre-
mium for most currencies (see Levich (1985) for a review of other
studies of related isues). The tests performed by Blejer (1982)
using monthly data for Argentina for June 1977 through August
1981, however, could not disprove the hypothesis that for Argen-
tina during this period the uncovered interest rate differential was
white noise.15 Broadly speaking, the evidence appears fairly
mixed on the interest-parity condition in open economies.
Of course there exists the possibility that, because of frictions
arising from transactions costs, information lags, and the like,
domestic interest rates respond with delay to any changes in the
foreign rate of interest or in exchange rate expectations. This type
14
From a methodological point of view, even if interest-parity arbitrage differ-
entials are white noise it is still possible that other variables, besides the world
interest rate and the expected rate of devaluation, will affect the domestic
interest rate. For this reason a more appropriate procedure is to test directly
whether other variables suggested by the theory have an effect on /,.
15
In a more recent study of Uruguay, Blejer and Gil Diaz (1985) found that
the risk premium was highly serially correlated.

of lagged response can be modeled straightforwardly in a partial

adjustment framework as follows:
where 0 is the adjustment parameter, 0 < 0 < 1. If the financial

market adjusts rapidly, this parameter 0 will tend toward unity.
Conversely, a small value of 0 would imply slow adjustment of the
domestic interest rate.16 The solution of equation (10) in terms of
the domestic interest rate is
The General Case

The preceding discussion has examined interest rate deter-
mination in the two polar cases related to the degree of openness
of the economy. If, however, the economy under consideration is
one that has some controls on capital movements, as most devel-
oping countries do, it is possible to visualize that both open and
closed economy factors will affect the behavior of domestic inter-
est rates at least in the short run. A straightforward way of con-
structing a model for such an economy is to combine the closed
economy and open economy extremes. In particular, it can be
assumed that the equation for the nominal interest rate can be
specified as a weighted average, or linear combination, of the
open and closed economy expressions discussed above. Denoting
the weights by i|i and (1 - i|i) and combining equations (1) and (9)
allows the following model for the nominal interest rate to be
specified:
where the parameter i|i can be interpreted as an index measuring

the degree of financial openness of the country. If t|i = l, the
economy is fully open, and equation (12) collapses into the inter-
est arbitrage condition (9). If i|i = 0, however, the capital account
16
During the period when the parity condition does not exactly hold there
would obviously be unexploited profit opportunities. The attempts by trans-
actors to take advantage of these opportunities would set in motion the very
forces that would bring about equality between domestic and foreign interest
rates (adjusted for expected exchange rate changes). How long this process takes
is an empirical question and would have to be estimated from the data.

is closed, and equation (12) becomes equal to the Fisher closed

economy equation (1). In the intermediate case of a semiopen
(semiclosed) economy, the parameter i|i will lie between zero and
unity; the closer it is to unity, the more open the economy will be.
In a sense, estimating fy from the data makes it possible to deter-
mine the degree of openness of the financial sector in a particular
country. This estimated degree of openness will provide some
information on the actual degree of integration of the domestic
capital market with the world financial market.17 To the extent
that official capital and exchange controls are not fully effective,
the empirically estimated "economic" degree of openness can be
significantly higher than the "legal" degree of openness given by
the system of capital controls in the country.
If we assume slow adjustment to interest parity and thus use
equation (11) instead of equation (9), the appropriate form for the
general case becomes
In this case full interest parity would require the condition

i|i = 6 = 1; when \\i = 0, the Fisher closed economy condition would
emerge. It should be noted that there will be some relation be-
tween the index of financial openness, i|i, and the speed of adjust-
ment, 6. For example, if the domestic financial market is fully
integrated with the international capital markets, it is also likely
that domestic interest rates would adjust quite rapidly.
Assuming that the excess money supply term is given by equa-
tion (4) and that the demand for real money function is provided
by equation (5),18 we obtain from equation (13) the following
expression for the nominal interest rate:19
17
It is, of course, assumed here that the degree of openness (v|/) is constant over
time. The implications of relaxing this assumption, and the possible procedures
for doing so, are considered in Section III.
18
Strictly speaking, in the shift from the closed economy to the open economy
case the demand for money function should be generalized to allow for foreign
interest rates, the expected change in the exchange rate, or both. A suggested
procedure for doing so is presented in Section III (under "Effects of Currency
Substitution").
19
Note that when 6 = 1 the lagged interest rate term would drop from the
specification, so that the equilibrium model is only a restricted version of this
formulation.

where the reduced-form parameters 8, are
and e is a random error term. If we assume that the income

elasticity of the demand for money is unity, then the model can be
further simplified. In this case 82 = — 83, and real income and
lagged real money balances can be combined into one composite
variable—that is, [log yt - log m r _J.
Equation (14) is quite general because it not only incorporates
open economy and closed economy features but also permits the
possibility of slow adjustment on both the foreign and domestic
sides.20 One can see that, in the case of a completely open econ-
omy with instantaneous adjustment of the domestic interest rate
(that is, i|i = 0 = l), §! becomes equal to unity, and 80 = 82 =
83 = 84 = 85 = 0. According to equation (14), the nominal interest
rate will then be equal, in both the long and short run, to (i* + et).
In the case of a completely closed economy (i|j = 0), the param-
eters Si and 85 will be equal to zero, and equation (14) collapses
to the closed economy equation (8).
The preceding discussion has assumed that agents are risk neu-
tral. As mentioned, if agents are risk averse, equation (14) should
be modified to take this fact into account. The simplest way of
doing so is to replace the expected rate of devaluation et by the
forward premium. From a practical viewpoint, however, this sub-
stitution poses difficulties because there are few developing coun-
tries that have forward markets for their currencies. An alterna-
tive way to deal with the problem of risk aversion is to introduce
a risk premium explicitly into the analysis, and to make some
assumptions about its statistical properties. For example, it can be
assumed that the risk premium is equal to a constant plus a ran-
dom term. In this case the constant part of the premium will be
20
Note that an equation of the form of equation (14) can be derived from
a portfolio model with imperfect substitutaoility between domestic and for-
eign assets.

added to the constant in equation (14), and the random com-

ponent becomes a part of the error term. In principle it would be
possible to incorporate any number of alternative assumptions
about the behavior of the risk premium into the empirical
analysis.
II. Empirical Tests of the Model
To assess the ability of the general model to describe the process

of interest rate determination in developing countries, it was esti-
mated using quarterly data for Colombia and Singapore. Because
these two countries are quite different, both in the development
of their domestic financial markets and in the extent of controls
over capital flows, they should provide a fair test of the basic
model. Since both countries vary in their openness, it would have
been preferable to round out the picture by also including in the
analysis an example of a closed economy. For obvious reasons this
was not possible.21
Since 1967 Colombia has followed a growth strategy based on
export promotion. During the past 15 years a crawling peg ex-
change rate system has been in effect, and, at least in a segment
of the capital market, interest rates have been allowed to fluctuate
freely (Diaz-Alejandro (1976), Wiesner (1978), and Montes and
Candelo (1982)). Over this period the domestic capital market
was slowly liberalized, but some restrictions to capital movements
were maintained. For example, there were restrictions on the
minimum maturity of loans obtained from abroad (usually five
years); the movement of capital in and out of the country required
formal approval from a number of government agencies, including
the Exchange Office, the Ministry of Finance, and the National
Planning Department; and there was a 95 percent advance pay-
ment deposit on all capital outflows.22 Although there was some
capital mobility, the existence of such legal restrictions make it
best, for practical purposes, to characterize Colombia as a semi-
open economy rather than a fully open one. In terms of our
model, therefore, we would expect to obtain a positive value for
the openness parameter i|j, and a value for 9 of less than unity.
21
First of all, there are few developing countries that can be viewed as com-
pletely closed; second, those that would qualify do not have developed financial
systems with market-determined interest rates.
22
See International Monetary Fund (1984) for a detailed description of the
nature and extent of capital controls in Colombia.

In contrast, the Singapore economy can be regarded as highly

open, with virtually no restrictions on trade and capital flows
(see Blejer and Khan (1983)). For example, imports are mostly
unrestricted, with a very small number subject to tariffs, and all
payments can be made freely. As far as the capital account is
concerned, the last elements of exchange controls were eliminated
in June 1978, and there are no hindrances to the movement of
capital.23 After being pegged to the pound sterling, the Singapore
dollar floated from June 1973 through late 1975. From then on the
currency has been pegged to a trade-weighted basket of the cur-
rencies of Singapore's major trading partners. The floating of the
Singapore dollar led to a rapid development of the foreign ex-
change market, and, although the volume of transactions is not as
large as in the world's major financial centers, the Singapore
market has over the years become among the largest in developing
countries. An active forward market, covering transactions of
various maturities, has also developed, with quotations being
given on a daily basis by participating banks. In general, the
progressive freeing of financial transactions, the exchange rate
policy, and direct encouragement by the government through its
financial development program have combined to make Singa-
pore an important financial center with close links to other major
financial markets. These institutional factors would suggest that
for Singapore the openness parameter v|; would be close to unity,
and that domestic interest rates would respond rapidly to foreign
developments (6 — 1).
Equation (14) and its equilibrium variant excluding the lagged
interest rate term were estimated by ordinary least-squares meth-
ods for the two countries using quarterly data. For Colombia the
data were for the period running from the third quarter of 1968
through the fourth quarter of 1982, whereas for Singapore the
data cover the period from the third quarter of 1976 through the
last quarter of 1983 (see the Appendix for data sources and defi-
nitions). In the estimation equations for Colombia, the expected
rate of devaluation between periods t and t + 1, et, was replaced
by the actual rate of depreciation in period t. This assumption
implies that, during the period under consideration, the rate of
23
Even before 1978 there were no limits on residents' investments in the
Scheduled Territories (comprising the former Sterling Area). Because Hong
Kong was included in the Scheduled Territories, residents could, in theory,
transfer funds anywhere via the Hong Kong market, so that this restriction was
not particularly effective.

devaluation in Colombia can be represented approximately as a

random walk process with zero drift (Edwards (1985a)). Because
forward rates are available for the Singapore dollar, we used the
forward premium to proxy the expected exchange rate change.
Thus it is implicitly assumed in the analysis that the exchange rate
risk premium is captured in the constant and error terms.24 For
both countries the expected rate of inflation was calculated by
fitting an autoregressive process (with seven lags) to the actual
rate of inflation, then using the predicted values to represent TT* ,25
Finally, for reasons of efficiency the income elasticity for money
was set equal to unity, and thus we were able to combine the
income and lagged money variables.26 The results for the two
countries are shown in Table 1.
Taking the case of Colombia first, we can see from Table 1 that
the results are quite satisfactory. All the coefficients have the
correct signs and are significant at the conventional levels.27 In
particular, the significance of the coefficients of (if + et] and
[log yt - log m r _i] clearly indicates that the nominal interest rate
in Colombia has been sensitive to both foreign and domestic
influences. If either of these factors is ignored—as is the case
when more traditional approaches to interest rate determination
are used—important elements are left out of the story. Because
the coefficient of the lagged interest rate is different from zero at
the 5 percent level of significance, implying that 0 is significantly
different from unity, to exclude this variable from the specifica-
tion would obviously not be warranted. This is borne out by the
results, in which the restricted version of the equation yields a
poorer fit.
We further calculated the values of what we regard as the key
structural parameters: the openness parameter (i|/) and the adjust-
ment parameter for the interest rate (0). The value of \\f turns out
to be 0.84 (with a t-value of 5.94), which is quite high and indi-
24
Experiments with alternative approximations for the expected exchange
rate, such as the fitted values from a distributed lag function of the actual
exchange rate, yielded broadly similar results. This is to be expected because in
Singapore the forward rate has been a reasonably good predictor of the future
spot
25
exchange rate. See Blejer and Khan (1983).
Using the actual rate of inflation (that is, the perfect foresight model) did not
produce any significant differences in the results.
26
This assumption is consistent with independent empirical evidence on the
demand for money relation for both countries—for example, Montes and Can-
delo
27
(1982) for Colombia, and Khan (1981) for Singapore.
Recall that the sign of the reduced-form coefficient for expected inflation
(84) was ambiguous; the result in Table 1 indicates that \(1 - P)(a2 + a3) < 1.

Table 1. Results of General Interest Rate Model
Foreign Real Income Lagged

Interest - Lagged Real Expected Interest
Country Constant Rate1 Money Balances Inflation Rate
and Period (So) (Si) (82 = 83) (84) (85) R2 DW H
Colombia -0.189 0.353 0.303 0.256 0.484 0.820 — -1.29
(1968-82)2 (3.08) (1.98) (3.03) (2.00) (3.89)
-0.326 0.786 0.517 0.422 0.768 1.41 —
(5.78) (4.99) (5.49) (3.11)
Singapore -0.200 0.922 0.052 0.026 0.001 0.991 — 0.39
(1976-83)2 (0.20) (23.68) (0.24) (1.40) (0.02)
-0.203 0.923 0.053 0.026 0.991 1.83 —
(0.21) (39.62) (0.25) (1.42)
Note: The values reported in parentheses are £ -ratios; R2 is the coefficient of determination; DW is the Durbin- Watson test
statistic;
1
and H is the Durbin statistic for serial correlation in a model with lagged dependent variables,
2
Adjusted for expected exchange rate change,
From the third quarter through the fourth quarter of the years indicated.

cates that the Colombian financial sector has, in practice, been

more integrated with the rest of the world than one would have
believed from the nature and extent of capital controls during this
period. According to this estimated value of v);, an increase in the
foreign interest rate of 10 percentage points, for example, would
be translated into an increase of the domestic interest rate of over
8 percentage points in the long run. Because the coefficient of
adjustment (0) is equal to 0.422 (with a t-value of 2.5), however,
the average (or mean-time) lag in adjustment of the nominal
interest rate to a change in either the foreign interest rate or the
exchange rate would be between three and four quarters.
The results for Singapore are quite different from those for
Colombia, with foreign factors clearly playing the dominant role
in the determination of the domestic interest rate. The coefficient
of the foreign interest rate and expected exchange rate change, Si,
is not significantly different from unity at the 5 percent level. The
remaining coefficients in the equation have the expected signs but
are all statistically insignificant. This result implies that for all
intents and purposes the openness parameter v|; is unity, which is
a result one would have expected in the case of Singapore. Do-
mestic monetary developments have no direct effect on the inter-
est rate, although it is possible that they still could have indirect
influence through their effect on the forward premium. This par-
ticular channel, however, has not been considered here (see Sec-
tion III). Moreover, because the value of 9 is unity, implying that
the adjustment of the domestic interest rate is instantaneous and
that interest parity is maintained continuously, it is clearly a
matter of indifference which of the two specifications for Sing-
apore is considered. Both the equations—that is, with and without
the lagged interest rate term—appear equally well specified.
The results reported above were obtained by using the excess
supply of real money balances as the appropriate formulation for
the monetary disequilibrium term. As mentioned earlier, there
are other ways in which a monetary disequilibrium could affect
nominal interest rates. For example, it has recently been argued
(in Makin (1982), for example) that nominal monetary surprises
can have a temporary effect on nominal interest rates. To in-
vestigate this proposition, equation (14) was re-estimated by re-
placing [log mt - log mf] in equation (4) with a nominal money-
surprise variable, defined as the residuals from an equation in
which the rate of growth of nominal money was regressed on its
lagged values for up to seven periods. The results for both coun-

tries with this formulation were quite similar to those reported in

Table 1.
III. Limitations and Extensions
The model presented here has its limitations and can obviously
be expanded in several directions. In this section we briefly discuss
four possible extensions: (1) analysis of the determinants of real
interest rates in developing countries; (2) analysis of interest rate
behavior during the process of liberalization of the capital account
of the balance of payments; (3) explicit modeling of the expected
rate of devaluation in the context of interest rate behavior in open
developing countries; and (4) consideration of the effects of cur-
rency substitution. This list is by no means exhaustive; specifi-
cally, it does not incorporate various econometric issues that
could arise in estimating a model of interest rate determination.
Such issues would include, among others, simultaneity, specifica-
tion of the underlying dynamics, and the proper treatment of the
error structure. Here we focus on what we see as the principal
theoretical extensions.
Real Interest Rates in Developing Countries

Some recent studies (for example, Cumby and Mishkin (1984))
have empirically analyzed the behavior of real interest rates in
industrialized countries, placing special emphasis on whether
these rates have tended to equalize across countries. Even if there
are no exchange controls, the capital account is fully open, and the
nominal arbitrage condition holds, from a theoretical perspective
real interest rates can still differ among countries. For example, an
expectation of a real depreciation would cause a country to have
a higher real interest rate than the rest of the world.28
The framework discussed in this paper can be easily extended
to analyze the process of determination of (ex post and ex ante)
real interest rates. Because the ex post real interest rate is defined
as the nominal rate minus the actual rate of inflation, a simple way
of analyzing this issue is to add an explicit inflation equation to the
model. The resultant two-equation model could then be used to
28
On the relation between real exchange rates and real interest rates, see
Dornbusch
29
(1982a).
Note that the adjustment equation (6) in our model could be interpreted as
an inflation equation, although we do not explicitly do so.

determine simultaneously the nominal interest rates and the rate

of inflation, and the ex post real interest rates can then be directly
obtained from these two equations.30 Furthermore, if the inflation
equation is used to determine the expected rate of inflation, then
one can calculate the ex ante real rate of interest.
To keep within the spirit of the model outlined here, the in-
flation equation specified should be general enough to allow both
closed and open economy factors to play a role. In the extreme
case of a fully open economy, domestic monetary conditions will
have no direct effect, and the inflation rate will depend solely on
foreign inflation and the (actual) rate of devaluation. If, in addi-
tion, it is assumed that the expected real exchange rate will remain
constant, the model will predict the equality of domestic and
foreign real interest rates. If the economy is completely closed,
however, the domestic rate of inflation and the nominal and real
interest rates will have no relation to their world counterparts.
Interest Rates and Liberalization

One of the limitations of the model presented in this paper is that
it assumes a constant degree of openness of the financial sector in
the country under study. But several developing countries have
recently gone through liberalization processes characterized by,
among other things, the relaxation or removal of existing capital
controls. To the extent that these liberalization processes yield a
higher degree of integration of domestic and world capital mar-
kets, the assumption of a constant v|> is clearly inappropriate.31
There are several possible ways to proceed if the degree of
openness is changing over time. The simplest way to model this
variation would be to make the openness parameter a linear func-
tion of time:
where i|i0 is the constant part of the openness parameter and t is

a time trend. We would expect that i^ > 0. If the level and in-
tensity of capital controls vary smoothly and gradually over the
30 Bleier and Gil Diaz (1985) specify a two-equation model for the real interest
rate and inflation. Their model, of course, can be used to determine the nominal
interest rate as well.
31
Note also that \|> would depend on the interest rate chosen. For different
interest rates one could easily have different values of i|i. We are indebted to
Michael Mussa for this point.

period of study, then equation (15) would be a reasonable approx-

imation. One could use equation (15) to substitute for i|/ in the
interest rate equation and then directly estimate the resultant
reduced form. This simple form would obviously break down if
the changes in capital controls were abrupt or erratic, and it would
be necessary to consider other methods to capture the liberal-
ization process formally.
Ideally, of course, one would wish to have some type of index
that directly measured the degree of legal capital controls. It
would then be possible to specify openness as a function of this
index (C):
In the estimation process several alternative functional forms can

be assumed.32 The main problem with this formulation, however,
is obtaining data for the capital controls index C. One possible
way would be to construct a subjective measure from actual infor-
mation on the system of capital controls in the country in ques-
tion. Another approach would be to use some type of proxy
measuring the severity of capital controls, such as the black mar-
ket exchange premium.33
Expected Devaluation and Interest Rate Determination

No mention has yet been made of the way in which the expected
rate of devaluation or the forward premium is determined. For
purposes of the present exercise, these were assumed to be ex-
ogenous. This is quite a restrictive assumption, and a more real-
istic analysis would have to recognize that the expected exchange
rate change is likely to be affected by movements in domestic
interest rates and by domestic monetary conditions in general.
But recognizing this issue and actually doing something about it
are quite different matters, since in practice endogenizing the
expected rate of devaluation or the forward premium has in most
cases proved to be exceedingly difficult.
32
In formulating such equations, one has to recognize that the endogenous
variable (v|/) is bounded (0,1). For this constraint to be taken properly into
account, the precise functional forms would be more complicated than the linear
ones
33
described here.
A problem with the black market premium is that it will tend to capture a
variety of factors, including the effect of actual and expected capital controls.

The way to proceed would depend on the exchange rate system

operative in the country in question. If the country has a floating
exchange rate, standard contemporary theories of exchange rate
behavior can perhaps be used. Even so, the task would not be easy
because these models have not been particularly successful in
predicting exchange rate movements (Levich (1985) has surveyed
such models for the major industrial countries). Under fixed rates
the problem becomes even more complicated because the proba-
bility of an exchange rate crisis would then have to be modeled
explicitly. Some initial attempts have been made in this direction,
but the modeling of exchange rate crises is still in its infancy (see
Blanco and Garber (1983) for one such attempt for Mexico). By
and large it seems that the present state of the art of exchange rate
modeling would preclude paying anything more than lip service to
this particular issue.
Effects of Currency Substitution

In combining the closed economy version of the interest rate
model with the open economy formulation, the basic money de-
mand function was left unchanged. Recall that this function allows
for substitution to take place between money and domestic finan-
cial assets and goods. This substitutability is the appropriate speci-
fication for a closed economy, but it does prove to be somewhat
restrictive when the possibility of substitution between domestic
and foreign money, defined in general as currency substitution,
is admitted. In other words, one now has another asset in the
system—that is, foreign money, for which the rate of return also
has to be taken into account. Thus, in combining the two models
one has to recognize that the money demand function in an
open economy could be different from that function for a closed
economy.
The importance of the phenomenon of currency substitution
has been documented in several studies (for example, Ortiz (1983)
and Ramirez-Rojas (1985)). In contrast to earlier opinion, which
held that currency substitution was relevant only in countries with
developed financial and capital markets, these writers have re-
cently shown that currency substitution takes place frequently in
developing countries as well. Furthermore, it has been found to
occur in countries that differ considerably in the degree of fi-
nancial development and integration with the rest of the world

and in the types of exchange rate regimes and practices. Currency

substitution clearly is a factor that should be explicitly taken into
account in any realistic analysis.
How one would proceed to model the effects of currency substi-
tution is not, however, all that clear. The general consensus is that
the principal determinant of currency substitution is the expected
change in the exchange rate, although (as pointed out in the
preceding subsection) there is considerable controversy about
how it should be measured. Other things being equal, an expected
depreciation of the domestic currency, for whatever reason,
would cause residents to switch from domestic money into foreign
money, and vice versa. Once the difficult problems associated
with the choice of an appropriate empirical proxy for exchange
rate expectations have been surmounted, however, the rest of
the analysis becomes relatively straightforward. The (domestic)
money demand function (5) in an open economy could be re-
specified as:
The last term in this modified equation would then capture the
effects of currency substitution.
This type of formulation would not be applicable in the extreme
cases of interest rate determination in completely closed and com-
pletely open economies. In a closed economy the variable e would
obviously not enter; in a fully open economy domestic monetary
disequilibrium (and thus the demand for money), with or without
currency substitution, does not matter. Equation (5 a) would cer-
tainly be relevant in the intermediate case, which of course does
correspond to the actual case in most developing countries.
IV. Conclusions
As more developing countries proceed to liberalize their do-

mestic financial systems and to remove restrictions on capital
flows, the issue of interest rate determination becomes increas-
ingly important. In particular, how interest rates can be expected
to behave in the changed environment and how they will respond
to foreign influences and domestic policies are questions that
policymakers in developing countries must consider. Only when
interest rate behavior is well understood will it be possible to

predict confidently the effects of interest rate changes on key

macroeconomic variables such as saving, investment, the balance
of payments, and economic growth. To affect these variables is
presumably the real purpose for which the liberalization policies
were originally designed.
In this paper we have derived a theoretically consistent model
that we believe can serve as a starting point for analyzing the
process of interest rate determination in those developing coun-
tries that have undertaken policies of financial reform. Although
the model has a fairly simple structure, it is nevertheless able to
incorporate the principal determinants of interest rates, such as
foreign interest rates, expected changes in exchange rates, and
domestic monetary developments. One of the interesting charac-
teristics of the model is that it is sufficiently general to be applica-
ble to a variety of developing countries that differ widely in their
financial openness. Indeed, through the model it is possible to
determine empirically, from data for the individual country, the
degree of financial openness (defined as both the extent to which
domestic interest rates are linked to foreign interest rates and the
speed with which domestic rates respond to changes in world
rates). This measure of "economic" openness may differ quite
significantly from the "official" or "legal" degree of openness
implied by the prevailing system of capital controls.
For illustrative purposes the model was applied to two coun-
tries—-Colombia and Singapore—that, because they are at quite
different stages of financial development, provided a useful first
test of the general nature of the model. Colombia still maintains
restrictions on capital movements, and only part of the financial
sector can be characterized as free; Singapore, in contrast, is a
highly open economy with a dynamic and sophisticated financial
market that has close links with the world's major financial cen-
ters. The estimates from the model confirmed our prior assump-
tions: we found that both foreign and domestic factors were im-
portant in interest rate determination in Colombia, but that only
foreign factors appeared to matter in Singapore. Our results also
indicated that Colombia is more open than suggested by the actual
system of capital controls. In conclusion, although one should
obviously be careful in generalizing from the results for only two
countries, we nonetheless feel that this model has considerable
potential and can serve as a useful starting point for studying the
behavior of interest rates in developing countries.

APPENDIX
Data Sources and Definitions
This Appendix briefly gives the major sources of the country data and defines the
principal variables used in the model.
Colombia (1968-82)
The basic sources for the data were Montes and Candelo (1982); Direccion
Nacional de Planeacion (DNP); Direccion Administrativa Nacional de
Estadistica (DANE), Boletin Mensual de Estadistica (Bogota), various issues;
and International Financial Statistics (IPS), International Monetary Fund (Wash-
ington), various issues.
The definitions of the variables and specific sources are as follows:
e Percentage change in the official buying rate for export receipts and
capital inflows (Montes and Candelo (1982), and DNP)
i Domestic interest rate: for 1968-69, the average rate on mortgage bills,
for 1970-82, the effective annual yield on three-month certificados
de abono tributario, or tax certificates (Montes and Candelo (1982)
and DNP)
/* Three-month U.S. Treasury bill rate (IPS)
M Narrow (Ml) money balances: for 1968-80, data are from Montes and
Candelo (1982); for 1981-82, from DNP
P Consumer price index (DANE, Boletin Mensual de Estadistica)', TT is
defined as the percentage change in this index
y Quarterly real gross domestic product (GDP; Montes and Candelo
(1982)); updated through 1982.
Singapore (1976-83)
The sources of the data are IPS and the Monetary Authority of Singapore
(MAS), Monthly Bulletin (Singapore), various issues.
The definitions and specific sources are as follows:
e Three-month forward premium (MAS)
/ Three-month interbank rate (MAS)
/* Three-month Eurodollar rate (IPS)
M Narrow (Ml) money balances (IPS)
P Consumer price index (IPS); the variable IT is defined as the percent-
age change in this index
y Quarterly real GDP; the annual series were obtained from IPS and
interpolated to a quarterly basis using an index of manufacturing
production, also from IPS.

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Interest Rate Determination

SEBASTIAN EDWARDS and MOHSIN S. KHAN*

URING THE PAST DECADE or so economists have emphasized

* Professor Edwards was a consultant with the Research Department when

©International Monetary Fund. Not for Redistribution

effects of freeing interest rates to examining how interest rates are

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is important to determine the way in which these different factors

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finally, introducing the possibility of currency substitution. The

I. Theoretical Models of Interest Rate Determination

In this section three basic models for analyzing interest rate

Interest Rates in a Closed Economy

where p is a constant and represents the long-run equilibrium real

©International Monetary Fund. Not for Redistribution

its long-run value p if there is monetary disequilibrium; and excess

To estimate equation (3), however, some assumptions have to

©International Monetary Fund. Not for Redistribution

a strict form of rational expectations (that is, perfect foresight).

where m is the actual stock, and md the desired equilibrium stock,

It should be noted that long-run demand for money is assumed

where A is a first-difference operator, Alog mt = log mt - log m,_i,

©International Monetary Fund. Not for Redistribution

©International Monetary Fund. Not for Redistribution

Equation (6) can be simplified to

combining equations (4) and (6a), we obtain

where the composite parameters are

Once TTe is replaced by some appropriate measured variable,

Interest Rates in a Fully Open Economy

where i* is the world interest rate for a financial asset of the

©International Monetary Fund. Not for Redistribution

The analysis of interest rate behavior in open economies usually

©International Monetary Fund. Not for Redistribution

of lagged response can be modeled straightforwardly in a partial

where 0 is the adjustment parameter, 0 < 0 < 1. If the financial

The General Case

where the parameter i|i can be interpreted as an index measuring

©International Monetary Fund. Not for Redistribution

is closed, and equation (12) becomes equal to the Fisher closed

In this case full interest parity would require the condition

©International Monetary Fund. Not for Redistribution

where the reduced-form parameters 8, are

and e is a random error term. If we assume that the income

©International Monetary Fund. Not for Redistribution

added to the constant in equation (14), and the random com-

II. Empirical Tests of the Model

To assess the ability of the general model to describe the process

©International Monetary Fund. Not for Redistribution

In contrast, the Singapore economy can be regarded as highly

©International Monetary Fund. Not for Redistribution

devaluation in Colombia can be represented approximately as a

©International Monetary Fund. Not for Redistribution

Foreign Real Income Lagged

©International Monetary Fund. Not for Redistribution

cates that the Colombian financial sector has, in practice, been

©International Monetary Fund. Not for Redistribution

tries with this formulation were quite similar to those reported in

III. Limitations and Extensions

Real Interest Rates in Developing Countries