Up to the earl y part of the 1970s, there were two sets of opposing theories as far as interest rate policies were concemed. These were classified as the classical-neoclassical theories of growth and the Keynesian counter arguments. The classical-neoclassical thesis postulates that high interest rates have a positive, significant and a direct impact on savings and hence investment.
The Keynesians, however, postulated that low interest rates help to boost investment and income resulting in higher savings mobilized. It can be construed, therefore, that in the classical-neoclassical position, saving is tak:en as the dominant determinant of growth and development whereas Keynes and his disciples consider investment as the dominant determinant. Even though their policy prescriptions differ, the important role of the interest rate is recognized in both theses. As a result of this, interest rate policies differed from countries depending on whether they are adherents to the Keynesian or classical-neoclassical policy prescriptions.
In 1973, Mckinnon and Shaw criticized both ofthese earlier theories. The two authors introduced the notion of « Financial deepening » 4 which is a measure of the efficiency of capital allocation by diverting more resources to where there are better investment opportunities. In his submission, Mckinnon stated that domestic capital markets in developing countries and their
4 This is measured as the ratio ofbroad money to GNP (or GDP)
modus operanda are affected by monetary and fiscal policies. The prevalent theories of monetarism and financial processes whether of Keynesian or Monetarist leanings, he went on, could not exp lain the predominant role/ paramouncy of real money balances in the operation of capital markets in developing countries.
He dismissed the Keynesian madel on the grounds that it was « purely short-term oriented » such that as soon as available savings are used up in current investment, the madel did not clearly state how new savings would be generated to meet further investment requirements. He contended that the theory is also irrelevant to developing countries where savings, and not investment, are considered to be the major constraint on the development equation.
On the neoclassical monetary theory, Mckinnon(1973) attacked and dismissed it for positing a competitive relationship between real money balances and capital accumulation. He asserted that the competitive relationship presented in the madel would imply that an increase in say, real money balances, following high real interest rates, would lead to a reduction in investment (Mckinnon, (1973), pp. 42-50).
This brings us to his complementarity hypothesis which states that real money balances and physical capital are complementary and not substitute items. This complementarity means that large and fast-g;rowing real cash balances promote rapid growth in investment and aggregate output. It was argued in this madel that low and negative reallending and deposit interest rates reduce real cash balances, and hence measures to eliminate financial repression will increase real cash balances and enhance savings and investment, and thus growth.
The above arguments were represented diagramatically by Maxwell J. Fry (Fry 1988, p.16) in order to throw more light on the theoretical underpinnings why financialliberalization should be desired and adopted as a public interest rate policy prescription compared to financial repression.
The figure as adapted by the author from Fry (1988) is presented in the next page.
Savings and investment are on the horizontal axis while the real interest rate is on the vertical axis. The diagram depicts the theoretical postulates of a positive relationship between the real interest rate and savings on the one hand, and the inverse relationship between investment and the real interest rate, on the other. According to the authors (Mckinnon and Shaw), administratively determined nominal interest rates which characterized most developing countries at the time, holds the real interest rate far below its equilibrium level. In the diagram, given initial investment function (I) and savings function (S0 ) financial repression is represented by line RR, which amongst other things, consists of administratively determined nominal interest rate po licy that, as a matter of fact, holds the real interest rate far below its market clearing leve!
at z.
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Fig 1 : Savings, investment and the real interest rate
Real interest rate
r 3
r 1
r 0
Jo 1
1
1 2
Savings and Investment
R
This po licy holds the real interest rate at r0. Actual investment achievable with this rate of interest is Io, which is the arnount of saving mobilized at the real interest rate of r0. Also ceilings are put on lending rates, i.e. if r3 that would bring about equilibrium is not allowed, then non-priee rationing of excess demand for limited loanable funds would arise equal to VK
In such a case, credit allocation becomes less sensitive to transactions costs and perceived risk of default, and becomes more likely to be subjected to such other considerations as the quality of collateral, political pressures, loan size and covert benefits to loan officers. Consequently savings are likely to remain at low levels, and hence investment, since savings is the primary factor theorized to determine the real supply of credit. A second and equally important consequense is that investible funds are inefficiently allocated by means of non-priee criteria as a result of which
funding is likely to take place for a good number of low-yielding investments. This would negatively impact on output growth and hence employment in the overall economy.
Development of the financial sector and economie performance are seriously impaired by these two features.
On the other h~d, relaxation of the degree to which the financial system is repressed is expected to have positive effects on savings. Considera higher nominal interest rate corresponding to the lineR1R1with a real interest rate such as r1. This policy change will reduce the number of low-yielding investments previously funded at RR, thus increasing the average efficiency of investment. This increases the economie growth rate and shifts the saving rate function to S1 as shown in the diagram. The increase in the saving rate arises because increase in average efficiency of investment means increased productivity of investment which yields higher economie growth . This will consequently increase the level of economie activity, and all things being equal, output will also increase. Since savings is a positive function of output, it is also expected to respond positively by this theory.
Actual investment will also be higher at this rate of interest because of the increase in savings.
Thus the real interest rate as the return to savers, is very central to any policy that aims at increasing the lev el of investment. This increase in both quantity and quality of investment has a strong positive effect on economie growth. Growth in the financially repressed economy is therefore considered to be constrained by savings rather than investment opportunities (Mckinnon, 1973, pp. 59-61; Shaw, 1973, p.81).
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The policy recommendation arising herefrom requires that, a financial liberalization process, which will eventually liberalize interest rate ceilings be implemented in those countries whose financial systems are repressed. This, Mckinnon and Shaw hypothesized, will not only result in increased savings and loanable funds but also in a more efficient allocation of these funds both of which contribute in their own small ways to higher economie growth rates. The equilibrium condition as shown in the diagram, would give rise to a real interest rate of r2 and savings and investment equâl to h. The market for loanable funds equilibrates by the interaction of the forces of demand for and supply of funds.
The works of Mckinnon(1973) and Shaw(1973) gave rise to the financialliberalization theory which states that liberalization of the financial sector from interest rate ceilings and other restrictions promote economie development and growth because higher rates of interest make for increased savings and greater efficiency in capital allocation. 5 Is this submission true as far as The Gambia is concemed ? It must be noted that it was amidst such controversy as will be demonstrated in the literature that will follow that this policy was recommmended for financ.ially repressed economies. The responsiveness of savings to interest rate changes was characterized by mixed results and conclusions even in countries like the United States.This controversy aside, the implications of the policy on demand for money and its stability did not also attract much attention at the time. These are the issues that our study intends to investigate.