Interest Rate Deregulation and Private Investment: Revisiting the McKinnon –Shaw Hypothesis in Ghana

Abstract

The study re-examines the McKinnon-Shaw financial liberalization hypothesis, which posits simply that high real deposit interest rates increase financial savings, which in turn lead to increases in the quantity and quality of domestic investments. More specifically, the study investigates the impact of interest rate deregulation on investment in Ghana and the transmission mechanism through which this could happen. Utilizing co-integration and error correction model techniques with data from the period 1970 – 2005, the study findings are as follows. While the study finds a statistically significant and positive relationship between real deposit interest rate and financial savings as well as between bank credit and financial savings, the net effect of a real deposit rate on investment was found to be negative. In other words, holding all other variables constant, a higher real deposit rate which lead to a higher increase in financial savings and then bank credits, were offset by a higher cost of lending, thus making the net effect on investment negative. In this regard, our finding does not seem to provide support for the McKinnon and Shaw financial liberalization hypothesis. Other variables found to be important in explaining investment in Ghana were the financial deepening, the macroeconomic volatility that is proxied by inflation differential and the lagged change in GDP, affirming the accelerator model principle. The findings therefore have important policy implications for the on-going financial sector reforms.