Effect of inflation on interest rates in Uganda (2000-2014)

Abstract

This study concentrated on the effect of inflation on interest rates as the main objective, it covered the period 2000 to 20014. The approaches used was the ordinary least squares for the long-run effect, the error correction model for short run effect and Engle and Granger causality test for the long-run causal effect between the variables. The variables were; interest rates, inflation, gross savings, real exchange rate, gross fixed capital formation and gross national expenditure. The findings show that inflation had a positive significant effect on interest rates at 5% level of significance with a coefficient of 0.004, while gross fixed capital formation had a negative significant effect on interest rates at the same level of significance with a coefficient of -0.004. Conversely gross savings, real exchange rates and gross national expenditure had no significantly effect on interest rates. Results from the short-run model reveal that the Error Correction Term in the model is significant at 1 percent level of significance with a coefficient of -0.13. The Error Correction Term coefficient implied that in each period, the interest rate adjusts between the current level and the long run equilibrium level. The Granger-causality tests reveal that interest rate does not granger-cause inflation rate, but rather inflation rate Granger-cause interest rate. Thus, the direction of the relationship between inflation and interest rate runs from inflation to interest rate. The results from this study identify policy implications for reducing the lending rates and improving the financial sector performance. The study recommends that in controlling the interest rates, the Central Bank through inflation targeting monetary policy framework alone is not enough as evidence suggests that the gross fixed capital formation is also an important determinant of interest rates in Uganda. Therefore, policy makers must expand the variables they need to control for the interest rates to include gross fixed capital formation in order for interest rates to be kept at levels that can encourage borrowing.