The Determination of Interest Rates and the Effectiveness of Monetary Policy in Deregulated Financial Markets

Abstract

This paper examines two issues pertinent to the effective implementation of monetary policy: firstly, the ability of the monetary authorities to control interest rates and secondly, whether interest rates have exhibited a leading, relationship with economic activity since deregulation of the financial markets. If expenditures are unresponsive to changes in interest rates it is shown that the monetary authorities have the ability to determine the interest rate but if the authorities attempt to push interest rates into regions in which expenditures become interest rate elastic, a role for liquidity preference in determination of the interest rate is restored. This limits the effects of discretionary monetary policy to the short-term. Previous empirical studies, graphs and correlation coefficients indicate only limited evidence for a negative association between interest rates and changes in economic activity whereas Granger causality tests indicate that predictable relationships between interest rates and economic activity have existed in Australia for the period in which financial markets have been deregulated.