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Sérgio Pereira Leite is Chief of the Financial Sector Division of the Central Banking Department. He is a graduate of the Universidade do Estado da Guanabara and the Johns Hopkins University. V. Sundararajan is Assistant Director of the Central Banking Department. He is a graduate of the Indian Statistical Institute and Harvard University. An earlier version of this paper was presented at the CEMLA-ECCB Seminar on Interest Rate Management held in St. Kitts on March 28–29, 1988. The authors would like to thank Tomás Baliño, Barry Johnston, Linda Koenig, and Douglas Scott for their comments.
To the extent that higher interest rates shift savings from goods into financial instruments, the rate of inflation would decelerate.
However, some other country-specific variables such as political risk or reserve requirements may also play a role.
For a discussion of the empirical relevance of this variable in assessing the impact of interest rate policy, see Sundararajan (1987).
Most often, high reserve and liquid asset requirements that are not adequately remunerated contribute to widening the spread, particularly in times of high inflation.
Selective credit policies aim at granting credit to designated sectors (for example, agriculture or exports) under more favorable conditions (for example, amount, interest rate) than they would get in the absence of such policies.
This requires that certain conditions obtain, namely the existence of perfect competition, absence of externalities and government intervention, well-behaved risk distributions, and full information.
For a survey of developing country experiences in adapting such market-related policy instruments, see Johnston and Brekk (1989).
Similar problems may result from large changes in exchange rates, which often accompany or precede the financial reforms.
Although in this case the government allows interest rates to be market determined, it still can have a substantial impact on these rates because of the size of its financing operations.
In this section, we concentrate on the effects of government deficits on interest rates. The opposite effect is also relevant. Interest rate movements, by their effect on the cost of funds to the government, alter the financial flows and may force compensatory adjustments in taxation or inflation.
Large fiscal deficits would constrain the scope of open market operations by resulting in unacceptably high levels of interest rates for the specific debt instruments used in such operations. This is likely to be the case when the domestic debt management is not well developed and relies on a limited range of debt instruments. Also, a large and rising volume of treasury debt held by the non-bank sector could be associated with significant substitution away from bank deposits, with consequences for demand for reserve money and for the level and structure of interest rates.
The social rate of return may differ from the rate of return that a private investor might attribute to a project. For the social rate of return, all the benefits and costs of the projects are computed, even those that do not accrue to the owner of the project.