Abstract
This study investigates whether the interest rate has a significant negative impact on investment. For an interest rate channel to support the achievement of monetary policy objectives, the prevalent interest elasticity of investment should be high and assume a negative value. The present study applies the co-integration and vector error correction tests to estimate the long run model and the short run dynamics of investment and independent variables; using interest rate, income, exchange rate and price level. Results show that the interest rate is negatively related to investment, with a coefficient value of 0.06. This negative relationship proves that low interest rates can negatively influence investment to achieve monetary policy objectives. A marginal effect on investment (based on the magnitude of coefficient) is not enough to maintain the efficiency of monetary policy. According to Sri Lankan experience, price level and income are positively related to investment in the long run, while the nominal exchange rate is negatively related to investment. According to short run dynamics, (-71%) of the disequilibrium in investment will be adjusted towards equilibrium within a one year period.
Highlights
Many Central Banks use interest rate as an instrument in conducting monetary policy
Unit root tests were conducted for each variable; LCONSTR, fixed deposit rate (FDR), LCCPI, LER and LRGDP that are used for the analysis are identified as I(1) variables, and Tables 2 and 3 report the results of the Augmented Dickey Fuller (ADF) test at 1%, 5% and 10% significance levels
The ADF unit root test indicates that these variables are integrated in the order one [I (1)], and those are suitable for co-integration and vector error correction (VEC) tests to examine both long run relationship and short run dynamics
Summary
Many Central Banks use interest rate as an instrument in conducting monetary policy. The interest rate mechanism is used to achieve monetary policy objectives, and for the Central Bank of Sri Lanka (CBSL), these objectives are to maintain economic and price stability.If the interest rate elasticity of investment is negative, expansionary monetary policy can achieve higher economic growth and higher employment performance through higher aggregate demand. Many Central Banks use interest rate as an instrument in conducting monetary policy. The interest rate mechanism is used to achieve monetary policy objectives, and for the Central Bank of Sri Lanka (CBSL), these objectives are to maintain economic and price stability. If the interest rate elasticity of investment is negative, expansionary monetary policy can achieve higher economic growth and higher employment performance through higher aggregate demand. Policymakers consider adopting expansionary monetary policies to increase investment and aggregate demand, thereby securing higher economic growth
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