Dept: ECONOMICS File: Word(doc) Chapters: 1-5 Views: 2


Many developing countries, under a crushing burden of debt and other external disequilibria, have adopted programmes to restructure their economies. A major cornerstone of such adjustment programmes is the liberalization of financial markets and a greater role assigned to market forces in the allocation of financial resources, and generally involves interest rate deregulation and relaxation or cancellation of the policy of directed credits. The policy of interest rate in developing countries seems to have been backed by the McKinnon-Shaw financial intermediation hypothesis which postulates that interest rates have a positive response to savings and economic growth (McKinnon, 2009; Shaw, 2005). The link between interest rate responsiveness and savings, as postulated by the McKinnon-Shaw hypothesis, is investment. However, behaviourally and operationally, savings and investment differ (Bhatia and Khatkhate, 2001; Fry, 1978); the transfer of savings to investment being dependent on a ho


1.1 Background of the Study

Interest is the reward that accrues to people who provide the fund with which capital goods are bought (Soyibo and Adekanye, 1992). Interest can also be defined as the payment made to a lender by a borrower for the use of a sum of money for certain period of time. The charging of interest on loan was initially abolished during medieval days, both was later legalized by King Henry VIII in 1545 when he abolished the usury laws in it was condemned. These usury laws were established during the medieval time when the payment of interest rate was strongly condemned and termed usury. During that time it was believed that loan was an aid to an individual or neighbour who is distressed, for such reason, they felt charging of interest on loan was not proper (Bhatia and Khatkhate, 2000).

Interest rate deregulation was later introduced into the monetary system by Central Bank of Nigeria, which was part of the Structural Adjustment Program (SAP), which was introduced in July 1986 by the head of state then-Gen Ibrahim Babangida (Osofisan, 2011). Interest can also be said to be the charge assessed for the use of money. It can also be seen as “the payment made to owners of capital fund which they are ready to put at the disposal of others; thus, interest rate is like a price which bring into equilibrium the demand for resources to invest with the readiness to establish from present consumption. Interest rate is determined by the force of demand and supply of capital and for the condition that demand and supply of fund are equal. Hence, interest level is arrived at by the intersection between savings and investment (Luckett, 2012).

Savings is defined as that portion of income after tax, which is not spent on consumption goods. Savings can also be seen as that part of income, which is not devoted to the purchase of household items and firm (McKinnon, 2009). Investment on the other hand can be defined as the expenditure of funds lending to the creation of net additions to the stock of physical capital; it is done almost exclusively by firms. Interest rate favours the investors when the interest rate is low. The major factor that determines investment is interest rate and this is influenced by savings.

The investors will also be favoured when the marginal efficiency of capital is high. Marginal efficiency is defined as the expected rate of returns from additional unit of capital asset. It refers to the expected rate of profit per year on real investment of the most efficient type, it depends upon the entrepreneur expectation of future return. However, there will be no investment of profit expectation which are not very bright, this is the reason why investment falls to a low level during a depression despite all the encouragement to stimulate private investment (Revel, 2012).

Interest rate favours savers when the rate is high, savings were looked upon as beneficial both for the individual and the society at large. Thus, an increase in savings will ultimately lead to an increase in savings of the community. It was due to this effect that the classists believed in thriftiness (Ritter and Siber, 2007). They were of the view that an individual saving was a great private as well as social virtue.

The Nigeria were at a different view, which they advocate that individual savings is a social virtue but rather supported the view that individual savings is greatly a social vice. Increase savings on the part of individuals will result in a general curtailment in the expenditure. When savings increase, investment is very essential for the economic development of an economy. With increase investment, employment is bound to increase which will in turn increase demand, prices, profit and more production expansion. This expansion if properly utilized will lead to economic development of a country (Shaw, 2005).

Investment results as a consequence of capital accumulation, which in turn depends upon savings (Ndulu, 2000). Savings by profit earners and their conversion into investment was the main actor responsible for the economic development of Great Britain in the 19th century. The realization of the role of interest rate in the attainment of monetary policy objectives, the central bank of Nigeria decided to have a uniform rate of interest on loan for all the commercial banks in Nigeria, as contained in its credit guidance of 1969. The credit guidance of the Central Bank of Nigeria was later changed in 1987. It introduced an interest rate policy based on free market forces in view of the effort of government to deregulate the economy in the wake of the second-tier foreign exchange market. This interest rate deregulation is a system where the forces of demand and supply determine the prevailing interest rate. This implies that there is no fixed rate to be charged by the bank on their loans and advances and no given rates to be paid to depositors (Soyibo and Adekanye, 1992).


There are three main approaches in economics to the determination of interest rates. These theories vary in their views on interest rate, although there are some similarities among them, these theories include the following; the classical theory of interest (loanable fund), the liquidity reference theory (Nigeria Approach), the general equilibrium approach (modern). An overview of these theories of interest rate reveals that interest rate can influence the growth of savings and investment in an economy, the understanding of the nature, meaning and role of interest rate in the same economy is crucial, in a nutshell, interest rate is a given prominent position as a catalyst for growth in the economy and particularly a factor in determining the growth of savings and investment (Osofisan, 2015).

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